UBTI Blockers for Retirement Accounts

Alternative investment strategies inside tax-exempt entities like retirement accounts often carry a special type of tax that is unfamiliar to most investors. Unrelated Business Taxable Income (UBTI) is income not “substantially related” to the purpose of a tax-exempt entity. The IRS levies an additional tax on this type of income, and investors using tax-exempt structures to invest in alternatives need to be aware of this tax and the common approaches to UBTI mitigation.

Additionally, using leverage inside most tax-exempt accounts to acquire or improve property produces Unrelated Debt-Financed Income (UDFI), which proportionately converts investment income to UBTI. So if you purchase real estate in your retirement account financing 60% of the acquisition, then roughly 60% of the income, both rents and capital gains, is considered UBTI. Importantly, paying off the loan more than 12 months before selling takes the capital gains out of UDFI.

UBIT, or unrelated business income tax, is the tax that is levied against UBTI. So UBTI is the income; UBIT is the tax. There is a three-pronged test to determine whether UBTI is generated, but as the “U” in UBTI indicates, if the income comes from a trade or business that is both regularly carried on and unrelated to the purpose of the tax-exempt entity, UBTI is generated.

For example, if a retirement account holds an interest in a private operating business through an LLC or partnership, the income generated from these investments is likely UBTI. Similarly, many private equity funds generate UBTI because the PE structure is typically a pass-through entity holding interests in many different operating businesses. This is different from a non-profit hospital charging fees. Yes, that income is regularly earned, but the hospital fees are directly related to the purpose of the tax-exempt organization and are therefore not taxed.

For retirement accounts, UBTI is taxed at trust tax rates, which climb to 37% on income above roughly $15,000. The goal for investors has been to structure investments so that UBTI is mitigated, if not eliminated.

The C corporation blocker

One common strategy is to form a C corporation and fund it with retirement dollars, effectively owning the C corp within the retirement account. The C corp tax rate is a flat 21%, or more if there are state tax consequences as well. This strategy reduces the yearly UBTI tax drag from 37% to 21% on income over $15,000. The income can be reinvested directly from the C corp or sent back to the retirement account as dividends. Importantly, the retirement account is not taxed on those dividends as income; they are taxed either when the funds are withdrawn during retirement, as is the case for a traditional IRA, or never, as in the case of a Roth IRA.

Foreign corporation blockers

For retirement accounts investing in offshore alternatives with UBTI exposure, a foreign corporation can serve as the blocker instead of a domestic C corp. The structure is typically a corporation formed in a zero-tax jurisdiction. Alternative investments and any leverage live inside the foreign corporation while the UBTI they generate is trapped there rather than flowing up to the retirement account. A domestic blocker pays 21% federal tax on its income, while a foreign blocker in a zero-tax jurisdiction pays no entity-level income tax at all.

There are two catches with foreign blocker entities. Generally there is withholding tax of 30% on U.S.-source income such as dividends and certain interest paid to a foreign corporation. This makes a foreign blocker less efficient than the C corp for holding U.S.-source investments, and it is best reserved for offshore assets, where the withholding does not apply. The second catch is overhead. A foreign blocker brings significant U.S. reporting. Offshore administration, including directors and a registered office adds further cost. Because of this, the foreign blockers generally only makes sense for larger accounts, where eliminating the C corp drag justifies the compliance burden.

The Solo 401(k) real estate carve-out

Solo 401(k) can avoid UDFI on leveraged real estate entirely. There is a statutory carve-out that lets a “qualified organizations” treat debt on real property as if it were not acquisition indebtedness. Qualified organizations include 401 plans, defined benefit plans, and profit-sharing plans, as well as a few others. Congress added this carve out in 1980 because pension funds are enormous real estate investors, and wanted to let that capital flow cleanly into leveraged real estate without UBTI. The carve-out only applies to real property, so leverage cannot be used to purchase marketable securities without triggering UDFI.

REITs as a built-in UBTI blocker

REITs are a built-in UBTI blocker for retirement accounts, and they beat the C corp blocker on tax drag. REIT dividends are passive income excluded from UBTI. Additionally, all the leverage sits within the REIT, making the REIT shares themselves unleveraged. As such, retirement accounts can hold highly leveraged real estate and receive dividends from the REIT without UBTI exposure. REITs must meet structural requirements, including a minimum of 100 shareholders and a prohibition on five or fewer individuals holding more than 50% of shares.

UBTI beyond retirement accounts

Other tax-exempt structures, like charitable trusts, need to consider UBTI. Most institutional hedge funds and private equity firms offer UBTI blocker share classes, often via offshore structures in jurisdictions with zero corporate tax. This achieves the UBTI blocking without the administrative overhead of forming and administering your own foreign entity.

Related reading

• What Is a Self-Directed IRA?
• SDIRA Prohibited Transactions
• Holding REITs in Retirement Accounts
• Roth IRA Conversion Guide
• Types of Self-Directed Retirement Accounts

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Sources

• IRS — Unrelated Business Income Tax (overview)
• IRS — Publication 598, Tax on Unrelated Business Income of Exempt Organizations
• 26 U.S. Code § 512 — Unrelated business taxable income (Cornell LII)
• 26 U.S. Code § 514 — Unrelated debt-financed income (Cornell LII)
• IRS — IRC 514, Unrelated Debt-Financed Income (history of the §514(c)(9) carve-out)
• 26 U.S. Code § 11 — Tax imposed on corporations (Cornell LII)
• 26 U.S. Code § 952 — Subpart F income / controlled foreign corporations (Cornell LII)
• IRS (TE/GE) — Tax Cuts and Jobs Act: Foreign Dividends, Subpart F and GILTI as dividends excluded from UBTI
• SEC Investor.gov — Real Estate Investment Trusts (REITs)
• SEC — Investor Bulletin: Real Estate Investment Trusts (REIT qualification requirements)