Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income Tax (UDFI)

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Unrelated business taxable income (UBTI)

If a tax exempt entity (e.g., non-profit) engages in a business that is unrelated to its primary purpose, any income derived from such business will have generated unrelated business taxable income (UBTI) and will be subject to what's known as unrelated business income tax (UBIT). IRAs are also subject to UBIT if they conduct unrelated businesses that produce profits.

For example, if an IRA forms an LLC to buy and operate a dry cleaner or gas station, businesses obviously unrelated to the primary purpose of an IRA, the net income will be taxed as UBIT at the trust tax rate because an IRA is considered a trust under the tax code. Taxes on UBTI and UDFI are calculated and reported on IRS form 990-T and the applicable state tax forms.

Unrelated debt-financed income (UDFI)

When debt is used by a tax-deferred or tax-exempt entity (with some exceptions), tax is applied to that portion of the gain that is debt-financed. This income is called unrelated debt-financed income (UDFI).

Any property held to produce income is debt-financed property if at any time during the tax year there was acquisition indebtedness outstanding for the property. When any property held for the production of income by a tax-exempt organization or IRA or Roth IRA is disposed of at a gain during the tax year, and there was acquisition indebtedness outstanding for that property at any time during the 12-month period before the date of disposition, the property is debt-financed property. In general, average acquisition indebtedness for any tax year is the average amount of the outstanding principal debt during the part of the tax year the property is held by the entity or IRA.

Examples

Residential rental property which produced income:
An IRA purchased a residential rental property that produced $10,000 of gross rental income last year. The average adjusted basis of the rental during the year was $100,000, and the average indebtedness (e.g., bank mortgage) with respect to the rental property was $50,000. Thus, the relevant fraction was 50% and therefore the unrelated debt-financed income was $5,000 (50% of the $10,000).

The residential rental property is sold:
The same property is sold at the end of the year and the average indebtedness was $50,000 over the 12 months prior to sale. Assuming the basis remained at $100,000, and that the property was sold for $140,000, and because the debt / basis ratio remains 50%, then 50% of the $40,000 gain or $20,000 will be subject to taxes. Because the gain is a capital gain, the tax on this percentage of the gain will be determined according to the usual rules for capital gains and losses.

See IRS Publication 598 for additional rules for debt-financed property and income tax.

There can be many factors governing whether an alternative asset in your self-directed retirement account would be subject to UBTI or UDFI.

Consult with an experienced tax professional to help you with your unique situation.

Next steps

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This information is for general informational purposes only and is not intended as an individualized recommendation or to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, PENSCO recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. PENSCO performs the duties of a custodian and, as such, does not provide investment advice or sell investments, nor offer any tax or legal advice.