UBTI and UDFI tax considerations.

Pacific Premier Trust clients enjoy the benefits of using self-directed IRAs to grow their investments tax-deferred in the case of a traditional IRA or tax-free in the case of a Roth.

However, there are circumstances in which the income produced by an investment in your IRA could trigger certain types of taxes. It’s important for you to understand the factors that trigger Unrelated Business Taxable Income (UBTI) and/or Unrelated Debt-Financed Income (UDFI) when making investment decisions using IRA funds.

Every situation is unique, and it is important you consult with a CPA or attorney. See below for some general information and links to IRS resources for more detailed information.

Unrelated Business Taxable Income (UBTI)

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What Is UBTI?

UBTI is a unique tax enacted by Congress in 1950 that applies to tax-exempt entities such as charities, churches and universities. Congress was concerned about exempt organizations running unrelated businesses without paying taxes on the income produced by that unrelated business.

The purpose of UBTI is to level the playing field and prevent tax-exempt entities from competing unfairly with taxable entities, like corporations. UBTI can affect IRAs, including Traditional IRAs and Roth IRAs, as well as qualified plans.

What Is UBTI and What Does It Mean for IRAs?

While UBTI is the actual tax itself, UBTI is the income generated by a tax-exempt entity, such as an IRA, when it invests in a trade or business unrelated to its tax-exempt purpose and/or uses debt to generate income. UBTI is what triggers UBTI.

The IRS states that unrelated business income is income generated from an ongoing trade or business that is not related to the organization's exemption. 

IRAs are considered by the IRS to be a tax-exempt or tax-deferred entity for the purpose of saving for retirement. So, if your IRA owns an operating company, the income it produces from selling goods and services would be subject to UBTI because the operating company itself is unrelated to the central purpose of an IRA — which is to save for retirement. 

What Is an Operating Company?

A company that makes a good or provides a service that it then sells to customers or clients. An operating company differs from a holding company whose main function is to own other companies.

What Type of Legal or Business Structures Trigger UBTI or UDFI?

LLCs and LPs are considered pass-through entities, meaning that any taxes due are the responsibility of the owner of the entity to pay. In this case, the owner is your IRA.

With the tax implications associated with the use of retirement funds, it is important to consult a professional to help you with the proper structure for the type of investment being considered — and help you optimize your specific tax situation. If taxes need to be paid, you will want to optimize your tax situation.

Are There Investments I Can Make With My IRA That Will Not Trigger UBTI/UDFI?

Yes, there are many. To name a few, you can invest in hedge funds, notes, REITS, and private corporations that are not LLCs or LPs.  

In situations where UBTI could occur, you would want to consult with a CPA familiar with UBTI to help you determine if an investment you are considering is worth paying the UBTI taxes. It is always best to consult with a professional to optimize your specific tax situation.

How Do I Know if I Owe Taxes Generated by UBTI or UDFI?

As your custodian, Pacific Premier Trust cannot advise on or calculate UBTI or UDFI. It is strongly recommended that you work closely with a tax professional who has expertise in this area if you are considering an IRA investment that may generate UBTI and to determine what taxes, if any, you may face.

Please note, taxes generated by UBTI or UDFI in your IRA must be paid with IRA funds and not your personal funds.

The IRS provides detailed guidance on UBTI in Publication 598.

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Unrelated Debt-Financed Income (UDFI)

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What Is UDFI?

If a property purchased in an 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 you take out a mortgage to finance a $100,000 rental property purchase in your IRA. The average value of your mortgage for the year is $50,000 and the property produces $10,000 in rental income. Because your average indebtedness was 50% of the property value, this fraction is applied to the rental income of $10,000 to calculate your UDFI of $5,000. 

If you then sell the property for $140,000 at the end of the year, your average indebtedness of 50% will also be applied to your gain to calculate UDFI. Your UDFI is therefore 50% of your $40,000 gain, or $20,000.

How Do I Know if I Owe Taxes Generated by UDFI?

As your custodian, Pacific Premier Trust cannot advise on or calculate UBTI or UDFI. It is strongly recommended that you work closely with a tax professional who has expertise in this area if you are considering an IRA investment that may generate UBTI and to determine what taxes, if any, you may face.

The IRS provides detailed guidance on UBTI in Publication 598.

How Do I Report It?

UDFI is calculated and reported on IRS form 990-T. Additional rules for debt-financed property and income tax are available in Publication 598.

How Do I Pay the Taxes on UDFI?

Taxes on UDFI in your IRA must be paid with IRA funds (not personal funds). For more information, please see these instructions.

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For Pacific Premier Trust Clients: UBTI tax is generally reported on the IRS Form Schedule K-1 which will be provided to you by your investment sponsor. UBTI and UDFI must be reported on IRS form 990-T. For more information about reporting UBTI and/or UDFI, please read these instructions.

Pacific Premier Trust 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. Pacific Premier Trust 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.