Unrelated Business Taxable Income (UBTI), targets ordinary income-produced by businesses that are tax-exempt but doesn't qualify for one of the exceptions
The ‘unrelated’ income necessitates a payment from the tax-exempt entity of Unrelated Business Income Tax (UBIT).
Common examples of the generation of UBTI in IRAs occurs with private-equity & real estate based vehicles. Additionally, debt-financed investments; which are often part of the investment structure for these asset classes can generate Unrelated Debt-Financed Income (UDFI). UDFI is assessed on any income generated from the debt-leveraged portion of the asset. An example is a piece of real estate with a 50% equity + 50% debt ratio will have half of its total income tagged for UDFI. This generation of UDFI results in UBTI, requiring a tax payment from the IRA. So that half of the investments gains will result in a tax payment from the IRA, diminishing the tax-advantaged returns.
When related to real estate, UBIT is a tax on real estate activities that are not passive in nature. Rental income and capital gain income from the sale of real estate are exempt from UBIT. There is a special caveat to the capital gain exemption on the sale of real estate which does not allow it to apply when the real property was acquired with the intent to immediately sell it.
For UBTI income over $12,500, the tax is 37%
While the tax for UBIT can be high, many self-directed investors have strategies or investments that they are more confident than traditional stocks and bonds. Over time, experienced self-directed investors learn how to minimize UBIT or how to target bigger investment opportunities through a strategy of a non-recourse loan.
These taxes were created by the Federal government so that a business paying a corporate tax would be able to compete fairly, and so that a business owner could not shelter large amounts of different types of business activity in a tax-exempt account. Over time corporate tax rates have changed.
What should I know about tax reporting for UBIT?
If your Self-Directed Solo 401(k) or Self-Directed IRA invests in an operating business (Limited Partnership (LP) or LLC) that sells goods or services and generates more than $1,000 in UBIT, the 401(k) or IRA must file IRS Form 990-T and pay the tax due from the 401(k) or IRA.
The 990-T form is a complex tax form that not all CPAs are familiar with. You can contact Rocket Dollar to be introduced to a CPA that has expertise in this area.