For most of you, your IRA will never incur either of these taxes. Taxes? Did you say taxes?
Yes, as a general rule, your self-directed IRA or 401(k) will never incur taxes from the investments it makes. You know the drill…do things correctly and pay taxes (for those without a Roth IRA or a Roth Solo 401(k)) when you take out distributions in retirement years. But, it is possible for an IRA or 401(k) to incur taxes associated with UBIT and UDFI, so let’s review.
UBIT — Unrelated Business Income Taxable
The provision of UBIT applies when any tax-exempt entity (e.g., charity, churches and IRAs/401(k)s carry on a business activity that is not related to its core purpose. Please read the historical perspective (below).
The UBIT tax was created so that tax-exempt entities could not have a competitive advantage over non-tax-exempt entities, including IRAs and 401(k)s. As an example, why should a tax-exempt entity (e.g., church) be able to purchase a McDonald’s restaurant and either not pay tax or not pay as much tax as someone/entity who does not have tax-exempt status? If you keep this type of visual in your mind, it goes a long way in explaining why this law exists. The whole intent is that both tax-exempt and non-tax-exempt are playing by the same rules.
UDFI — Unrelated Debt-Financed Income
UDFI is a subset of UBIT. Important: UDFI does not apply to a 401(k) that utilizes debt financing in the purchase of a real estate investment….the UDFI tax does apply to an IRA under the same circumstances.
UDFI is a tax on investment income derived by an IRA when debt-financing occurs with the investment. The UDFI tax is proportionate to the debt that is held on the property.
Quite honestly, once you understand the historical perspective, it is very easy to understand the basic concept of UBIT. If applicable, UBIT and UDFI rules are (or can be) very complicated, so you should always review the investment transaction with your tax or legal professional before you make the investment. As one might say, it is not as easy as saying, “UBIT is applicable” or “UBIT is not applicable.”
Prior to 1950, tax-exempt organizations (e.g., churches, charities, universities) had a unique tax advantage. There was no law which prohibited these tax-exempt organizations from conducting business activities unrelated to their core purpose, AND not paying income taxes on the profits generated from these business activities.
Think of this visual: you are a tax-exempt entity (e.g., charity) which owns a tire shop. You believe the entity should not have to pay an array of taxes (e.g., Federal income tax) simply because you are a charity. Do you think this would fly with the IRS? It doesn’t, nor should it. The charity should pay taxes as it is “running a business” outside the tax-exempt purpose of the entity. That, I believe, would make sense to most people. Besides not paying taxes that it should, it can also provide the tax-exempt entity (charity) an unfair competitive situation compared to other businesses…think about how you would feel if you owned a tire shop across the street and you paid all taxes, but the tax-exempt entity owning the tire shop across the street did not?!
Being aware of this tax loophole, the loop was closed and the new law prohibited this type of activity. Therefore, UBIT, as we know it today, was born. While UBIT was created to “even the playing field” of competition and paying one’s “fair share of taxes” (and make sure the IRS got their tax receipts), it was applicable to IRA and 401(k) plans later on as they are certainly tax-exempt, and their only core purpose is to passively invest the funds of the plan.
In a nutshell: tax-exempt organizations (including IRAs, 401(k)s, etc.) can operate business activities from within their plan, they just have to pay taxes on income realized.
Again, while UBIT/UDFI will probably never apply to your investments (passive investments), this post is to address UBIT and UDFI and the implications for your IRA or 401(k) if you trigger these events. Both are important for you to know…and, if applicable, discuss with your tax or legal professional before you make an investment that may trigger a tax to your IRA or 401(k).
Also, keep in mind that neither UBIT or UDFI is inherently evil. It is simply a tax for “operating a business” (versus a passive investment), or by acquiring debt-financed property held in whole or in part by your IRA….with a 401(k), provided the investment is structured correctly, UDFI does not apply to a 401(k) debt-financed property transaction. YEAH for 401(k)s! Neither UBIT or UDFI, by definition, is an IRS/DOL Prohibited Transaction. Nor does UBIT or UDFI transactions disqualify your IRA or 401(k)…unless, of course, you triggered a PT in making an investment that just flat out is against IRS rules.
There are two ways an investment made by an IRA or 401(k) may owe tax with income resulting from an investment. As noted, investments that trigger UBIT are permissible, you just may owe taxes on a portion of the profits/income generated.
The IRS uses three distinct tests or considerations: 1) is the entity (in this case the IRA or 401(k)) conducting any trade or business; 2) is this trade or business being actively carried on; and, 3) is this trade or business unrelated to the core operating mission of the tax-exempt entity (again, your IRA or 401(k))? In simple terms, IS the IRA/401(k) conducting or appearing to carry on the traits of an actively-run business by through its investments? IS this activity regularly carried on? IS the investment activity unrelated to the IRA/401(k)s core purpose of making permissible, passive investments?
Two scenarios which may indicate whether a potential UBIT/UDFI tax may be applicable from your investment:
It’s not all bad news: remember, IF UDFI is applicable, the IRA is only taxed on the debt-financed portion of the investment income. For example, if an investment was made with $50,000 IRA funds and $50,000 debt-financed income, the IRA would be paying the UDFI tax on the investment income generated from the debt-financed portion of the investment. Further, the IRA is permitted normal expenses and depreciation in determining the UDFI tax. Finally, there is no tax if the debt has been paid off at least 12 months prior to the sale of the property.
Again, this will be why, in the vast majority of cases, your investments will not trigger UBIT/UDFI. The IRS notes the following list of exempt income from UBIT/UDFI calculations:
While the IRS defines UBIT, they do not necessarily define common occurrences in which UBIT may be triggered. Part of the reason for this apparent lack of clarity is possibly due to the fact that there can be many factors involved in a particular transaction. Here are some scenarios that you may want to carefully review before you execute the investment as they could trigger UBIT:
As noted, very few investors conduct investment activities that raise to the level of triggering UBIT or UDFI…but, it can happen. It is important that you consider each investment opportunity for many factors, including whether the investment, in any way, can trigger UBIT or UDFI. Again, even if it does not trigger one of these two events, that is not necessarily bad…it is just something you need to consider in determining whether the investment is in your best interests for what you want to accomplish.
Some Investment Activities that should be Clear of UBIT?
As you can see, UBIT/UDFI conceptually is not a difficult concept; however, there can and usually are “circumstances” that can make each scenario confusing to break down with an easy, “UBIT applies” or “UBIT does not apply”.