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, 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.
IRC 501 allows tax exemption to several 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.
UBTI Tax – A Dual Purpose
As you can see, UBTI has a dual purpose:
- Prevent tax-exempt businesses from competing unfairly with taxable organizations
- Prevents tax-exempt businesses from engaging in business unrelated to their primary business objectives
Many tax advantages 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, are subject to UBTI tax. For example, the operation of a gas station by an LLC or partnership that a Self-Directed IRA LLC owns will likely be subject to UBTI tax.
Related: How to Avoid Unrelated Business Tax
Understand the Difference: UBTI tax and UDFI
UBTI also applies to unrelated debt-financed income (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. 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 to 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 to finance the purchase of real estate, the portion of rental income attributable to the debt is taxable as UBTI.
Related: How to Avoid UBTI Taxes on Real Estate
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
Almost all Solo 401(k) investments generating passive income will not be subject to UBTI or UDFI.
- In sum, UBTI is triggered for a Solo 401(k) if:
- The Solo 401(k) uses margin to buy stock and the net income is above $1,000
- The Solo 401(k) invests in an active business through a pass-through entity, such as an LLC, and the net income is above $1,000. Note – if the pass-through income is passive and not considered a trade or business, such as rental income, then the Solo 401(k) plan would not be subject to the UBTI tax.
The UBTI rates listed below will apply in these instances.
Solo 401(k) for Real Estate
A major advantage of using a Solo 401(k) plan for real estate investments with leverage is that IRC 514(c)(9) exempts a 401(k) plan from the UBTI tax when using leverage (loan must be non-recourse as per IRC 4975). Whereas an IRA that uses a non-recourse loan to acquire real estate would be subject to the UBTI on debt related income above $1,000.
When using the 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 2024, 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
There is no formal guidance regarding UBTI implications for a Self-Directed real estate IRA. However, there is a lot of guidance on UBTI implications for real estate transactions by tax-exempt entities.
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.
Common Transactions that May be Unrelated Business Activity:
- The use of non-recourse loans to buy real estate with a Self-Directed IRA. Note: an exception exists for a Solo 401(k) plan using a non-recourse loan for the acquisition of real estate property.
- Investment in an active business (i.e., restaurant) operated through a pass-through entity, like an LLC, using a Self-Directed IRA or Solo 401(k) Plan
- Making an investment in a private equity firm operating active businesses through pass-through entities, such as an LLC using a Self-Directed IRA or Solo 401(k) plan
- An investment in master limited partnerships (MLPs) through a pass-through entity using a Self-Directed IRA or Solo 401(k) plan
- Investing in an investment fund that is using debt for investment purposes using a Self-Directed IRA or Solo 401(k) plan.
Related: How to Avoid UBTI When Investing in Private Businesses
Get in Touch
Do you still have questions regarding the UBTI tax and how it may affect you? Contact IRA Financial Group at 800-472-0646. You can also fill out the form to speak with an on-site tax specialist.
Did You Know?
The IRS taxes “unrelated business taxable income” at the UBTI Tax Rate applicable to trusts or corporations, depending on the organization’s legal characteristics. Reach out to our specialists now for more information!
