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IRA Tax Implications: Understanding UBTI and UDFI

The investment income generated by most passive investments held in an IRA – such as dividends, gains on the sale of real estate or interest from loans – are exempt from IRA taxes. 

However, you, your clients and your investors should be aware that there are circumstances in which the income produced by an investment in a self-directed IRA could trigger taxes. It’s important to understand what may cause Unrelated Business Taxable Income (UBTI) and/or Unrelated Debt-Financed Income (UDFI) when making investment decisions using IRA funds.

Custodians, like PENSCO, cannot advise on UBTI or UDFI. Given the tax implications associated with the use of IRA funds, it is important for your clients and investors to consult with a professional who can help determine the proper structure for the IRA investment and help to optimize the specific tax situation. For instance, LLCs and LPs are two types of legal and business structures that tend to trigger UBTI or UDFI.

Below is some general information about UBTI and UDFI.

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

What is it?

The purpose of UBTI is to level the playing field and prevent tax-exempt entities from competing unfairly with taxable entities, like corporations. IRAs are considered by the IRS to be a tax-exempt or tax-deferred entity for the purpose of saving for retirement, making them subject to UBTI. UBTI can affect Traditional and Roth IRAs, as well as qualified plans.

According to tax code, net income generated from a for-profit business purchased in an IRA – and unrelated to its primary purpose – is taxed at the trust tax rate as UBTI. 

What’s an example?

If an LLC is formed in an IRA to purchase a gas station, this business is unrelated to the primary purpose of the IRA (which is to save for retirement) and net income will be taxed as UBTI at the trust tax rate. 

How does UBTI get reported?

If gross income of $1,000 or more is generated from UBTI during the previous tax year, your client will be required to file IRS Form 990-T by the April 15th filing deadline and pay the associated taxes.

Taxes generated by UBTI in an IRA must be paid with IRA funds and not with personal funds. 

What is it?

If a property purchased in a self-directed IRA is financed by debt, income produced by that property is subject to UDFI tax. 

An average indebtedness is calculated for the year, and only that portion of the income is taxed as UDFI.    

What’s an example?

Let’s say a client’s IRA takes out a mortgage to finance a $100,000 rental property purchased in an IRA. The average value of the mortgage for the year is $50,000 and the property produces $10,000 in rental income.

Because the client’s IRA has an average indebtedness of 50% of the property value, this fraction is applied to the rental income of $10,000 to calculate a UDFI of $5,000*. 

 *Note – the first $1,000 of UBTI is not taxed.

How does UDFI get reported?

UDFI is calculated and reported on IRS form 990-T. Additional rules for debt-financed property and income tax are available here.

The IRS provides detailed guidance on UBTI here.

 

PENSCO Trust Company performs the duties of an independent retirement custodian, and, as such, does not provide investment advice, sell investments or offer any tax or legal advice. PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. The information above is being provided for informational purposes only. It is not intended as an individual recommendation, and each individual is encouraged to consult with a tax or legal advisor regarding proper handling of UBTI or UDFI.