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A Primer on Unrelated Income: UBTI and UDFI

Estimated reading time: 2 minutes, 19 seconds

Retirement accounts like Self-Directed IRAs are attractive investment vehicles largely due to their tax-advantaged status. But if you hold a limited liability company (LLC), limited partnership (LP) or certain real estate-related assets, among others, your investment could generate unrelated business taxable income (UBTI) and/or unrelated debt-financed income (UDFI).

In this introduction to unrelated income, we define the related yet quite different concepts of UBTI and UDFI.

To understand UBTI, the best resource is Chapter 4 of IRS Publication 598. UBTI is generally defined as gross income regularly generated by a tax-exempt entity via taxable activity unrelated to the entity’s main function. For example, if your IRA owns a private construction firm, which derives some income from leasing equipment to other companies, then the lease income may be considered UBTI.

If income is generated by a trade or business whose activity is regularly carried on and not substantially related to the exempt status, then the investment will likely generate UBTI. Such investments could include the aforementioned LLCs or LPs, leveraged real estate or active businesses. Note that exceptions do exist, as most passive investment income like dividends, loan interest and even rental income are exempt from unrelated business income tax.

Compare this with UDFI, which is covered in 26 U.S. Code § 514. It is generally defined as income derived from a leveraged (debt-financed) property owned for income-producing purposes. Therefore, any gain or profit realized through the debt may be subject to UDFI.

unrelated income

Some retirement account investors have the option to finance a real estate purchase with a non-recourse loan. In the event of loan default/foreclosure, the lender must only look to the property as the sole source of repayment and cannot pursue other accounts assets or assets owned directly by the account holder. Not all lenders make this type of loan, however, and those that do often require significant down payment. Also, not all properties will qualify for a non-recourse loan.

So, if a tax-exempt or tax-deferred entity like an IRA holds a leveraged property or interest in an LLC which obtained financing, UDFI tax may apply to any portion of profits realized through the debt. While most leveraged real estate properties won’t owe UDFI tax for the first few years because of depreciation, when debt-financed property is sold for a profit, UDFI tax may apply unless the debt is paid off at least 12 months prior to the sale.

Taxation related to unrelated income can be complicated—much beyond the realm of this introductory article. So, consult with your team of professionals if you’re considering an investment that may generate UBTI or UDFI. In particular, ensure your tax advisor explains Schedule K-1 (which shows UBTI) and Form 990-T (which reports unrelated business income). To avoid any surprises, make sure you know whether these tax situations will apply to you.