At New Direction Trust Company, a self-directed IRA custodian, we hear a lot of questions about UBIT, or Unrelated Business Income Tax, or UBIT.
Many investors are afraid of acting on money, which can cause them to pass up opportunities because they think UBIT is a penalty or an excessive tax. However, in the case of retirement accounts, the account is making money. It is not a penalty, just a way to even the playing field between tax-exempt and tax-deferred entities like a retirement account and other entities/people.
To get a basic understanding of UBIT and Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI), that two types of income that may be assessed UBIT, let’s go straight to the source: the IRS. The IRS Publication 598 outlines what these tax consequences are and how you’ll incur them.
Below are some excerpts from the IRS that may help an IRA holder to understand the parameters.
Unrelated business income - Unrelated business income is the income from a trade or business regularly conducted by an exempt organization and not substantially related to the performance by the organization of its exempt purpose or function, except that the organization uses the profits derived from this activity.
Income - Generally, unrelated business income is taxable, but there are exclusions and special rules that must be considered when figuring the income.
Exclusions - The following types of income (and deductions directly connected with the income) are generally excluded when figuring unrelated business taxable income.
Gains and losses from disposition of property - Also excluded from unrelated business taxable income are gains or losses from the sale, exchange, or other disposition of real estate.
Income From Debt-Financed Property - Investment income that would otherwise be excluded from an exempt organization's unrelated business taxable income (see Exclusions under Income earlier) must be included to the extent it is derived from debt-financed property. The amount of income included is proportionate to the debt on the property.