Breaking the Taboo: Understanding UBIT and UDFI in Self-Directed IRAs

The thought of Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI) in Self-Directed IRAs (SDIRAs) can make anticipating investors hesitant. The mention of either is treated like a superstition, viewed by many as a fine for wrongdoing. While in fact, yes – triggering UBIT or UDFI will result in owing more money – it is not a punishment for bad behavior. I would like to change the perspective that’s shared amongst the financial community. Accumulated UBIT and UDFI is purely just extra fare for doing business, and likely, doing it exceptionally.?

I stand passionately beside my stance on UBIT and UDFI and am excited to be speaking on said subject at Limitless, the Financial Freedom Expo slated for the end of August in Texas. Prior to the live panel, I wanted to offer a bit of an introduction on this subject to help the undecided potentially proceed with either an investment, or with attending this efficacious event. We’ll begin with brass tacks: defining UBIT and UDFI, analyzing investments holding a track record for eliciting it, and why you should still consider moving forward with your desired investment, despite it.?

What Exactly is UBIT, UDFI, and UBTI??

To start, let’s get concrete definitions of these terms.?

UBIT (Unrelated Business Income Tax) - This refers to tax imposed on the income generated by a tax-exempt organization. This tax occurs because there’s evidence that activity is happening unrelated to its purpose of exemption. An example would be a nonprofit congruently operating a for-profit business that is unrelated to its charitable initiative. In this instance, UBIT is triggered to ensure that tax-exempt entities don’t hold an upper hand or competitive advantage in comparison to a taxable business.??

UDFI (Unrelated Debt-Financed Income) – This type of income is typically earned by a tax-exempt entity that stems from a debt-financed investment property. Using borrowed money to finance an investment or property accrues this type of tax because the tax-exempt account is not using its own, actual money. It can appear as though it’s leveraging its tax-exempt status to gain fiscal advantages that taxable businesses or accounts cannot access.?

UBTI (Unrelated Business Taxable Income) – This is the phrase used when referring to the income that is subject to UBIT. It is the gross total of all the income derived from endeavors unrelated to the tax-exempt purpose of the organization or account. (With an exception for permitted deductions.)??

How Does This Relate to a Self-Directed IRA??

There’s one thing that all these components have in common: they all begin with the word, “unrelated.” This is for good reason. An SDIRA’s intent is to cultivate an enriching retirement experience. It helps develop savings for a possibly prosperous retirement – not prosperity in the present. If your SDIRA is receiving a substantial income, it can appear as though you’re exploiting the tax advantages a Self-Directed IRA offers to reap those benefits currently.?

Self-Directed IRAs are individual retirement accounts that permit investments in alternative assets like real estate, precious metals, private placements, and beyond. Access to alternative investing can lead to a diversified retirement portfolio as these investments are generally uncorrelated with Wall Street products. Therefore, it’s likely that any drops in the stock market generally won’t waive the value of your alternative investment.??

When creating a Self-Directed IRA, you get to determine which tax advantage your savings carry. A Self-Directed Traditional IRA lets your gains grow in tax-deferment, while a Self-Directed Roth IRA permits growth, tax-free. This indicates that in some respect, Self-Directed IRAs behave as tax-exempt entities.?

If your retirement plan involves performing numerous transactions and purchasing more than one investment under your SDIRA, you may find Self-Directed Checkbook IRAs better suit your needs. You can choose to upgrade your account to either a Self-Directed IRA LLC or Self-Directed IRA Trust. Checkbook IRAs receive the same tax advantages as classic Self-Directed IRAs. Yet, if your account is considered to be generating active income by the IRS, excessive transactions could still trigger UBIT or UDFI.?

What Investments Tend to Frequently Cumulate UBIT + UDFI??

While these investments may conduct as UBIT provokers, they still hold the potential to mount up enough revenue that it’s worth the UBIT incurred. Since Self-Directed IRA custodians cannot offer any financial advice, it’s strongly encouraged that you perform due diligence on any prospective investment, in addition to corresponding with a financial advisor to get the full picture of any possible UBIT implications.?

With that in mind, these investments can potentially trigger UBIT:?

• Recurrent Real Estate – If you’re repeatedly buying or selling real estate throughout the year, it may signal earned income to the IRS. A couple of real estate ventures that have this ability are fix and flips and rental properties, such as vacation rentals or Airbnbs.??

• Excessive Private Lending – Loaning money by means of a promissory note through your SDIRA can be considered a kind gesture. If you’re engaging in multiple private loans within the year, it could motion that you’re clandestinely operating a lending business.?

• Businesses that are Income Prompting - Businesses that emanate regular income such as laundromats, gas stations, convenience stores, and restaurants, can possibly provide tremendous returns. This surplus amount could possibly indicate that your SDIRA is earning unrelated revenue, thereby triggering UBIT.?

• Investments Utilizing Third-Party Loans - If you opted to purchase an investment property by means of a non-recourse loan, that’s perfectly acceptable and the only type of loan designed for Self-Directed IRAs. For evenhandedness, since the money did not originate from within your account, you would owe UBIT.?

As debt leverage can activate UBIT, many wonder if it’s worth acquiring a non-recourse loan. Employing a loan for an investment property grants you the ability to make more for your retirement savings than possible without the added boost of said leverage. The debt-leverage is the only portion of money contributed to your account that did not have to align with the IRA’s annual contribution limits. Turns out, non-recourse loans have their own advantages, too.?

These tax implications have absolutely nothing to do with the passive income your SDIRA generates. Royalties, interest, dividends, and rent payments (say, for a condominium investment for example) wouldn’t incur UBIT.?

Best Practices for Evading UBIT Impact?

You thought I was going to reveal my secrets that easily? I’m saving these climactic tidbits for my next UBIT unraveling – as well as for my speaking presentation at Limitless. Now that I’ve laid the foundation, join me this year on Friday, August 30th as I further break the taboo on UBIT and UDFI. If you can’t make it this year, stay tuned -I’ll be imparting more information in the next chapter.?

As the manager of the Investments and Sponsors Teams, I have been rigorously trained in a wide variety of asset classes. Me, and our team of Self-Directed IRA Specialists, are eager to educate you on the types of investments your retirement funds can be utilized towards. Schedule a call with me today and learn just how many possibilities there are for your future.??

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Madison Trust Company (“Madison”) is a passive Self-Directed IRA custodian, and, as such, does not provide investment advice, sell investments, or offer any tax or legal advice. Accordingly, Madison is not a fiduciary.? Madison is not affiliated with any financial professional, investment, investment sponsor, tax, or legal advisor. It is not Madison’s responsibility to review the prudence, merits, viability, or suitability of any investment directed by clients or to determine whether the investment is acceptable under ERISA, the Internal Revenue Code, or any other applicable law. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity and/or professionals to assist them with an investment opportunity.??????

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