UDFI, UBTI, and UBIT...What's the Difference, and What Do They Mean for My IRA?

Patricia McCrystal
February 25th, 2016


Some retirement investors are hesitant to invest in assets that may incur UBIT (Click to Learn More), or Unrelated Business Income Tax, because they see it as a penalty or as excessive tax. However, in the case of retirement accounts, UBIT means the account is making money. It is not a penalty, but a cost of doing business.

When Does UBIT Occur?

First, UBIT can occur when owning a “pass-through” or untaxed entity that owns and operates a business.
UBIT can also occur on debt-financed IRA purchases. This could include when the investment uses leverage like a non-recourse loan for real estate, or if the IRA invests in a company that uses debt-leverage. In both cases, the percentage of profits that is derived from the debt-leverage could incur UBIT. For real estate, if a property has outstanding debt-leverage associated with it when it’s sold, UBIT would apply to the debt-leveraged profits.

Unrelated Debt-Financed Income (UDFI) and Unrelated Business Taxable Income (UBTI) trigger UBIT. UDFI occurs when an IRA takes out a loan in order to increase its buying power. Debt-leverage can be used to purchase a rental property that the IRA does not have the funds to cover. The loan must be a non-recourse loan, and the collateral that’s associated with that loan is the “subject asset.”

There are two chunks of money associated with the purchasing of the asset, which make up two different percentages of ownership. The first is the down payment, which comes directly from the IRA money that’s been contributed to the IRA through annual contributions. The second is the debt-leveraged money that comes from outside the IRA. UBIT only applies to the percentage of the net-income that’s attributed to debt-financing, after deductions (including depreciation). You can take deductions like depreciation and expenses to try to mitigate the amount of net income that is subject to UBIT.

UBIT also applies to rental income from real property as the property moves through time. Form 990-T is like a 1040 for your IRA. This form functions as the tax-return for your IRA, where you calculate if UBIT is due. Upon sale of the IRA property, UBIT applies to the sale of a property based on the debt-leveraged portion.

UBTI occurs when an IRA invests in an operating business or an entity that is operating a business (such as an LLC, LLP, etc.), if it’s not paying business tax, UBIT will probably occur on all profits associated with that business. Almost any business your IRA would invest in would not be part of the tax-exempt purpose of UBIT (to level the playing field for businesses in competition with non-profits). So if you invest in a business with your IRA, make sure you file a 990-T and calculate UBIT.
 
Believe it or not, fix-and-flip projects can be considered an ongoing business, even if there is not debt-leverage associated with it. Therefore, investors who perform fix-and-flips may incur UBIT.

Why Use Leverage if it Might Trigger UBIT?

Despite UBIT, with leverage you can still make more money (Click to Learn More) for your IRA than you would have without it. Debt-leverage is the only strategy allowed by the IRS that will let you make money on money that you didn’t have to contribute to the IRA for your retirement. Unlike debt-leverage, all the other money put into your IRA had to follow annual contribution limits.
When considering whether or not you should leverage your IRA to make a real estate purchase, do the calculations. Some factors to consider include but are not limited to:
  • Rental income & vacancy
  • Operating Expenses
  • Reserves for Contingencies
  • Percentage Loan to Value
  • Bank Terms
  • Future Appreciation
As the account holder, it’s up to you to decide about your IRA’s participation in debt-leverage and subsequently UBIT. If you loan money to an entity, you won’t accrue UBIT. However, if you buy private equity in an entity that owns a business with debt-leverage, it is possible for UBIT to apply. If you buy property without leverage, you will avoid UBIT. If you buy a larger and potentially more lucrative property with leverage, UBIT is once again possible.
 
Because UBIT is not incurred by the IRA receiving income such as dividends resulting from C-Corp stock, rent from real property, or interest from an IRA loan , it is possible to avoid UBIT even when you invest in an ongoing business or real estate.
 
Consider these seven ways to lessen the impact of UBIT, or to avoid it altogether:

1. Have your IRA buy real estate with 100% cash from the account. UBIT is levied on the debt-leveraged portion of net income of an asset. So you will only need to consider UBIT if you take out a loan. Leverage can be a valuable tool to increase the buying power of an IRA, and in many cases UBIT assessed on debt-leveraged profit will be far less than the overall monetary growth of the account. However, if your aim to is to eliminate UBIT, don’t use leverage.
 
2. Use a Solo 401(k) for debt-leveraged real estate. Typically, UBIT is assessed on UDFI in an IRA. However, with Solo 401(k)s this is not the case.
 
3. Partner instead of leverage.  Partnering is a way to increase the buying power of your account without using debt leverage. An IRA can partner with both disqualified and non-disqualified persons/entities.
 
4. Use losses from previous years to offset profits in the current year. Net losses from an IRA in a given year can be “banked” to use in later years to offset profits.
 
5. Pay off debt leverage quickly. By paying off UBIT quickly, the overall tax paid by your IRA will be less.  Keep in mind that your IRA can use profits from other IRA investments to pay down this debt.
 
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 an average of the debt leverage percentage over the previous 12 months. So, if your IRA sells its property 12 months and one day 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 will occur.
 
Other UBIT Facts:

Who pays the tax bill? The IRA pays the UBIT, not the IRA account holder.
When are tax payments necessary?  UBIT tax payments are necessary if the IRA generates taxable net income over $1000. Like you may set up outside of your IRA, quarterly estimated payments may be advantageous.
 
When debating the pros and cons of fixing-and-flipping properties within an IRA, investors shouldn’t be asking, “How do I avoid UBIT?” but rather, “How much will the IRA grow if I fix-and-flip properties and pay UBIT?” or “What is the resulting rate of return within my IRA?”
 
Dismissing an investment because of the potential payment of taxes can keep an investor from making an otherwise lucrative investment. Consult with your legal and tax advisors regarding investments involving potential UBIT within your IRA.

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