Understanding UBIT, UDFI & UBTI

What Do These Terms Mean?

UBIT

Unrelated Business Income Tax (UBIT) is often misunderstood by self-directed IRA investors and their professional advisors. In essence, UBIT is a tax that is due to an IRA when it receives “business income” as opposed to “investment income.” 

UBIT is a cost of doing business for an IRA, HSA, or 401(k) when that account utilizes a few particular investment structures. Some investors are hesitant to invest in a manner that may incur UBIT because they see it as wrong or as a penalty. In reality, it’s not prohibited, and it’s not a penalty. That said, it is a tax that may affect your ROI. Therefore, it is important to know how UBIT works in order to choose your best investment strategy.

UDFI

Unrelated Debt-Financed Income (UDFI) is generated when an IRA borrows money to purchase property. UDFI is the result of Acquisition Indebtedness on the portion the IRA investment purchased using a loan.

UBTI

Unrelated Business Taxable Income (UBTI) is income earned by a tax-exempt entity, such as an IRA, that is not related to the exempt purpose of the tax-exempt entity.

When Would My Investment Incur UBIT?

Passthrough Business

Passthrough businesses don’t pay taxes at the corporate level— they pass those taxes through to their investors. If your self-directed account derives earnings (Unrelated Business Taxable Income or UBTI) from such a business, it will have to pay taxes on any income attributable to the investment.

Important to keep in mind:

• Your IRA will never have to pay UBIT if the business it has invested in pays taxes at the corporate level.
• It is important to distinguish between an asset and a company that makes money on an asset. For instance, your IRA could acquire land for oil extraction (no UBIT) or invest in a privately traded oil company (possible UBIT).

Debt-Leveraged Property

If your account took out a non-recourse loan to purchase property, any earnings yielded from the leveraged portion of the asset (Unrelated Debt-Financed Income or UDFI) may incur UBIT.

For example:

• Your IRA holds a rental property. It paid cash for half and financed the other half (50%).
• The rental property earns $10,000 in a given year. Since the debt percentage is 50%, half of those earnings ($5,000) will be taxed at the current UBIT rate.

The debt percentages from each of the previous 12 months will be averaged to represent the single debt percentage for that year. Profits garnered from the sale of a debt-leveraged property will also be subject to UBIT, but not at the current Trust Rate. Such profits would be taxed as capital gains.

Things to Remember on UBIT Generated by UDFI

• For profit created by debt leverage on a property, the outstanding debt percentage is calculated by averaging the previous 12 full months’ debt percentage
• The debt percentage at the time of sale of a property is considered to be the highest debt percentage in any of the 12 full months prior to the sale date
• Can do a 1031 exchange within IRA to defer UBIT from the sale of a property
• When calculating UBIT, the IRA can offset net profits in a year with losses claimed in earlier years
• UDFI incurred at sale of real estate is a combination of sec. 1250 gain and short or long-term capital gains (depending on how long IRA owned property)
• When calculating potential UBIT, the IRA can offset net profits in a year with losses claimed in earlier years
• Review your K-1 for possible UBTI
• “Fix-n-Flip” real estate income is generally considered to be operating income
• UBTI pays UBIT at Trust and Estate Rate
• Ongoing UDFI pays UBIT at Trust and Estate Rate

Consider These 7 Ways to Lessen the Impact of UBIT or Avoid it Altogether

1. Have your IRA buy real estate with 100% cash from the account. UBIT from debt is levied on UDFI, the net profit that corresponds to the outstanding debt-leveraged percentage. So, if there is no debt, there will be no UBIT calculation.
2. Solo 401(k)s generally do not have to pay UBIT from UDFI.
3. Partner instead of leverage. Partnering is a way to participate in an asset that costs more than your IRA has without using debt leverage. An IRA can partner with both disqualified and non-disqualified persons.
4. Use losses from previous years to offset profits in the current year. Losses from an IRA in a given year can be “banked” to use in later years to offset profits.
5. Pay down debt leverage. By decreasing the debt percentage, the overall tax paid by your IRA will be less. Keep in mind that your IRA can use earnings from its other investments to pay down this debt if desired.
6. Pay off debt leverage12 months prior to the sale of an IRA owned property. The percentage of debt leverage with which UDFI is calculated is the debt leverage percentage of the month that is the highest amongst the previous 12 months. So, if your IRA sells its property 12 full months after it has paid off its debt leverage, no UBIT will occur on sale profits.
7. When investing in an ongoing business, choose a C-Corp. If the corporate entity is paying “business” tax before profits are disbursed to investors (including IRA investors), then no UBIT from UBTI will occur.

Owe UBIT? Here's What You'll Need to Do

If your IRA earned operating income from a pass-through entity or debt-leveraged property, your account may owe unrelated business income tax (UBIT). The pass-through entity in which your self-directed retirement account is invested should issue a Schedule K-1 to report the net UBTI gain (or loss) attributed to your IRA’s investment. You may also ask the entity managers to help determine whether or not your IRA earnings qualify as UBTI. 

If you and your financial team determine that your IRA owes UBIT, you must file a Form 990-T on behalf of your account. New Direction does not prepare or file these forms but may sign Form 990-T on behalf of your IRA.