Self-directed IRAs (SDIRAs) allow you to invest in a variety of alternative assets, typically with tax-free benefits. However, in some situations, an SDIRA asset may earn unrelated debt-financed income (UDFI) and trigger unrelated business income taxes (UBIT). Understanding when and how this can happen can help you make informed investment decisions and meet your annual tax obligations. 

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What Is UDFI?

UDFI, or unrelated debt-financed income, refers to income generated by a financed asset, often real estate,  held in an IRA or checkbook LLC. 

For instance, say you purchase and subsequently rent out a home using a combination of IRA funds and a non-recourse loan.  Your rent payment would be considered unrelated debt-financed income since it’s generated by an IRA-held property that was at least partially financed. 

UDFI will come into play as long as at least a portion of the asset is financed.  

When you invest in tax liens, earnings come from the interest applied to the lien

What Is UBIT in an IRA?

Unrelated business income tax (UBIT) in an IRA is a tax applied under certain investment scenarios that result in earnings of $1,000 or more. In most cases, earnings from IRA investments, when held in the account, are considered tax-exempt—one of the benefits of this type of account. However, if earnings flow in from an asset that was at least partially financed, the earnings can be considered unrelated debt-financed income and are then subject to UBIT.   

UBIT Examples in an IRA

There are three common IRA scenarios that result in UBIT:

  • Debt-financed income is the most common example of UBIT in IRAs, and it is often associated with real estate investments. If you purchase a property and a portion of that purchase is financed, earnings equal to the percentage financed will be subject to UBIT. For instance, if you financed 50% of a property and you earn $200,000 from it, you’ll need to pay taxes on $100,000 of the earnings. 
  • Income generated from unrelated business activities. For example, say you invested in an LLC construction business using SDIRA funds and leased the equipment out during the slow season. The income earned through the lease agreement is subject to UBIT. 
  • Income generated from an unincorporated active business. If you invest in an unincorporated business, such as a restaurant or gas station, any income earned from the unincorporated business is subject to UBIT. 
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UBIT Exemptions in an IRA

While some SDIRA earnings can be subject to UBIT, it’s more common that they are exempt.  The following earnings are not subject to UBIT:

  • Interest income
  • Rental income
  • Capital gains
  • Income from royalties 
  • Dividends from C-Corps

For instance, if you held real estate in your property and did not finance it, you wouldn’t need to pay UBIT on rental income. Likewise, you would not need to pay taxes on those gains if you sold that property. Of course, if you have a traditional SDIRA, you will be subject to taxes upon withdrawal, as mandated by the IRS. 

Tips to Reduce Your IRA’s UBIT at the End of the Year

In some cases, it’s possible to reduce or avoid UBIT, depending on your investment circumstances. Here are a few ways tips to mitigate your tax risks:

  • Avoid financing asset purchases. For instance, if you want to invest in real estate but don’t have enough money in your IRA, consider partnering with another SDIRA holder instead of applying for a non-recourse loan. 
  • Pay down SDIRA debts quickly. If you finance assets in your SDIRA, pay down the loan as quickly as possible. Paying it off quickly can reduce your UBIT obligation in any given year and eventually get rid of the tax.
  • If you plan to sell an SDIRA-held property, pay off any financing within 12 months or more of the sale to avoid paying taxes on the gains.   
  • Consider using a solo 401(k) if you want to invest in an asset like real estate but need to finance the purchase. Solo 401(k) investments are not subject to UDFI in the same way.
  • Consider investing in C-Corps. The C-Corp is responsible for paying taxes, leaving the IRA  free from UBIT. 

FAQs

Can UBIT and UDFI apply to traditional IRAs as well? 

UBIT and UDFI can apply to a traditional IRA if the account holds a financed asset, such as real estate purchased using a non-recourse loan, and that asset leads to capital gains. For instance, if your IRA holds a residential property and you collect rent or sell the property, earnings from that property are subject to a UDFI tax at the UBIT rate. 

It’s important to note that in the case of a traditional IRA, UBIT can result in double taxation: once while in the account and a second time upon a distribution. 

What are the consequences of not paying UBIT or UDFI taxes on SDIRA investments?

Failure to pay UBIT or UDFI taxes on an SDIRA will result in penalties, including a 5% late penalty for every month the amount goes unpaid, with a maximum of 25% of the unpaid UBIT.   UBIT may not seem like an ideal use of earnings, but failure to pay them will further erode your account and jeopardize your IRA. 

Can tax deductions offset UBIT and UDFI liabilities?

You may be able to reduce UBIT liabilities with allowable deductions, such as those associated with net operating losses and qualified business deductions.  For more information on how you may be able to leverage tax deductions to offset UBIT and UDFI, contact a financial professional.