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An individual retirement account can invest in a wide range of assets, including units of master limited partnerships. Although IRAs shield investment income from current taxes, MLPs can generate unrelated business taxable income, or UBTI, that can require your IRA to make tax payments.
Unrelated Business Taxable Income (UBTI)
The federal government recognizes that tax-exempt entities would have an unfair advantage if they competed directly with taxpaying businesses. Congress designed UBTI to remove this advantage. Any income not related to the primary purpose of a tax-exempt entity, such as an IRA, can be UBTI. The IRS taxes UBTI using trust rates, which are steep. In 2013 the top trust tax rate of 39.6 percent kicks in on a mere $11,950 of income. The IRS exempts the first $1,000 of UBTI from taxes.
MLPs are publicly traded partnerships that invest in energy, commodities and real estate properties. MLP units trade on a stock exchange. An MLP must pass its income through to unit holders. MLPs can be attractive because of their relatively high yields, often 6 percent or more. Another attraction is that investors can deduct certain MLP expenses, such as depreciation. This gives MLPs tax advantages. Buying an MLP in an IRA wastes these advantages, because IRA investments are tax-free or tax-deferred. Besides UBTI, MLPs can also create tax obligations for IRAs through unrelated debt-financed income, or UDFI.
UDFI is income arising from property purchased with debt. An example would be a real estate MLP taking out a mortgage to purchase rental property. The portion of the property’s income that is UDFI is the percentage of the purchase amount financed through debt. UDFI and UBTI share the same $1,000 exemption and the same reporting requirements. Rental income does not create UBTI or UDFI when it's purchased without debt, so it’s possible for an IRA to invest in certain real estate MLPs without creating a current tax obligation.
Each year, MLP investors receive IRS Form 1065, commonly called a K-1, detailing the previous year’s business income. If your IRA's share of the MLP's annual income exceeds $1,000, your IRA custodian must fill out Form 990-T and file it by April 15. IRA owners should forward copies of their K-1 forms to their IRA custodians. If you anticipate that your IRA will owe taxes of $500 or more in the upcoming year because of UBTI, have your custodian make estimated quarterly payments using Form 990-W. An IRA can request an automatic three-month filing extension for Form 990-T by using Form 8868. The custodian can request a second extension using the same form, but the IRS doesn't approve these requests automatically.
- Internal Revenue Service: Publication 598 Tax on Unrelated Business Income of Exempt Organizations
- Internal Revenue Service: Revenue Procedure 2013-15
- The Street: Cramer on Retirement; Can Master Limited Partnerships Hurt Your IRA?
- Wealth Counsel: The Self-Directed IRA – Part 5; Current IRA Taxes (UBTI & UDFI)
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