Selected Federal Income Tax Issues of Self-Directed IRAs

Federal Income Taxation of Income Earned by (i.e. within) an IRA
A. Generally, federal income tax on income earned by an IRA is deferred until it is distributed to the IRA owner. IRC § 408(e).

1. Of course, if it’s a Roth IRA, then subject to certain requirements, distributions are also exempt from Federal income tax. IRC § 408A(d).

B. However, IRA’s are subject to the unrelated business taxable income (“UBTI”) rules of IRC § 511-514. IRC § 408(e)(l), second sentence.

UBTI
A. The UBTI rules generally take the approach that any income from any business activity not substantially related to the purposes of the entity’s tax exemption is income from an “unrelated business,” but exempt out all common forms of passive investment income. See IRC § 512 and 513.

1. The UBTI rules specifically provide that in order not to constitute an unrelated business under the “substantially related” test, an activity must be substantially related to the purpose of the entity conducting the business activity in a way other than raising funds needed by the entity to pursue its exempt purpose. IRC § 5 13(a). Since an IRA has no purpose other than to earn funds to provide the IRA owner with retirement income, any income of an IRA will be UBTI unless the income falls under one of the exempt passive income categories.
   
   
2. There is no tax on the first $1,000 of UBTI in a taxable year. TRC § 512(b)(12).

B. The categories exempt from UBTI are:

1. Dividends, interest, payments with respect to securities loans, amounts received as compensation for agreeing to make loans, and annuities. IRC § 512(b)(1).
   
   
2. Royalties. IRC § 512(b)(2). Some royalties involving substantial personal services (i.e. intellectual property) may be subject to UBTI.
   
   
3. Rents from real property and from personal property incidental to real property. IRC § 512 (b)(3).
   
   a. Rents received for real property are not exempt if more than 50% of the total rent received under the lease is attributable to personal property. IRC § 51 2(b)(3)(B)(I).
   
   b. Hotel room rents and parking fees are UBTI because considered to be primarily for services.
   
   c. Participating rent (i.e., where “the amount of ... rent depends in whole or in part on the income or profits [of the lessee]”) is UBTI. IRC § 512(b)(3)(B)(ii).
   
   
4. Gains from the sale of real or personal property are exempt unless the IRA holds an inventory of such property or the property was held primarily for sale to customers in the ordinary course of the trade or business of the IRA. IRC § 512(b)(5).
   
   a. This is basically the same rule as for determining whether a taxable entity realizes ordinary income or capital gain on the sale of property.
   
   b. In one case, e.g. the repeated purchase, fix-up, and sale of distressed homes, can you avoid problem by having multiple IRA's.
   
   c. In other cases, e.g. match-up between an IRA and a real estate developer, is contingent interest (i.e., an “equity kicker”) exempt interest or is it disguised nonexempt income from a development partnership?
   
   
5. Leveraged investments will generally produce UBTI under the “debt-financed property” rules. IRC § 512(b)(4).
   
   a. The amount of rent from debt-financed property that is subject to tax is proportional to the percentage of the property’s purchase price that is debt-financed. IRC § 514(a)(1).
   
   b. Importantly, the IRC § 514(c)(9) exception to UBTI treatment for debt-financed real estate that generally applies to tax-exempt charities and employer-sponsored pension and profit sharing plans DOES NOT apply to IRA’s. See IRC § 514(c)(9)(C).
   
   (1) Therefore, subject to the $1,000 deduction of IRC § 512(b)(12), leveraged property owned directly by an IRA, including leveraged real estate, will generally cause the IRA to have UBTI and be required to file a federal income taxreturn and pay tax.

The Prohibited Transaction Rules of IRC § 4975
The prohibited transaction rules of IRC § 4975, generally do not prohibit IRA’s from investing in any particular class of assets, or investment activity, but instead prohibit IRA’s from engaging in business transactions directly or indirectly with certain insiders to the IRA, called "disqualified persons."

A. IRC § 4975 is reproduced as Exhibit A to this outline.

B. While IRC § 4975(a) and (b) impose excises taxes on prohibited transactions, in the case of a prohibited transaction involving an IRA and the IRA’s owner, the IRA is treated as losing its tax exemption and distributing all of its assets to the IRA owner. IRC § 408(e)(2).

Copyright 2005, Luke Bailey, Partner Strasburger & Price, LLP Dallas, TX from Selected Federal Income Tax and Other Legal Issues of Self-Directed IRA’s by Luke Bailey, Partner Strasburger & Price, LLP Dallas, TX Contact: (214) 651-4572 or luke.bailey@strasburger.com