Self-Directed SEPs and IRAs are wonderful tax shelters for growing investments tax-deferred, or even tax-free in the case of Roth IRAs. Since the financial crises a decade ago already, we recommend all of our wealthy clients move at least some assets to one of the dozens of qualified providers for such accounts. It is amazing the flexibility we all have to avoid taxes—and how much about it we probably don’t understand. However, there are occasions where the income produced by an IRA-owned investment might generate taxes known as Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI). It’s important to know when your IRA itself may need to file the IRS 990-T Form.
Basically, UBTI occurs when a retirement account earns active business income, which is considered unrelated business income under federal tax law and is subject to its own tax. This might occur if you owned a Manufactured Home Community and cross-sale ancillary services such as WIFI, laundry, or pet sitting. UDFI occurs when a retirement account owns a real estate property that is debt-financed (with a non-recourse promissory note) and the property generates income. Believe it or not, there are still lenders willing to loan us money! Next time you run into one, will you send them my way?
Hopefully, your custodian will be able to recognize when a Form 990-T is necessary, but the IRS puts the onus on the IRA owner. At the end of each year, the investment sponsor must report each investor’s financial information on a Schedule K-1 or IRS Form 1065. This information needs to make its way to the custodian one way or another, either by you or the sponsor. Again, make sure you know who is responsible for this part of the process. If your K-1 shows a loss in the early years as many projects do, file a 990-T anyway. You’ll be able to write off future gains with the earlier losses.
It may seem like a lot of work (and this is where a great custodian can earn their fees), but just remember all of your best real estate investments. Had they been done in a Self-Directed SEP, IRA, or even better, a Roth IRA, just imagine how big a deal you’d be doing today. Feel free to reach out for recommendations to some of the custodians we’ve worked with over the years.