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Did you know that a limited liability company (LLC), limited partnership (LP), or certain real estate-related investment assets could generate unrelated business taxable income (UBTI) and/or unrelated debt-financed income (UDFI)? When this occurs, UBTI or UDFI will likely subject your account to unrelated business income tax (UBIT). Have you factored in how UBIT could affect your investment income?
In this acronym-heavy post (apologies!), we break down how UBIT could be owed by your investment account.
UBTI is gross income regularly generated by a tax-exempt entity through taxable activity unrelated to the entity’s main function. For example, did you know your tax-advantaged Individual Retirement Account (IRA) could own a private business deriving income from leasing equipment to other companies? While this could provide a steady stream of investment income, 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. So, investments like LLCs or LPs, leveraged (debt-financed) real estate, or active businesses may be affected. Note that some exceptions exist, as most passive investment income like dividends, loan interest, royalties, rental income, and gains are losses from the sale of property are exempt from UBIT (unless UDFI comes into play, as discussed below).
UDFI is income derived from a leveraged property owned for income-producing purposes. Therefore, any gain or profit realized through the debt may be subject to UDFI. If an IRA holds a leveraged property or interest in an LLC which obtained financing, a tax may apply to any portion of profits realized through the debt.
Most leveraged real estate properties won’t owe such a tax for the first few years because of depreciation. However, the tax may apply when debt-financed property is sold for a profit unless the debt is paid off at least 12 months prior to the sale.
If UBTI is generated by your investment, you should receive a Schedule K-1 (IRS Form 1065) from the investment sponsor.
Occasionally, your custodian will receive the K-1, at which point it is forwarded to you. The UBTI amount is listed as Code V under Section 20 on the K-1. Any income or loss shown on the K-1 for an IRA-owned asset should not be reported on your tax return. After all, taxes owed for an IRA-owned investment must be paid from the IRA. Therefore, you must also ensure the K-1 properly reflects your custodian’s tax ID number instead of your Social Security number.
If an IRA investment generates UBTI or UDFI of $1,000 or more during a tax year, IRS Form 990-T must be prepared and filed with the IRS on or before Tax Day.
You must consult with your investment advisor to determine if you must file Form 990-T and any additional processes that may be required (such as obtaining an Employer Identification Number). Once complete, Form 990-T can be submitted to your custodian with written authorization to file and pay the tax.
To understand UBTI and UDFI, the best resources are IRS Publication 598 (Chapter 4) and 26 U.S. Code § 514, respectively. Also, consult with your team of professionals if you have, or are considering, an investment that may result in UBIT. To avoid any surprises like UDFI and UBTI, make sure you know what will affect your investment. Awareness and due diligence are key to ensuring the asset is right for your investment goals.
Of course, finding a custodian providing the service and solutions to hold investments like these is key to moving forward. Once you’re ready to invest in any of these assets (or perhaps other alternatives), Kingdom Trust is here to help! Chat with a member of our experienced team to get started!