What are the tax implications of investing through an SDIRA?

Investing through a Self-Directed IRA (SDIRA) offers unique tax advantages, allowing individuals to grow their retirement savings in a tax-advantaged environment. However, depending on the types of investments and how income is generated, certain tax implications may apply. Understanding these tax rules is essential to maximizing the benefits of an SDIRA while avoiding unintended tax consequences.

Tax-Advantaged Growth

1. Tax-Deferred or Tax-Free Growth

The primary benefit of an SDIRA is that investment earnings grow either tax-deferred (Traditional IRA) or tax-free (Roth IRA):

• Traditional SDIRA: Contributions are typically tax-deductible, but withdrawals in retirement are taxed as ordinary income.
• Roth SDIRA: Contributions are made after-tax, but qualified withdrawals (after age 59½ and five years) are tax-free.

Regardless of the investment type—real estate, private placements, cryptocurrency, or precious metals—gains and income stay within the IRA without immediate taxation.

Potential Tax Liabilities for SDIRA Investments

2. Unrelated Business Income Tax (UBIT) & Unrelated Debt-Financed Income (UDFI)

While most income within an SDIRA is tax-sheltered, certain types of income can trigger tax liabilities, particularly Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI).

Unrelated Business Income Tax (UBIT)

UBIT applies when an SDIRA earns income from an active trade or business instead of passive investment income.

✅ Income NOT Subject to UBIT:

• Rental income (if no debt is used)
• Dividends, interest, and capital gains
• Royalties and most passive investments

🚫 Income That May Trigger UBIT:

• A private business owned by the SDIRA that operates actively
• Certain partnerships generating operating income
• Some real estate investments that involve direct business activities

If an SDIRA earns more than $1,000 in UBIT-taxable income, the IRA must file IRS Form 990-T, and taxes must be paid from IRA funds.

Unrelated Debt-Financed Income (UDFI)

UDFI applies when an SDIRA uses debt (e.g., a non-recourse loan) to acquire an investment, such as leveraged real estate purchases.

Example:

• If an SDIRA buys a rental property with a 50% non-recourse loan, 50% of the rental income and capital gains may be subject to UDFI tax.

Like UBIT, UDFI taxes require the filing of Form 990-T, and any owed tax must be paid from IRA funds.

Distributions & Tax Consequences

3. Taxes on Withdrawals

The tax treatment of SDIRA withdrawals depends on the type of IRA:

✅ Traditional SDIRA

• Withdrawals are taxed as ordinary income at the account holder’s tax rate.
• Required Minimum Distributions (RMDs) begin at age 73.

✅ Roth SDIRA

• Qualified withdrawals (age 59½ + 5-year rule) are 100% tax-free.
• Non-qualified withdrawals may trigger taxes on earnings and a 10% penalty.

🚨 Early Withdrawals (Before 59½)

• Traditional SDIRA: Ordinary income tax + 10% penalty unless an exception applies.
• Roth SDIRA: Contributions can be withdrawn tax-free, but earnings may be taxed/penalized.

Prohibited Transactions & Tax Consequences

4. Engaging in a Prohibited Transaction Can Lead to Severe Tax Penalties

If an SDIRA owner engages in a prohibited transaction—such as self-dealing or transacting with a disqualified person—the entire IRA may be distributed, resulting in:

❌ Immediate taxation of the entire account balance
❌ Early withdrawal penalties (if under 59½)
❌ Potential additional IRS penalties and interest

AET may also treat the asset as distributed, meaning it is removed from the IRA, and the account holder must report it as taxable income.

Tax Reporting Requirements for SDIRA Investments

5. Required Tax Filings

While SDIRA owners generally do not file taxes on IRA investments, certain scenarios require tax reporting:

📌 IRS Form 990-T – Required if an SDIRA generates UBIT or UDFI income over $1,000.
📌 IRS Form 1099-R – Issued when a withdrawal or distribution is taken from the IRA.
📌 IRS Form 5498 – Reports contributions and Fair Market Value (FMV) of the IRA, filed by AET.

Final Thoughts: Navigating SDIRA Taxes

✅ SDIRAs offer tax-deferred or tax-free growth, depending on the IRA type.
⚠ UBIT and UDFI can apply to certain business and debt-financed investments.
❌ Prohibited transactions can trigger severe tax consequences, including full account distribution.
📌 Understanding tax reporting obligations ensures compliance and avoids penalties.

If you're considering an investment that may trigger tax liabilities, it's highly recommended to consult a tax professional. By staying informed, you can make strategic decisions that maximize your SDIRA’s tax advantages while ensuring compliance with IRS regulations.