Since the launch of our Fund 3 in December 2020, we’ve received a lot of questions about a couple of weird acronyms that can be bit of a nuisance. UBIT (Unrelated Business Income Tax”) and UDFI (Unrelated Debt-Financed Income Tax) are two taxes that can apply to your retirement account.

Now, it’s not the end of the world if you have to pay them but knowing about them in advance will help you make smarter investment decisions. Remember, when you’re using a retirement account in general, you’re getting rental income or you sell an asset for profit, you get a capital gain or any interest income it is going to the retirement account and will be tax deferred in a traditional account or tax free if it’s a ROTH.  You get to keep all that money and reinvest everything into the next investment. But UBIT and UDFI are the one caveat to that, where you can get hit with tax and the IRA ends up paying tax and filing its own tax return called the 990-T to the IRS, which is no fun.

You’ve just got to know the rules. You may not like them, but you must be aware before investing!  Even a Roth can end up paying this tax now

This is a fairly important issue that has been litigated for almost one hundred years. It’s about leveling the playing field whenever a nonprofit is going to go play in the business world, not just invest, but play in the business world.  As society’s mouthpiece Congress say’s, you know what, they got to pay their fair share tax because it’s not fair to the regular John Q Public.

So, UBIT is that thing, whether it’s a non-profit charitable entity or an IRA or a Roth or a 401K, is we’re leveling the playing field. if my retirement account goes out and buys a piece of land, sits on it and sells it, that’s capital gain. That’s passive tax, it’s investment. But if my retirement account goes out and buys a restaurant and makes money in that restaurant, it needs to pay its fair share of tax so the other restaurants in town don’t get undercut by the pricing of this other restaurant that’s owned by a retirement account who in effect, could charge less for a chicken fried steak platter because they’re not paying taxes and the restaurant owner across town is upset because they have to charge more because they have to pay tax.

So, a retirement account pays this tax called UBIT when it’s competing in an operational business against other operational businesses. The tax rate, though, is a problem. It’s 37%, which is legal robbery. But, UBIT tax only applies when you’re competing in an operational business if you are not then no worries.

 

Now, one way to avoid/reduce it is what’s called a blocker corporation. In one instance we created an LLC and added a C Corp election to it. Now that Blocker Corp receives that income & pays corporate tax rate of 21% and there might also be a corporate state tax depending on the state. Then the income from the corporation or the Blocker entity, goes down to the IRA as a dividend.  IRAs don’t pay tax on dividend income exempt from UBIT, so in the instance of this client he reduced his tax hit by 16% since it was in Texas where they have no corporate tax. In this instance that 16% savings made the deal he wanted to do worth it.

There are some states that have a state UBIT tax also, like California, Massachusetts, & Illinois. Now, remember, if you do have you to, you will need file a 990-T for the IRA and the IRA pays the tax, not on your personal 1040.  So, think about where to incorporate to offset as much as possible.  Consult with your counsel and tax strategist as our client did and learned that: The franchise tax on a C Corp in Texas is assessed on the gross revenue. And the no tax due threshold the 2020 filing year is $1.18 million. So, if you’re a small Blocker corp. that doesn’t have a ton of revenue, you’re not even going to pay the Texas tax.

Creating an investment portfolio from scratch can be an intimidating prospect, but you can maximize your odds of outstanding profits by following sound investment principles. You’ve worked hard to earn it, now let’s put it to work. Fund 3 offers a preferred return and a profit split, take a look: https://hiscapitalgroup.com/fund3

Next time we’ll tackle UDFI tax……..

Source:  Mark J Kohler

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