Self-Directed Real Estate IRAs and Taxes: The Basics of UBIT and UDFI

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While assets are still in your self-directed IRA, you generally don’t have to pay taxes on the income. But, in certain situations, you do. This happens when the IRA owns property has been leveraged or is an operating business. The two phrases you’ll need to know about this are Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI).

Unrelated Business Income Tax (UBIT) is a tax on income from a trade or business that is not significantly related to charitable, educational, or other exemptions of a company or organization.  UBIT applies when the earned income is over $1,000.

Not all income earned within the IRA is subject to UBIT, it depends on the source of the income. For example, rental income from real estate, dividends, investment income, and royalties are all exempt from UBIT. The income from these types of earnings go back to the IRA, tax-free or tax-deferred depending on the type of account. This is one of the reasons real estate is so popular with self-directed IRA investors.

But, if the self-directed IRA uses a non-recourse loan to buy the real estate, the debt financed part of the profits is subject to UBIT. The profits generated from the non-recourse loan’s percentage of ownership would be taxed.

When an IRA owns a currently operating business, the IRS “levels the playing field” by applying UBIT. A business that makes income primarily from the sale of goods or services, where the activity is performed regularly and is not substantially related to the IRAs exempt purpose, is subject to this tax.

An example of this in action: If your IRA invests in an LLC that owns and operates a restaurant, which is doing well and generating monthly income. While it may be a good investment, the restaurant is not related to the IRA’s exempt purpose. So, the earnings from the restaurant are subject to UBIT.  If UBIT did not exist, the LLC-owned restaurant could potentially charge less than competitors or otherwise enjoy this advantage, due to the tax benefits of being IRA-held. Thus, the IRS implemented UBIT, placing a tax burden on the otherwise tax-favored entity.

What is Debt Financed Income?

Unrelated Debt-Financed Income (UDFI) is income derived from the use of “acquisition indebtedness” in the self-directed IRA and is subject to tax. “Acquisition indebtedness” is, in this case, income from a property where debt is acquired during the purchase of the property. For example, say your IRA Resources account uses $100,000 in IRA funds and utilizes a $100,000 non-recourse loan to buy a $200,000 property. If your property brings in $10,000 a year in income, 50% of that income is subject to UDFI, since 50% of the property was debt-financed with your non-recourse loan. In this example, the IRA would pay taxes on $5,000. If the net income was below $1,000, UDFI does not apply.

Unrelated Debt-Financed Income (UDFI)

Total price of real estate

$200,000

IRA

$100,000 (50%)

Non-recourse loan

$100,000 (50%)

Net income generated from rental

$10,000

[Table 1a] Income and expenses are divided equally in this example due to investment percentage.     

 Unrelated Business Income Tax (UBIT)

Allocated Net income

$10,000

IRA 50%

$5,000

Non-recourse loan 50%

$5,000 is subject to UBIT

[Table 1b] Amount UBIT applies to for Table 1a.

To simplify— UBIT is a tax and UDFI is the income being taxed.  Also, keep in mind—  if you have to pay UBIT then your investment is performing well.  UBIT is not to be feared, but you do need to consider it in your investment strategy, especially when leveraging your IRA.

When Doesn’t UBIT Apply?

We gave some examples of when UBIT applies, but here are some situations where UBIT does not apply:

  • When investing into a business, like an LLC. The LLC can be treated as a corporation instead of a partnership for tax purposes. Since the entity will have already paid the tax before paying out any dividends to the IRA, the dividend would be tax-deferred or tax-free depending on the type of IRA. Another option is to invest in a C Corporation instead of an LLC.
  • Instead of your IRA investing directly into the property (with the IRA’s name on the deed), your IRA can lend the money to someone looking to buy real estate. The loan can then be secured by a lien on the property.
  • As mentioned earlier, when property is not leveraged and was acquired via a direct purchase, UBIT would not apply. Income from rentals is exempt from UBIT.

How is UDFI Paid?

We recommend you work with a financial professional to determine UBIT and UDFI.  IRS Form 990-T needs to be filed to pay UBIT if there are net profits of more than $1,000 or if there are losses you wish to carry forward. Once you complete the form, you would submit it to IRA Resources directing us to pay the tax.  The payment must be made from the IRA, not from your personal funds. Remember, all income and expenses from IRA owned assets must be paid by the IRA.

For more information on UBIT and UDFI visit IRS website.

BONUS:  Here are the top 3 frequently asked questions regarding UBIT and UDFI.

  1. If I use loan when purchasing a property with my IRA, do I need to pay tax on the debt-financed part when I sell the property and pay off the loan? Assuming there is an appreciation on the property.

Yes, you would need to pay UBIT on the loan-financed portion. If the IRA obtained a non-recourse loan to buy the investment property, then taxes would need to be paid on the percentage of profits associated with the ownership percentage of the amount debt financed. Expenses and depreciation can be used to minimize the profit calculation on the debt leveraged percentage of the property.

For example, say your IRA paid $100,000 and you also utilized a non-recourse loan for $100,000 to purchase a property worth $200,000. This means the ownership is split 50-50, with your IRA owning 50% of the property. If in a few years the property appreciates and you decide to sell it for $1,000,000, you would split the return on the sale the same way. Your IRA would receive 50% of the proceeds (or $500,000, minus additional costs), with the other $500,000 subject to UBIT.

  1. Since my Roth IRA is tax-free, does UBIT apply?

    Yes, even in a tax-free Roth environment, you will still need to pay UBIT. The Roth IRA allows your money to grow tax-free, but UBIT rules still apply.
  1. Do I need to file IRA Form 990-T if the net income is less than $1,000?

    No, you do not. UBIT only applies to earned income over $1,000 a year. If there is a loss, the 990-T must be filed to offset the loss against future gains.

To learn more about self-directed IRAs and taxes, call us at 888-322-6534.

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