UDFI, UBTI, and UBIT - What’s the Difference, and Why Does it Matter?

Some retirement investors are hesitant to invest their IRAs in assets that may incur UBIT, or Unrelated Business Income Tax, because they view it as a penalty or as excessive tax. But in the case of retirement accounts, incurring UBIT means the account is making money. UBIT is not a penalty, but a cost of doing business.

When Does UBIT Occur?

UBIT can apply to any “pass-through” or untaxed entities that own and operate a business.

UBIT can also occur on debt-financed IRA purchases. These purchases could include when the investment uses leverage like a non-recourse loan for a real estate investment, or if the IRA invests in a company that uses debt-leverage. In either case, the percentage of profits that is derived from debt-leverage could incur UBIT. If an IRA real estate property has outstanding debt-leverage associated with it when it’s sold, UBIT could apply to the debt-leveraged profits.

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

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

UBIT also applies to rental income from property as it moves through time. Form 990-T  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 portion of the sale based on the debt-leveraged percentage.

UBTI occurs when an IRA invests in an operating business or an entity that operates a business (such as an LLC, LLP, etc.). If it’s not paying business tax, UBIT may occur on the profits associated with that business. The majority of businesses your IRA would invest in would not be part of the tax-exempt purpose of UBIT (which is to level the playing field for businesses in competition with non-profits). If you invest in a business with your IRA, make sure you file a 990-T and calculate UBIT.

Fix-and-flip projects can be considered an ongoing business by the IRS, 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 Could Trigger UBIT?

Despite UBIT, you can still make more money for your IRA than you would have without using leverage. Debt-leverage is the only strategy IRS sanctioned strategy that allows you to make money on money that you didn’t contribute to the IRA yourself. Unlike debt-leverage, all the other cash put into your IRA had to follow annual contribution limits.
When considering whether or not to use leverage in your IRA to make a real estate purchase, make sure to do the calculations. Some factors to consider include:

• Rental income & vacancy
• Operating Expenses
• Bank Terms
• Reserves for Contingencies
• Future Appreciation
• Percentage Loan to Value

It's up to you as the account holder to make the decision about your IRA’s participation in debt-leverage, and subsequently its participation in UBIT. If you loan money to an entity, you won’t accrue UBIT. But if you buy private equity in an entity that owns a business with debt-leverage, UBIT may apply. If you buy property without leverage, you will avoid UBIT. If you buy a larger and potentially more lucrative property with debt-leverage, UBIT is once again possible.

Exceptions: Because UBIT is not incurred by the IRA receiving income such as dividends resulting from C-Corp stock, rent from property, or interest from an IRA loan, it is still possible to avoid UBIT when you invest in an ongoing business or real estate.

Consider these seven ways to lessen the impact of UBIT, or avoid it altogether:

1. Buy IRA real estate with 100% cash from the account. UBIT is levied on the debt-leveraged portion of net income of an asset. You only need to consider UBIT if you take out a loan. Debt-leverage can be a valuable tool to increase the buying power of your IRA, and in many cases UBIT assessed on debt-leveraged profit will be much less than the overall monetary growth of the account. However, if your goal to is to eliminate UBIT completely, don’t use leverage.

2. You can use an Individual 401(k) for debt-leveraged real estate. Typically UBIT is assessed on UDFI in an IRA. With an Individual 401(k), this is not the case.

3. Partner your IRA instead of using debt-leverage. Partnering is a way to increase the buying power of your account without using debt-leverage. An IRA can partner with disqualified and non-disqualified persons/entities.

4. Net losses from an IRA in a given year can be “banked” to to offset profits in later years, so you can use losses from previous years to offset profits in the current year.

5. Pay off any debt-leverage quickly. By paying off UBIT quickly, the overall tax paid by your IRA will be less. Your IRA can use profits from other IRA investments to pay down the debt.

6. Pay off all debt-leverage twelve months (and a day) 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-leveraged percentage over the previous twelve months. If your IRA sells its property twelve months and one day after it has paid off its debt leverage, there will be no UBIT on sale profits.

7. When investing in an ongoing business, choose a C-Corp. When the corporate entity is paying business tax before profits are disbursed to investors (including retirement investors), no UBIT will occur.

Other UBIT Facts:

• The IRA pays the UBIT, not the IRA account holder.
• 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 investing in a business that uses debt-leverage or fixing-and-flipping properties within an IRA, investors shouldn’t ask themselves “How do I avoid UBIT?” but instead, “How much will the IRA grow if I fix-and-flip properties and pay UBIT?” or “What will be the resulting rate of return within my IRA?”

Dismissing an investment because of the potential for UBIT can keep an investor from making otherwise lucrative investments. Consult with your legal and tax advisers regarding investments involving potential UBIT within your IRA.