IRA Owners: Learn About Unrelated Business Taxable Income
Investment income generated by most passive investments held in an IRA—like dividends, interest on loans, or gains on the sale of real estate—are exempt from taxes. This benefit makes IRAs an attractive long-term savings tool for many investors.
However, while most income generated within an IRA is tax-free, not all of it is. That’s why it’s crucial for all IRA owners to understand how an investment in an IRA could produce Unrelated Business Taxable Income (UBTI) or Unrelated Debt-Financed Income (UDFI)—and be subject to taxes.
Understanding Unrelated Business Taxable Income (UBTI)
UBTI (also referred to as UBIT) is a unique tax that was created by Congress in 1950, and it applies to tax-exempt entities such as charities, churches, and universities. Congress was concerned about exempt organizations running unrelated businesses without paying taxes on the income produced by those businesses.
The purpose of UBTI is to level the playing field and prevent tax-exempt entities from competing unfairly with taxable entities, like corporations. The IRS states that unrelated business income is income generated from an ongoing trade or business that is not related to the organization's exemption.
Unrelated business taxable income is an issue for retirement investors because all IRAs—traditional IRAs and Roth IRAs—are considered by the IRS to be a tax-exempt or tax-deferred entity for the purpose of saving for retirement. That means if an IRA produces income from an “unrelated business,” that income could be taxable.
Using a Christmas Tree Farm to Explain UBTI
IRS Publication 598 covers the rules for UBTI, but understanding UBTI can be complicated. To illustrate the concept, consider an investor who owns a piece of undeveloped land in their IRA through a single member LLC. This undeveloped land is a passive investment that produces no unrelated business income, so it’s not subject to UBTI taxes.
A few years later, the IRA pays to make improvements to the land and turns the property into a Christmas tree farm. Suddenly, the investment is no longer passive, and it begins to produce an income stream by selling Christmas trees.
The improvement of the land and the sale of the trees mean the IRA could be subject to unrelated business taxable income. If your IRA owns an operating company—like a Christmas tree farm—the income it produces from selling goods and services—like those Christmas trees—would be subject to UBTI. Why? Because the operating company itself is unrelated to the central purpose of an IRA—which is to save for retirement.
UBTI’s Close Cousin—Unrelated Debt-Financed Income
There is a sub-set of unrelated business taxable income that self-directed IRA investors should also understand—Unrelated Debt-Financed Income, or UDFI. If a property purchased by an IRA is debt-financed, income produced by that property could be considered UDFI, and the income could be subject to taxes.
For example, UDFI can be triggered if your IRA owns a rental property. Let’s say your IRA takes out a mortgage to finance a $100,000 rental property purchase. The average value of the mortgage for the year is $50,000 and the property produces $10,000 in rental income. Because your IRA’s average indebtedness was 50% of the property value, this fraction is applied to the rental income of $10,000 to calculate a UDFI of $5,000. That $5,000 is then taxed at the trust rate to determine how much UBTI will be owed to the IRS.
The UDFI related to this property should decrease over time as your IRA pays down the mortgage.
Tax Implications of UBTI and UDFI
LLCs and LPs are considered pass-through entities, meaning that any taxes due are the responsibility of the owner of the entity to pay. In this case, the owner is your IRA.
Given the tax implications associated with the use of retirement funds, it is important to consult with a professional who can help you determine the proper structure for the investment you are considering for your IRA and to help you optimize your specific tax situation. IRA custodians, like PENSCO, cannot advise on UBTI or UDFI.
If gross income of $1,000 or more is generated from UBTI or UDFI during the previous tax year, you are required to file IRS Form 990-T by the Tax Day filing deadline and pay the associated taxes. Taxes generated by UBTI or UDFI in your IRA must be paid with IRA funds and not your personal funds.
Because tax situations are complex, PENSCO strongly recommends that you work closely with a financial professional who has expertise in this area. A CPA can help with the proper tax forms that need to be filed to account for UBTI, like the K-1 for the business and reporting taxes to the IRS on Form 990-T.
Learn more about unrelated business taxable income in our Q&A blog on the topic.
Editor’s Note: This is an updated version of a post we originally published in March 2016. We welcome new comments and questions below.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.