UBIT and UDFI Taxes for Self-Directed Real Estate IRAs

A Self-Directed Individual Retirement Account (SDIRA) gives investors a tax-advantaged way to invest in alternative assets like private placements, LLCs, and even real estate. While assets are still in your Self-Directed Individual Retirement Account (SDIRA), you generally don’t have to pay taxes on asset income until you have to start taking withdrawals. In other words, an IRA is a tax-exempt entity until you start taking distributions.

However, in certain situations, you may have to pay taxes on asset income before you take distributions. Some examples are when the IRA owns property that has been leveraged or is an operating business. The two phrases you’ll need to know are Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI).

This article will cover what you need to know about both in relation to owing taxes on your real estate IRA.

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 exceeds $1,000 for the year. Furthermore, an organization is required to make quarterly estimated tax payments if it expects its tax for the year to be $500 or more.

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 for the purchase of real estate, the part of the profit which is acquired through debt will be subject to Unrelated Business Income Tax. The profits from the non-recourse loan's share of ownership will be taxed as well. 

When an IRA owns a currently operating business, the IRS “levels the playing field” by applying UBIT. An active business in real estate may include gas stations, grocery stores, restaurants, and more. The net income (profit) generated is subject to this tax if it meets two conditions:

• The sale of goods and services where the activity is performed regularly
• The income generated is not substantially related to the IRAs exempt purpose

An example of this in action: 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 that are distributed through the IRA’s share of LLC ownership 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.

IRA UBIT Tax Rates for 2022

For 2022, a Self-Directed IRA subject to UBIT is taxed at the following rates:

• $0 – $2,550 = 10% of taxable income
• $2,551 – $9,150 = $255 + 24% of the amount over $2,550
• $9,151 – $12,500 = $1,839 + 35% of the amount over $9,150
• Over $12,501  = $3,011.50 + 37% of the amount over $12,500 

Calculating UDFI Taxes for Self-Directed Real Estate IRAs

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.

Say you want to invest in a piece of property. You plan to finance half of the purchase using IRA funds and the other half using a non-recourse loan. The property costs $200,000. So, you will use $100,000 in funds from your IRAR account and $100,000 in non-recourse loan funds to buy the property.

Let’s say the property brings in $10,000 in net income for the year. 50% of that income is subject to IRA 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.

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

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

UBIT Taxes vs. UDFI Taxes for Self-Directed Real Estate IRAs

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.

To recap, income generated from unrelated business activities, and income generated from an unincorporated active business (e.g. sale of goods/services) are all subject to UBIT. Debt-financed income is subject to UDFI tax.

UBIT Tax Exemptions for Self-Directed Real Estate IRAs

We gave some examples of when UBIT applies, but there are some situations where UBIT does not apply. Generally, rental income, interest income, dividend income from publicly traded companies categorized as C-corporations, royalty income (payments to an owner for using an asset or property), and capital gains made from the sale or exchange of property in the long term. Let’s take a closer look at some investment transactions that may not be subject to UBIT.

C-Corporations and LLCs

When investing in 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.

Loans and Property Liens

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.

Rental Property Income

As mentioned earlier, when a property is not leveraged and was acquired via direct purchase, UBIT would not apply. Income from rentals is exempt from UBIT.

Filing UBIT or UDFI Taxes for Self-Directed Real Estate IRAs

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 during the year or if there are losses you wish to carry forward.

Once you complete the form, you would submit it to IRAR 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 the 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 of 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.

2. 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.

3. 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.

Why You Should Choose IRAR as Your Custodian

At IRAR, we have helped IRA account holders for more than 30 years leverage alternative investments through self-directed IRAs to secure a financially free retirement. Part of our role has been to empower our clients to make the best-informed decisions possible through our shared resources and dedicated team of IRA specialists. Book a free consultation if you are ready to invest in real estate with retirement funds.

Editor’s Note: This post was originally published in August 2017 and has been completely revamped and updated for accuracy and comprehensiveness.