The UBTI tax rate is in existence to prevent tax-exempt entities from competing unfairly with taxable entities. Tax-exempt companies are subject to UBTI tax when their income comes from trade or business that has no relation to its tax-exempt status.
Unrelated Business Taxable Income is the “gross income derived by any organization from any unrelated trade or business regularly carried on by it.” Typically, an exempt organization will not be taxed on its income from activities that are charitable or educational. Such income is exempt even when the activity is a trade or business. However, certain types of investment income, such as dividends, interest, and capital gains, may be exempt from UBIT when associated with IRAs.
However, to prevent tax-exempt entities from competing unfairly with taxable entities, tax-exempt entities are subject to the UBTI tax. This is the case when the entity derives its income from a trade or business that has no relation to its tax-exempt status.
What is UBTI and Why Does it Matter?
Unrelated Business Taxable Income (UBTI) is income from a business or investment that is unrelated to a tax-exempt entity’s primary purpose. Its purpose is to prevent tax-exempt entities (such as an IRA) from gaining an unfair advantage over taxable businesses.
What Triggers UBTI?
- Investing in active businesses through pass-through entities like LLCs or partnerships.
- Using a non-recourse loan to buy real estate within a Self-Directed IRA.
- Investing in private equity firms, hedge funds, or master limited partnerships (MLPs).
UBTI vs. UDFI: What’s the Difference?
UBTI is income from an active business in which your IRA holds an interest. Unrelated Debt-Financed Income (UDFI) is income from debt-leveraged investments, such as real estate, bought with a loan.
IRC 501 allows tax exemption to a number of organizations, such as non-profits. However, if the organization engages in activity unrelated to its business, and generates income from said activity, it may be liable for UBTI tax.
Understanding UBTI and UBIT
Definition and Purpose
Unrelated Business Taxable Income (UBTI) and Unrelated Business Income Tax (UBIT) are crucial concepts for tax-exempt entities, including Self-Directed IRAs, to understand. UBTI refers to the income earned by a tax-exempt entity that is not related to its exempt purpose. UBIT, on the other hand, is the tax imposed on this income. The purpose of UBTI and UBIT is to ensure that tax-exempt entities do not unfairly compete with taxable businesses and to prevent them from accumulating unrelated business income without paying taxes.
Tax-exempt entities, such as non-profits and IRAs, enjoy significant tax advantages. However, when these entities engage in activities that generate income unrelated to their primary exempt purpose, they must pay taxes on that income. This ensures a level playing field between tax-exempt and taxable entities, preventing tax-exempt organizations from gaining an unfair competitive edge.
UBTI Tax – A Dual Purpose
As you can see, UBTI has a dual purpose:
- Prevent tax-exempt businesses from competing unfairly with taxable organizations
- Prevent them from engaging in business unrelated to its primary business objectives
There are many tax advantages that come with an IRA. One example is tax-free gains until you make a distribution. Most passive income investments will not be seen as UBTI. However, funds you generate from income that is UBTI taxable, and goes back into the IRA, is subject to UBTI tax. Tax-exempt organizations must pay tax on UBTI exceeding $1,000 to ensure compliance and maintain a fair competitive landscape. For example, the operation of a gas station by an LLC or partnership that a Self-Directed IRA owns will likely be subject to the UBTI tax.
UBTI vs. UDFI
UBTI also applies to UDFI. “Debt-financed property” refers to borrowing money to purchase real estate. In a case like this, the income attributable to the financed portion of the property will be taxed. Income generated from investments in a tax-exempt account, especially when leveraging debt, can trigger taxes under UDFI and UBIT regulations. Gain on the profit from the sale of the leveraged assets is also UDFI unless the debt is paid off more than 12 months before it’s sold.
There are a few exceptions from UBTI tax. They relate to the central importance of investment in real estate. Some examples include:
- Dividends
- Interest
- Annuities
- Royalties
- Most rentals from real estate
- Gains/losses from the sale of real estate
The rental income you generate from the real estate that is “debt-financed” loses the exclusion. That portion of income becomes subject to UBTI. As a result, if the IRA borrows money in order to finance the purchase of real estate, the portion of rental income attributable to the debt is taxable as UBTI.
What Triggers UBTI?
UBTI is triggered when a tax-exempt entity, such as an IRA, earns income from a business or investment that is not related to its exempt purpose. This can include income from partnerships, limited liability companies (LLCs), and other business entities. For instance, if an IRA invests in a partnership that operates a business, the income generated from that business is considered UBTI.
Additionally, rental income can trigger UBTI, especially if it involves leasing equipment or property that is not directly related to the entity’s exempt purpose. Investments in master limited partnerships (MLPs) and limited partnerships (LPs) that use leverage can also result in UBTI. These scenarios highlight the importance of understanding the sources of income and their relation to the entity’s exempt purpose to avoid unexpected tax liabilities.
Calculating UBTI
Calculating UBTI involves determining the gross income earned by the tax-exempt entity from its unrelated business activities. This includes income from partnerships, LLCs, and other business entities, as well as rental income and income from MLPs and LPs. Once the gross income is determined, deductions for business expenses, losses, and depreciation are subtracted to arrive at the net income.
The net income is then subject to UBIT, which is calculated using the tax rates applicable to corporations. For example, if a tax-exempt entity earns rental income from a property that is not related to its exempt purpose, the net income after deductions will be subject to UBIT. It is essential to note that UBTI can be complex and may require consultation with a tax professional to ensure accurate calculation and compliance with tax laws.
Failure to file Form 990-T and pay required UBIT by the IRS filing deadline can result in penalties. Therefore, it is crucial for tax-exempt entities to understand UBTI and UBIT to avoid tax liability and maintain their tax-exempt status. Consulting with a tax professional can help navigate the complexities of UBTI and ensure compliance with all relevant tax laws.
UBTI Tax on the Solo 401(k) Plan
Internal Revenue Code Section 511 taxes “unrelated business taxable income” at the UBTI Tax Rate applicable to corporations or trusts, depending on the organization’s legal characteristics. Generally, UBTI is:
- Gross income from an organization’s unrelated trades or businesses
- Less deductions for business expenses
- Losses
- Depreciation,
- Similar items directly connected therewith
A Solo 401(k) Plan is not subject to UBTI tax. Internal Revenue Code Section 515(c)(9) permits a few organizations to make debt-financed investments without being taxed. This includes qualified pensions, such as the workplace 401(k) plan and the Solo 401(k) plan.
When using a Self-Directed IRA in a transaction that will trigger the UBTI tax, the IRA is taxed at the trust tax rate because an individual retirement account is considered a trust. For 2025, a Self-Directed IRA subject to UBTI is taxed at the following rates:
- $0 – $2,550 = 10% of taxable income
- $2,551 – $9,150 = $255 + 24% of the amount over $2,550
- $9,151 – $12,500 = $1,839 + 35% of the amount over $9,150
- $12,501 + = $3,011.50 + 37% of the amount over $12,500
Real Estate UBTI Implications for Tax Exempt Entities
There is no formal guidance regarding UBTI implications for a Real Estate IRA. However, there is a lot of guidance on UBTI implications for real estate transactions by tax-exempt entities. Income generated from investments in a tax-exempt account, especially when leveraging debt, can trigger taxes under UDFI and UBIT regulations.
Commonly, gains and losses on dispositions of property will not be included unless the property is inventory or property that’s up for sale to customers in the ordinary course of an unrelated trade or business. The exclusion covers gains and losses on dispositions of property used in an unrelated trade or business as long as the property was never on sale to customers.
To reiterate, the following are transactions that may be unrelated business activity:
- The use of non-recourse loans to buy real estate with a Self-Directed IRA.
- Investment in an active business (i.e., restaurant) operated through a pass-through entity, like an LLC.
- Making an investment in a private equity firm operating active businesses through pass-through entities.
- An investment in master limited partnerships (MLPs) though a pass-through entity.
- Investing in an investment fund that is using debt for investment purposes.
Get in Touch with a Tax Professional
Do you still have questions regarding the UBTI tax and how it may affect you and your investments? Contact IRA Financial at 800-472-1043.
