Tax Requirements for a Self-Directed IRA

We get asked a lot, “Does a Self-Directed IRA file a tax return?” In most cases, no, your IRA does not file a tax return. But that doesn’t mean you are off the hook when it comes to your IRA and its investments. Depending on the investments you make, you may be subject to taxes even though the plan is tax-advantaged. For example, you borrow funds to buy real estate with your IRA, you would be subject to the UBTI tax. If you don’t owe UBTI, you will likely fill out a simple valuation form as explained below. In the following, we’ll discuss the tax requirements for a Self-Directed IRA.

Introduction to Individual Retirement Accounts

Individual Retirement Accounts (IRAs) are a popular way for individuals to save for retirement, with tax benefits and flexibility in investment options. A Self-Directed IRA (SDIRA) is a type of IRA that allows account holders to invest in alternative assets, like real estate, precious metals and private placements. A Checkbook IRA give you full control of the account, meaning you do not need custodial consent to make investments.

SDIRAs are subject to the same rules and regulations as traditional IRAs, but offer more control and flexibility for investors. With a Self-Directed IRA, account holders can diversify their investment portfolios and potentially increase their retirement savings. It’s important for retirement investors to understand the tax implications, including Unrelated Business Taxable Income (UBTI) and Unrelated Debt Financed Income (UDFI) to be in compliance with IRS regulations.

What forms do I need to file for my IRA?

Let’s back up a bit:

First, you need to know that your LLC (Limited Liability Company) is owned by your IRA account — not by you personally. This is a key distinction and a foundational rule when setting up a Checkbook IRA (also known as an IRA LLC).

Second, IRAs are not taxed, no matter what type of account you open — regular IRAs, Self-Directed IRA, Checkbook IRA, etc. The taxation of your IRA withdrawals depends on the type of IRA you have. If it’s a traditional plan, contributions are taxed during withdrawals. Ideally, the withdrawal is made when you are 59 1/2 or older. If you make a withdrawal prior to that age and it’s not permitted, you will get a 10% early withdrawal penalty. If you have a Roth IRA, the account is funded with after-tax money. Qualified distributions are tax free!

Third, there is a difference between a single-member LLC and a multi-member LLC. A single-member LLC has one owner — in the case of a Checkbook IRA, that’s your IRA — and it’s typically treated as a disregarded entity for tax purposes, meaning it’s tax-neutral and simpler to manage. A multi-member LLC, on the other hand, has two or more owners and is generally treated as a partnership for tax purposes

Multi-Member LLC vs Single Member LLC

A single-member LLC is a Limited Liability Company holding one set of IRA funds, often referred to as an IRA-owned LLC or Checkbook IRA LLC. In other words, the LLC only contains funds from one IRA owned by a single individual. This structure is simpler for tax reporting purposes—typically treated as a “disregarded entity” for federal tax purposes—meaning it doesn’t file a separate return.

The IRA account holder may serve as manager of the LLC, and can also appoint a co-manager, as long as the co-manager does not contribute IRA or personal funds into the LLC. It’s crucial that all capital in the LLC comes from one IRA to maintain single-member status and stay compliant with IRS rules.

A multi-member LLC, on the other hand, is defined as a Limited Liability Company with two or more separate ownership interests. This could mean:

• More than one person (e.g., a husband and wife, business partners, or family members) contributing IRA funds into the LLC
• More than one type of IRA or retirement plan funding the LLC (e.g., one person using both a Traditional IRA and a Roth IRA)
• Two or more retirement accounts from the same person or different people—such as a Solo 401(k) and a SEP IRA—participating as members of the LLC

Because there are multiple funding sources or owners, a multi-member LLC is typically treated as a partnership for tax purposes and must file IRS Form 1065 annually, along with issuing K-1s to each member, even if no taxes are due.

Multi-member LLCs can offer greater investment flexibility and allow families or partners to pool retirement funds—but they come with added complexity and the need for careful compliance and tax reporting.

Prohibited Transactions and Disqualified Persons

Prohibited transactions in a Self-Directed IRA can result in significant tax consequences, including the loss of tax-exempt status. The IRS prohibits certain transactions, such as investing in life insurance, collectibles and S-Corporations. Disqualified persons, including close family members and fiduciaries, are also subject to restrictions.

For example, a disqualified person cannot provide services or goods to the SDIRA, and cannot receive compensation from the SDIRA. It’s important for account holders to understand the rules and regulations surrounding prohibited transactions and disqualified persons to avoid any potential issues. A financial advisor can provide investment advice and help SDIRA account holders navigate the complexities of prohibited transactions and disqualified persons.

UBTI and UDFI

There are two specific tax requirements when investing with a Self-Directed IRA. Understanding how UBTI and UDFI affect your IRA’s income is crucial for compliance with IRS regulations. UBTI, is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it.” Basically, if your IRA owns a business, such as a restaurant, you will be subject to UBTI.

When it comes to real estate investing, you may or may not be subject to UBTI. Rental income from real property is considered passive income and is not subject to UBTI. However, if you buy and sell many real estate properties throughout the year, this may be considered an active business and you will owe taxes.

Speaking of real estate, UDFI is another type of UBTI. If you use a loan to acquire a property with your Self-Directed IRA, the income generated by the property is taxed. For example, you use a non-recourse loan to purchase 50% of a property, then half of the income generated from it will be subject to taxes. If you owe UBTI and/or UDFI taxes, you will need to file the appropriate forms with the IRS. See Below.

No UBTI or UDFI Taxes

You don’t need to file any tax forms with the IRS if your LLC is a single-member LLC. Your IRA is generally considered a tax-exempt organization, which means it is not subject to federal income taxes.

The IRS requires an annual valuation of the LLC and its assets. Your passive custodian will send you the valuation form (Form 5498) to complete and will file it with the IRS on your behalf. This is how the IRS keeps record of your Self-Directed IRA, its value, and holdings.

With a multi-member LLC, you are required to file Form 1065 with the IRS. However, no taxes are due.

Related: Fair Market Value in a Self-Directed IRA

You Owe UBTI or UDFI Taxes

Generally, there are two main reasons you might owe taxes on your Self-Directed IRA in any given year. The most common is when the account earns UBTI. This type of income—often generated from active business activities or leveraged real estate investments—can trigger tax liabilities that require the filing of IRS Form 990-T.

If your Self-Directed IRA does generate UBTI or related taxable income, you are responsible for ensuring the proper tax filings are made. While the IRA itself is a tax-advantaged vehicle, any taxes owed due to UBTI must still be paid annually using funds held within the IRA, not from your personal assets. This is an important distinction, as paying taxes from outside the IRA could be considered a prohibited transaction.

Because one of the primary benefits of using an IRA is to enjoy tax-deferred or even tax-free growth (in the case of a Roth IRA), it’s generally best to avoid investments that could lead to UBTI. Proper planning—especially when considering real estate or business investments—can help you structure your IRA activities to stay within the tax-free or tax-deferred lanes.

State Taxes

While the IRS governs Self-Directed IRAs at the federal level, state taxes vary. Some states tax SDIRA income, others don’t. Account holders need to understand the state tax laws and regulations in their area to comply.

For example, some states tax UBTI or UDFI, others don’t. A tax professional can help investors navigate the state taxes and ensure they are in compliance. They should also be aware of the tax liability on their investments, including income tax and taxes on investments.

Common Mistakes to Avoid

Self-Directed IRA investors can avoid common and costly mistakes by understanding the IRS rules that govern these accounts. While SDIRAs offer more investment flexibility than regular IRAs, that flexibility comes with greater responsibility.

One of the most frequent—and serious—mistakes is failing to file required tax forms. For example:

• Form 990-T must be filed if the IRA generates UBTI/UDFI over $1,000 in a given year.
• Form 8606 is required in certain cases when making nondeductible contributions or handling Roth conversions, and failing to file it properly can lead to double taxation.

Another common error is investing in prohibited assets or transactions. The IRS specifically prohibits IRAs from investing in collectibles, life insurance policies, and engaging in self-dealing transactions.

Beyond regulatory compliance, investors should also be aware of the risks associated with alternative investments. These can include real estate, private equity, precious metals, or cryptocurrency. While potentially lucrative, these investments may carry higher risk, less liquidity, and more complex due diligence requirements. Diversification is key to managing risk and protecting long-term retirement goals.

To avoid missteps, it’s wise to work with a knowledgeable financial advisor and a tax professional familiar with Self-Directed IRAs. These professionals can help ensure that your investments stay within IRS guidelines, your filings are accurate and timely, and your strategy is aligned with your risk tolerance and retirement timeline.

Lastly, maintaining accurate records is crucial. You should keep detailed documentation of all income earned, expenses paid, and investments made. These records are essential not just for tracking performance, but for demonstrating compliance in the event of an IRS audit.

Summary: Tax Requirements for a Self-Directed IRA

While Self-Directed IRAs offer powerful tax advantages and investment flexibility, they still come with important tax responsibilities. Most SDIRAs don’t file annual tax returns, but depending on the type of investment, taxes may still apply—especially in cases involving leverage or active business income.

Investors must understand when IRS forms like 990-T, 1065, or 8606 are required, particularly in situations involving UBTI or UDFI. Failing to comply can lead to taxes, penalties, or disqualification of the IRA. By working with a tax advisor and staying aware of IRS rules, IRA investors can maximize benefits while staying compliant.

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