"Unrelated business income" is income from a trade or business, regularly carried on (showing frequency and continuity), that is not substantially related to the purpose of a retirement account. The Unrelated Business Income Tax (UBIT) was created by the IRS to level the playing field for businesses established under the umbrella of a tax-exempt entity, such as a retirement plan, and businesses established without that tax-exempt status. In other words, a business owned by a retirement plan should not have a competitive advantage over a business outside of a retirement plan. Both should shoulder some tax responsibility.
Whether your retirement plan owes UBIT on the real estate assets owned by the IRA depends on whether the property is leveraged and whether certain business structures were established to purchase the property (e.g., partnerships and LLCs). Certain incomes, such as rents and gains from sale of a property owned by an IRA outright, are exempt from UBIT.
UBIT is taxed using trust tax rates. The tax is owed by the IRA, not by you as the account holder. All UBIT must be paid out of the IRA account, not from your personal funds. If there is not enough cash in the IRA, you can transfer or rollover money from other retirement funds into the IRA to pay the tax or make a contribution. If you personally pay the UBIT out of your own pocket, the IRS considers it as a contribution.
A tax-exempt account that has $1,000 or more of gross income from an unrelated business in a 12-month period must file Form 990-T, the Exempt Organization Business Tax Return. Each IRA must file its own 990-T to report income it receives that is subject to taxation. If your IRA invests through a partnership or LLC, be clear about who files the Form 990-T. Tax forms for the partnership or LLC do not replace Form 990-T requirements. The 990-T is filed by the IRA. The IRA will need its own EIN (tax identification number) to report its received income and file the 990-T. Do not use your personal social security number.
Unrelated Debt-Financed Income (UDFI) is generated when an IRA borrows money to purchase a real estate. UDFI is the result of Acquisition Indebtedness (see below) on the part of an IRA. Having UDFI also may require filing a Form 990-T.
If your IRA acquired a debt as a means to purchase an investment such as property, the IRA is considered to have "acquisition indebtedness".
If your IRA borrows money to purchase a rental property, the percentage of debt compared to the value of the property will be 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.
Here’s an example: An IRA purchases an apartment complex for $200,000 using a loan to pay 50 percent of the purchase price ($100,000.) Thus, 50 percent of the net income of the rental property that is part of the acquisition indebtedness will be subject to tax, if the amount is greater than $1,000. The percentage of the property under indebtedness will be taxed until the loan is paid in full.
See IRS publication 598 which explains more about this topic.
To read a case study and more information on calculating UDFI, read Understanding UBIT and UDFI. Be sure to speak with a financial professional if you are considering an investment that may be subject to UBIT.