Most people we speak with understand the basics of Self-Directed IRA taxation. That is, they know that traditional Self-Directed IRAs have tax-deductible contributions (assuming you meet the income threshold) of $5,500 per year and $6,500 per year if you are age 50 or older. They also understand distributions are taxable, that they are mandatory beginning April 1st of the year after the year in which you turn age 70½, and that a 10 percent penalty applies to withdrawals if you are under age 59 ½, unless certain hardship provisions apply or unless you are making substantially equal periodic withdrawals in accordance with Section 72(t) of the United States Tax Code.
They understand that Self-Directed Roth IRAs operate with after tax contributions, and that as long as the money is left to grow in the account for at least five years, the assets grow tax free, and withdrawals are tax-free in retirement.
But that just applies to investments funded with your own money.
Once you start using other peoples’ money to fund your Self-Directed IRA investments – that is, your IRA is borrowing money to invest – things change. You may be taxed in the current year on income and gains attributable not to your own money, but to borrowed money within your Self-Directed IRA.
Many Self-Directed IRA owners get taken by surprise by this tax, but it is really just designed to level the playing field so that tax-exempt organization-owned and Self-Directed IRA-owned businesses do not gain an unfair advantage over taxable competition.
UBTI (Unrelated Business Taxable Income)
Whenever a tax-exempt or pass-through entity, such as a Self-Directed IRA, owns a business or uses borrowed money, unrelated business taxable income, or UBTI, may come into play. The tax applies to whatever gains or profits are realized during the year that are attributable to the leverage within your account. This applies to real estate investments as well.
You use your Self-Directed IRA to purchase a real estate investment worth $500,000. You put up 40 percent and take out a non-recourse mortgage for the rest. That property is the only investment in your Self-Directed IRA account.
That year, you take in $50,000 in rental income from the property. But you only have 40 percent equity in it. So only 40 percent of your income, or $20,000, is tax-deferred. You may owe taxes on the rest, since it was not your Self-Directed IRA’s money that generated that income. It is other peoples’ money! The IRS considers the other $30,000 to be unrelated debt-financed income, which is taxable.
If your Self-Directed IRA owned a business and leveraged the business to increase potential profits, it would have to pay taxes on the income attributable to the leverage as well.
Similar rules apply if you sell the property – Gain attributable to your own equity will be tax-deferred or tax-free if it is in a Self-Directed Roth IRA. But gain attributable to other peoples’ money may be taxable.