What is UBIT?
UBIT stands for Unrelated Business Income Tax. It is a tax on the unrelated business income received by a tax-exempt account such as an IRA. Most alternative assets that are placed in a Self-Directed IRA generate passive income, which is exempt from UBIT. These assets allow investors to enjoy tax-deferred (Traditional) or tax-free (Roth) retirement benefits. However, there are certain investments which are subject to taxation.
- UBIT is Unrelated Business Income Tax. It is a tax applied to non-profit accounts to avoid unfair competition with commercial businesses.
- If an IRA LLC operates an active business (like a restaurant or grocery), it would have to pay UBIT on the profits.
- Rental income from a property that is owned by your IRA is considered passive income and not subject to UBIT.
What is subject to UBIT?
Here are some of the scenarios where UBIT applies:
If a tax-exempt organization or entity engages in or invests in an unincorporated active business.
An active business is defined as one that sells goods or services. In such a case the net income of the business is subject to UBIT. If the business was filed as a corporation, the company would already be paying corporate taxes and thus not be subject to UBIT. However, in the case of an unincorporated business, taxes are levied so one company does not have an unfair advantage over the other.
If your IRA LLC purchases property with a loan.
In this case, the portion of the income derived from debt is subject to UBIT. For example, if a property costs $100,000 and your IRA LLC invests $75,000 and the other $25,000 comes from leverage, then 25% of your gross income (less expenses and depreciation) would be subject to UBIT.
If your IRA invests in an LLC or other partnership that purchases real estate with leverage.
For example, you may be a 5% partner in an LLC who is buying a rental property but is using a loan to purchase the property. This is similar to the above example.
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When calculating the amount subject to tax, you can deduct the following income earned from your profits:
- Interest income
- Dividend income
- Royalty income
- Rental income
- Capital gains from sale, exchange, or other disposition of property held over 1 year
- Profit under $1,000 is exempt from UBIT
Let’s say you are purchasing a rental property for $200,000 and pay 50% of that through your IRA LLC and the other 50% is debt financed. UBIT applies in this scenario because your IRA LLC is purchasing a property with a loan. Since 50% of the property is debt-financed, 50% of net profits are taxable. The income attributable to the debt, known as Unrelated Debt Financed Income (UDFI), is subject to UBIT.
Continuing with the example above, let’s assume you received $14,000 gross profit from rentals, expenses are $5,000, and there is $2,000 depreciation. To calculate the amount of UBIT subject to tax complete the following:
- Subtract your gross income minus exempt incomes. $14,000 - $7,000 = $7,000.
- Since 50% of the rental property was a non-recourse loan, take 50% of $7000 = $3,500.
- Subtract the exempt $1,000. $3,500 - $1,000 = $2,500
- Looking at the IRS’s UBIT Tax Rate, you would see that your profit is between $0 - $2,550, and thus subject to 10% of taxable income. Take 10% of $2,500.
- $250 should be paid in taxes.
Now that you know the amount of taxes owed, how do you file for UBIT? To file and pay UBIT, the IRA LLC must file IRS Form 990-T by April 15. The 990-T is separate from your personal and other business returns. There may also be separate forms to file based on the state your IRA LLC is filed in. Contact a financial advisor to see if you must fill out any additional state forms, in addition to the federal 990-T form.
Your IRA LLC holds and owns the investment. Therefore, the tax is paid using IRA funds and not personal funds. It is important to keep an eye on the amount of funds in your IRA and yearly contribution limits, to ensure your IRA has enough money to pay UBIT if necessary.
- Determine if your investment generates UBIT. Does it invest in an unincorporated active business? Did you use debt to leverage your investment?
- Calculate the amount of UBIT generated. Did you make over $1,000 in gross profits?
- Obtain an EIN (Employer Identification Number). This number is a unique nine digit number that identifies your business for tax purposes.
- File 990-T.
- Determine if your state requires additional filing.
It is encouraged to speak with a tax specialist regarding UBIT.