If there exists a subject that has the power to frustrate IRA real estate investors, it’s UBIT – or Unrelated Business Income Tax. Many investors shy away from certain IRA real estate investments out of fear that UBIT will take a big chunk out of their earnings. The truth is, there are still gains to be made from IRA investments that incur UBIT – including the ability to earn tax-deferred profits on fix-and-flips.
The Origins of UBIT
UBIT was initially created to “level the playing field” for for-profit businesses in competition with IRA-operated business. IRA-operated businesses all enjoy tax-deferred profits after business tax is paid. Investors may not realize that consistently fixing-and-flipping properties with an IRA account is also seen as an “ongoing business” in the eyes of the IRS. This “ongoing business” also enjoys tax-deferred profits, and can consequently accrue UBIT.
For-profit businesses which do not receive tax-deferred profits can suffer when in competition with these tax-advantaged structures. The IRS created UBIT in an attempt to equalize the advantages that IRA-operated business may have over other for-profit businesses.
The best example of the IRS’ logic behind UBIT can be found in the competition between a non-profit and a for-profit enterprise. An example is as follows:
A college bookstore sells books to students and other clients within the structure of their “non-profit” umbrella. Because the college bookstore is a non-profit, it is not taxed the same way as a for-profit enterprise. A non-profit does not pay taxes on most operations, and therefore can afford to sell books at a lower cost than the for-profit bookstore across the street. Since both the college bookstore and the for-profit bookstore are competing for the same customers, the college bookstore has the advantage of being treated differently for tax purposes. The advantage of this preferential tax treatment may allow the college bookstore to sell their books for less, thus attracting customers away from the for-profit store.
This is where UBIT comes into play: the IRS has placed a tax mechanism on the non-profit enterprise for running a business, i.e. selling books, under the main business of running a college.
This same philosophy and set of rules applies to IRA real estate investments when an IRA owns an “operating business”, which is what the IRS considers an entity that routinely fixes-and-flips real estate properties.
How is UBIT calculated?
UBIT is calculated on a form 990-T, which is a tax-filing form for IRAs. It can be advantageous to fill out this form even if the IRA is not going to incur
any tax, because losses can be used to offset profits in later years.
When an IRA owns an ongoing fix-and-flip business, tax on that business must occur. The tax can be taken at the corporate (C-Corp) level before profits are paid to the IRA (in which case, UBIT would not occur.) Or the company can pay profits to the IRA before business taxes, at which point the IRA would be subject to UBIT.
Unrelated Business Income Tax for most retirement account investments are calculated using the Trust & Estate Tax Rates found on the IRS website. A credible self-directed IRA provider can let you know when your investment strategy may incur UBIT.
The Payoff of UBIT
The payoff involved with UBIT-accruing strategies occurs when a retirement investor realizes that even with UBIT as a cost of doing business, the strategy still allows for greater overall return. Fixing-and-flipping properties with an IRA grants real estate investors unique tax-advantages that they otherwise wouldn’t have access to.
The Conclusion: No Need To Fear UBIT!
When debating the pros and cons of fixing-and-flipping properties within an IRA, investors needn’t be asking, “How do I avoid UBIT?” but rather, “How much will the IRA grow if I fix-and-flip properties and pay UBIT?” or “What is the resulting rate of return within my IRA?”
Dismissing an investment because of the potential payment of taxes can keep an investor from making an otherwise lucrative investment. Consult with your legal and tax advisors regarding investments involving potential UBIT within your IRA.
Written by: Clay Malcolm