Tax Planning

Experts highlight the tax issues every financial adviser should know

Putting alternatives into tax-exempt vehicles

Increase net income without adding risk by placing these typically tax-inefficient assets in retirement accounts

Feb 28, 2017 @ 3:00 pm

By Jeff Kelley

Generating adequate income for clients during their retirement is increasingly a challenge for financial advisers.

Longer life-spans, rising health costs and ineffective safety nets continue to exacerbate this challenge. Increasing allocations to alternative assets is one approach used in today's low-yield environment to provide much-needed diversification as part of a proactive risk-management strategy.

By also considering tax efficiency, advisers can potentially increase returns, while avoiding additional risk. Alternative assets such as real estate investment trusts, mortgage notes, limited partnerships, limited liability corporations, precious metals, joint ventures, actively managed funds and private equity are typically tax-inefficient and are taxed at short-term capital gains or ordinary income-tax rates.

(More: Wealthy clients might be vulnerable to IRS audit)

Moving these assets into tax-exempt vehicles, such as IRAs and other qualified retirement plans, can increase net income, without adding risk to the portfolio.


Certain alternative assets and leveraged investments (e.g., private equity, hedge funds, master limited partnerships) may produce unrelated business taxable income (UBTI), or, if debt financing is used, unrelated debt-financed income (UDFI) when included in IRAs or other tax-exempt vehicles. These assets are popular as income generators, but are likely subject to unrelated business income tax (UBIT). Generally, the two primary investment categories that generate UBTI in retirement accounts are:

• Limited partnerships, limited liability companies and similar pass-through entities, such as partnerships, master limited partnerships and limited liability partnerships that generate business income and issue Schedule K-1s to their investors.

• Debt financing and leveraged investments, most commonly found through real estate investments using non-recourse financing, rather than paying 100% cash from the tax-exempt account.

The IRS grants a deduction on the first $1,000 of UBTI, but if net income from retirement plan investments is $1,000 or more, Form 990-T must be filed. For debt-financed investments, net income is gross income minus gross expenses, multiplied by the debt-financed percentage.

Dividends, interest, royalties, rental income and gains or losses from the sale of property are not subject to UBIT unless debt-financing is involved or the rental income is derived from an unrelated business, such as an LLC or LP. For complete information, see IRS Publication 598.


In many cases, a little-known tax deduction can transform a loss into a gain. This tax deduction is something many investors with UBTI miss, but it is an important benefit to understand — especially as it pertains to entity investments that anticipate losses in the first few years.

When there is a net operating loss, the loss often may be carried back for up to two tax years before the loss occurred, or carried forward for up to 20 years after it occurred. This may nullify a good portion, if not all, of the taxes your client may have otherwise had to pay in years when there was no loss. You can choose which years you want to use the loss to offset any taxes due. According to IRS Publication 536, you may also choose not to carry losses back and only carry them forward.

(More: Estate-tax flux could boost grantor trusts)

To maintain proper records and the flexibility of this added benefit of UBIT compliance, it helps to file Form 990-T each year the investment is held in the account.

The IRS estimates record-keeping and Form 990-T completion could take professional tax preparers approximately 141 hours per year, and many consider it a nightmare. However, it doesn't have to be.

Jeff Kelley is a principal of UBIT Professional.


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