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UBIT and UDFI - What You Need to Know For Investing in Your IRAs

UBIT and UDFI - What You Need to Know For Investing in Your IRAs
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In this article, I look to cover the basic elements of Unrelated Business Income Tax (UBIT) and Unrelated Debt Financing Tax (UDFI) as they pertain to real estate investors. Usually, when we are talking about these taxes for real estate investors, it’s typically within the confines of a self-directed IRA or self-directed Roth IRA.  

Key Terms

Unrelated business income - the IRS defines this as (1) a trade or business; (2) it is regularly carried on ; (3) not substantially related to furthering the exempt purpose of the organization. 

Unrelated debt financed income - It is usually assessed when leverage (debt) is used in a retirement account (i.e. IRA). It is assessed whenever there is income for the investment. 

Form to File

You must file a form 990-T. Taxes are assessed at trust tax rates up to 37%. 

When UBIT Comes Into Play 

UBIT taxes generally come into play when you’re investing in an unrelated business. Let’s say you purchase a portion of a closely held family business in your IRA; that would be subject to UBIT taxes. What’s specifically excluded for UBIT are dividends, interest, annuities, and investment income. Rents are also excluded. The rest is what would be considered ordinary income. 

The most common examples in real estate are fix and flip income, wholesale income, and development income. For these, I would recommend not doing this within an IRA. While the tax is hefty should you file Schedule C on your 1040, it is simply not worth the hassle of doing these within the confines of an IRA due to the additional tax filings and amount of tax owed on these investments. 

Should you be inclined to invest within your self-directed IRAs, a better approach would be to lend money to flippers as this would be considered interest income and therefore exempt for UBTI. You could also be making a higher net profit as well depending on your expertise. If you’re still inclined to flip in your IRA, there’s another way to avoid UBIT. You would simply BRRRR (buy, rehab, refinance, rent, repeat) your property and therefore not have any realized income. Candidly, a better strategy would be to BRRRR outside of a retirement account. With the BRRRR though, you will bring UDFI taxes into play. 

When UDFI Comes Into Play

This tax applies when there is income from a leveraged investment. Given that most real estate is leveraged, UDFI will come into play in years when there’s income. A simple example for why this tax exists.
Let’s say you purchase a property worth $200,000 but your IRA only puts down $80,000 (40%). The remaining 60% is financed through debt. The IRS contends that this 60% financed with debt should not receive the same tax advantaged treatment. The tax is based upon the income brought in. Let’s say you earned $15,000 after all expenses. In this example, 60%, or $9,000 would be taxable income. 

The most common examples are when you purchase a rental property in your IRA, when you invest as a passive investor in a syndication that uses leverage, and when you purchase a rental property in your IRA with cash and later refinance into a loan. 

Ways to Avoid UDFI 

  1. Avoid debt - this is a tax only on the leveraged portion. If you don’t have debt, there’s no tax!

  2. Have losses - the same rules apply for how to calculate your profit for your Schedule E or Form 8825. If you have losses, these can also carry forward into future years. 

  3. Invest in a self-directed solo 401(k) - The IRS has permitted Solo 401(k)’s to be exempt from this tax. No one is sure why this is the case. 

Putting It All Together

Investing in real estate within a retirement account presents additional potential tax consequences and filings. Anytime you invest a self-directed IRA or self-directed Roth IRA in real estate, you should discuss this with your CPA, ideally prior to making the investment. My hope is that this article will provide you a baseline understanding for you to discuss your specific situation with your CPA. Should you want to delve deeper into UBIT and UDFI, see some additional resources below that will help to aid in your understanding. 

Additional Resources:

UBIT and UDFI Article #1

UBIT and DFI Calculations

Publication 598

If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at aaronz@thethinkers.com

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