Everything You Need to Know About UBIT and UDFI
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Of all the alphabet soup acronyms that self-directed retirement savers have to contend with, three of the oddest are UBIT, UBTI, and UDFI. These terms can be confusing to the many savers who use their self-directed, tax-deferred accounts to invest in businesses that generate income. This article explores some of the questions retirement investors have about this trio of taxing acronyms.
What do the initials UBIT, UBTI, and UDFI stand for?
• UBIT stands for “unrelated business income tax.” This is the tax that the IRS imposes on investments owned by charities or accounts that would otherwise be tax-exempt, like IRAs. The most common triggers for UBIT are retirement plans invested in businesses that generate income that is categorized as “trade or business income” from entities like a limited partnership or LLC. Another income that generates UBIT is real estate purchased within a tax-exempt retirement account that is debt-financed.
• UBTI is the actual “unrelated business taxable income,” that is taxable to the retirement plan.
And just to confuse the issue further, UBIT and UBTI are often used interchangeably. For the purposes of this article, we will use UBIT for both the income and the tax that must be paid.
• UDFI, or “unrelated debt-financed income,” is primarily used in the context of IRA investments that generate income derived from debt-financed real estate or other property owned by the IRA. The UDFI is subject to UBIT.
I thought an IRA was a tax-exempt way to save. Why would I owe taxes on UBIT or UDFI?
The key word here is “unrelated.” The purpose of an IRA is to provide income in retirement and not to run a business. When you use your IRA to invest in, for example, a limited partnership that runs a restaurant, the income generated by the restaurant is, under the IRA rules, unrelated to the purpose of the IRA. On the other hand, the “passive” income generated by your IRA in the form of interest, dividends, rents and royalties for example, are not UBIT, and are not taxable.
Even though the income will be saved in the IRA, the purpose of which is to provide income in retirement? That doesn’t make sense.
Maybe not, but that has been the rule almost as long as IRAs have been around. We are here to explain how the rules affect you, not the wisdom of the rules themselves.
Initially, UBIT was introduced in 1950 to level the tax playing field between businesses conducted by 501(c) nonprofit, tax-exempt organizations and for-profit businesses. Tax exempt businesses that conduct business transactions that are not a part of the reason behind their tax-exemption will generate taxable income. It was extended to IRAs soon after they were created in the 1970s.
How do I know if my IRA owes UBIT?
For UBIT to apply, the income generated must meet all of these criteria:
1. It is derived from a trade or business activity, for example the sale of goods or services.
2. The business occurs regularly, for example you receive monthly or quarterly income.
3. The business activity is not related to the tax-exempt status of the account.
The most common IRA investments that generate UBIT include:
1. Limited partnerships (LP)
2. Limited liability companies (LLC)
3. Investments using a third-party loan and that generated UDFI
If your IRA participates in any of the following activities, you may owe UBIT:
• Materially participating buying and selling a significant number of real estate properties in at least half of a year.
• Conducting operations in businesses—such as restaurants, convenience stores, a hotels, or gas stations, among others—that generate active income and are operated through a pass-through entity like an LLC or LP.
• Making numerous private loans within a single year as a business.
The best way to be certain about whether you owe UBIT is to talk with your tax professional.
How is UDFI calculated?
If your IRA borrows money to purchase a rental property, the percentage of debt compared to the value of the property is applied to the income generated by the property (after expenses are deducted, of course) to determine how much of the income is taxable. The acquisition indebtedness is taxed because, without the loan, the IRA would not have been able to purchase the property.
For example: Your IRA purchases an apartment complex for $200,000 using a loan to pay 50% of the purchase price ($100,000.) That means 50% of the net income is UDFI and will be subject to tax. The percentage of the property under indebtedness will determine the amount of net income received from the property that will be taxed until the loan is paid in full.
See IRS publication 598 to read more about this topic.
How much UBIT or UDFI triggers a tax liability?
You will owe UBIT if the gross income received from the investment is $1,000 or more. Net income is offset by the expenses incurred in the business. In this respect, owing UBIT is an indication that your investment is performing well, doing what it is intended to do: generate income that will support you in comfort when you retire.
For example, if your IRA owns an LLC that operates a horse barn and the LLC is making hay to the tune of $10,000 in net annual income, you will owe UBIT on that $10,000. If the stable has more empty stalls than occupants, and your annual net income dips to $900, you will not owe UBIT. If the LLC borrowed money to purchase the horse barn, that is UDFI and you will owe UBIT on that as well.
I own a rental property in my Real Estate IRA. Do I owe UBIT on the rent it generates?
If your IRA bought the building outright, you do not owe UBIT. Rent and the gains from property sold by an IRA outright, are exempt from UBIT. However, if you used debt to buy the property, you will have UDFI and will owe UBIT. Similarly, if you formed an LLC or LP within your IRA to buy and run the buildings, you may owe UBIT on income that exceeds $1,000.
What is the tax rate for UBIT?
Because an IRA is a trust custodial account, UBIT is taxed using trust tax rates, which are higher than individual tax rates. Talk with your tax professional to find out the current trust tax rates.
Who pays the UBIT, me or the IRA?
Because the investment is owned by the IRA, it is the IRA that is liable for the tax. UBIT will be paid from funds in the IRA and cannot come from your pocket. The IRA will have to file an IRS Form 990-T to report its UBIT. This means the IRA will also need to have its own EIN (employer identification number) under the IRA’s name.
What if there isn’t enough money in the IRA to pay the tax?
In that case, you can rollover or transfer other tax-advantaged money from another retirement plan into the IRA. If eligible you could also make a contribution to the IRA. If you pay the tax out of your own pocket, the IRS considers that to be a contribution to your IRA, subject to the usual annual limitations.
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