Unrelated Business Income Tax, or UBIT, applies to the profits of an active business owned by a tax-exempt entity such as a qualified retirement plan. For example, if an IRA invests in an unincorporated active business (such as a gas station, grocery store, etc.), the net income profit generated is subject to UBIT.
UBIT and UBTI are often used interchangeably.
UBIT (Unrelated Business Income Tax)
The tax owed based on the unrelated business income received by the tax-exempt account or entity.
UBTI (Unrelated Business Taxable Income)
The type of income that is taxable from an active business investment in your Self-Directed IRA.
Congress created UBIT to even out the competition between not-for-profit and for-profit organizations that operated the same type of business. Without unrelated business income tax rules, not-for-profit organizations had the unfair advantage of not having to pay the income taxes that for-profit organizations were subject to, allowing them to charge less for the same products and services.
Most alternative assets in Self-Directed IRAs never have to pay UBIT because the investments are passive in nature and tax-deferred (or tax-free within a Roth IRA). However, UBIT applies in the following scenarios:
The first is when a tax-exempt organization or entity, such as a non-profit organization or IRA/Solo 401(k), invests in an unincorporated operating business (such as an LLC that sells goods or services). The income that flows from the LLC to the IRA is ordinary income and, therefore, is subject to UBIT.
UBIT also applies to an IRA that uses debt financing to buy an investment, such as a loan on a real estate property. The income attributable to the loan, known as Unrelated Debt-Financed Income (UDFI), is subject to UBIT.
Do you have any questions about UBIT? Speak to a live representative today.Answer My Questions!
UBIT applies to real estate investments that either are debt-financed or undergo a short-term flip.
Ask these questions to see if UBIT applies to your Real Estate IRA investment:
Objective: Did you purchase the property to serve as a long-term investment or to be flipped and sold immediately?
Time Frame: Did you hold the property for more than a year? The longer the property is held, the more likely it is to be deemed held for investment and therefore not cause UBTI.
Property Improvements: Did you purchase, develop, and sell the property? The less work done on the property, the more likely it is held for investment purposes.
Debt-Financed: Did you use a loan to help purchase your property? If yes, the portion of the investment that was funded by the loan is subject to UBIT.
For example, if a property is purchased with 50% IRA funds and 50% through a loan, the amount subject to UBIT would be 50% of the net income earned from the property (through rental income or capital gains) after subtracting the first $1,000 and any deductions (expenses, tax, depreciation, etc.).
UBIT should not necessarily deter you from investing your Self-Directed IRA in alternative assets. Many investors miss out on profitable opportunities because they are unfamiliar with UBIT. Investing in alternative assets, rather than traditional investments, with a Self-Directed IRA creates a diversified portfolio and opportunity to increase IRA funds. There are also tax write-offs, such as depreciation, that limit the amount of UBIT owed.
To report and pay UBIT, the IRA must file IRS Form 990-T by April 15. If the annual gross UBIT income exceeds $1,000, the IRA must report and pay UBIT. UBIT is paid with IRA funds, not the IRA owner's personal funds. Some states may have their own paperwork for UBIT. Contact a financial advisor to see if this applies to your state.
When calculating UBIT, the tax rate depends on the annual income received.
Table 2: UBIT Tax Rate 2023
*Please note that tax rates may vary.
Assume a Self-Directed IRA invested in a grocery store that is an LLC and received a K-1 for $50,000 of net taxable income for the LLC for that year.
Find the excess amount: $35,550 ($50,000 minus $14,450)
Calculate 37% of the remaining $35,550, which equals $13,153.50
Add in $3,491. The total tax due is $16,644.50 ($13,153.50 plus $3,491)
The after-tax net amount the IRA would keep is $33,355.50 ($50,000 minus $16,644.50 in UBIT).
There are two options that may be used to avoid UBIT. A tax professional or financial planner can help you understand your options.
Corporate tax rates are significantly less than UBIT rates. Because of this, an IRA may benefit by establishing a 100% owned C-corporation, which the IRA invests in and receives ordinary income from. In this case, a C-corporation is used to "block" UBIT from being owed by the IRA in exchange for a lesser corporate tax.
For example, if an LLC reports $50,000 of net taxable income to a Self-Directed Roth IRA, if the IRA needs to pay UBIT, the tax bill would be $16,837.50. However, if the same ordinary-income business paid $50,000 in profits to a C-corporation that was owned 100% by an IRA, the C-corporation would only pay $10,500 (based on the corporate tax rate of 21%).
Foreign corporations often have much lower corporate income tax rates than in the U.S. However, a foreign corporation blocker company is a very complex structure and should only be considered after adequate due diligence.
In all cases, self-directed investors should contact a financial professional to understand the rules and taxes incurred by their investment. For more clarification, reach out to a Self-Directed IRA Specialist.Schedule a Call