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Does Your IRA Owe Tax?

Do you look at your IRA or other retirement accounts as a good place to try out your aggressive investment strategies without worrying about current tax consequences? If you do, watch out — a wrong move could make you pay tax on income that stays in your retirement plan.

Few people realize that these tax-sheltered plans are subject to current tax on “unrelated business taxable income” (UBTI). The UBTI rules were put in place to prevent exempt organizations such as churches, schools and charities from running for-profit businesses that have an unfair competitive advantage against taxpaying entities. IRAs and other tax-qualified retirement plans are likewise subject to the UBTI rules.

No problem, you say: My IRA is just a passive investor, not an active business operator. You still are not safe. Investments in corporations or mutual funds are fine, but investments in partnerships — general or limited — will often generate UBTI. The IRS underlined that point in a recent ruling, PLR 9703026, which held that a 3.32% interest in a limited partnership engaged in a tire retailing business would generate UBTI on which the IRA must pay current income taxes. The IRA is exempt, however, from tax on the first $1,000 of UBTI.

Another problem area is debt-financed property. The same letter ruling held that rental income from a warehouse that is acquired subject to a mortgage also constitutes UBTI. Likewise, the ruling points out, securities acquired in margin might yield debt-financed income subject to the tax on UBTI.

A separate ruling, PLR 9703027, concluded that income from short sales of securities is not debt-financed and is not classified as UBTI. But this ruling described an arrangement in which the retirement plan carefully avoided borrowing any of the funds that are used to cover the margin requirements on the short sales. A less-carefully structured plan might also run afoul of the UBTI rules.

Today’s lesson: Your tax-sheltered retirement account may be less sheltered than you think. Be careful.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us” and Chapter 4, “The Family Business."

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