Tax and financial advice from the Silicon Valley expert.

Does your Roth or IRA owe an income tax?

Many people aren’t aware that “tax exempt” entities, including charities and retirement plans, are subject to income taxes on certain types of income, called “unrelated business income.” How to apply the tax rules for unrelated business income is one of the more complex sections of the income tax laws.

Just because an activity owned by a Roth or IRA is subject to unrelated business income tax doesn’t mean you shouldn’t do it. The key issues are: 1) What is the net return on investment after income taxes and compliance costs?; and 2) What is the risk to get that return? If the return is greater than your other alternatives with a reasonable risk, it can be favorable to go ahead with the activity. With banks paying very low interest for certificates of deposit and the stock market netting flat for the last 10 years, many people will find it hard to keep up with inflation without making alternative investments.

The federal tax form on which the income tax is computed for tax-exempt entities is Form 990-T, Exempt Organization Income Tax Return. You can get a copy of the form and instructions at the IRS web site,

When tax-exempt trusts, like retirement accounts, are subject to the tax on unrelated business income, they are generally taxed under the rules and rates that apply to trusts. The first $1,000 of unrelated business income is not subject to tax. For 2009, taxable income over $11,150 is subject to the 35% maximum federal income tax rate.

For example, when many properties are bought and sold during a tax year in “quick turn” transactions, these transactions may be determined to be a trade or business. (“Occasional” sales of properties, especially without rehabilitation, is not a trade or business. The crossover point from “investor” to “dealer” hasn’t been clearly defined.) The properties are not considered to be held for investment, but for sale to customers in the ordinary course of a trade or business. These transactions and related business expenses should be reported as unrelated business income.

The IRS has recently “looked through” an IRA to find a “wash sale” for a sale of securities by the participant and purchase by the IRA. This may be an indication the IRS could try to aggregate “quick sale” transactions in multiple IRA accounts to find a trade or business, resulting in unrelated business income.

Another type of activity that is probably a business is subdividing land and building homes for resale.

There is a special exception for property purchased by a tax exempt entity from a financial institution in conservatorship or receivership or from the conservator or receiver of such a financial institution. The property must have been identified within the 9-month period beginning on the date of its acquisition as property held for sale, but no more than one-half of property acquired in a single transaction may be designated. The sale must take place before the later of (1) the date 30 months after the date of acquisition of the property, or (2) a date otherwise specified by the IRS. While the property was held by the tax exempt entity, the total expenditures on improvements and development activities included in the basis of the property may not exceed 20% of the net selling price of the property.

Trade or business income of a partnership or an S corporation for which the tax-exempt entity has an ownership interest is unrelated business income. There is a special exception for S corporation employer shares held by an ESOP. IRAs and Roths aren’t permitted shareholders for S corporations anyway.

Any income received from a “controlled entity,” including rental income which would usually not be subject to tax, is taxed as net unrelated trade or business income.

The general rule is rental income from rental real estate is not unrelated business income, but see below about debt-financed income. Rent from personal property that is incidental to renting real estate is also not unrelated business income. To be “incidental,” the rent for the personal property may not exceed 10% of the total rents for all property leased.

Gains from the sale of real estate are also generally not unrelated business income, unless the property is inventory or held for sale to customers for a trade or business, or the gain is debt-financed income.

Unrelated debt-financed income
Real estate is an especially attractive investment vehicle because you can use leverage to enhance your returns. This means you can finance a big portion of the purchase price and control a big value of property with a relatively small cash investment.

When you use leverage to purchase property in an IRA or Roth, a proportionate part of the income, including rental income and gain when the property is sold, is unrelated business taxable income. A percentage (an average of the acquisition indebtedness divided by the average adjusted basis of the property during the period it’s held by the organization during the taxable year) is applied to the income and deductions to compute the amounts to be reported on the unrelated business tax return.

There is a special exception from the unrelated debt-financed income rule for company retirement accounts, including 401(k)s, profit-sharing plans and pension plans (but not Simplified Employee Pensions (SEPs)) and government retirement accounts.

Since the custodian firms for self-directed IRA accounts typically don’t prepare the tax forms for unrelated business income tax, this is an area that tax preparation firms like ours can be of service to clients. To discuss this further, call me, Michael Gray, at 408-918-3161

IRS Circular 230 Disclosure:
As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

Tax and financial advice from the Silicon Valley expert.