These three acronyms relate to tax implications within an otherwise tax-exempt account or entity. Unrelated business income tax/taxable income (UBIT/UBTI) is a provision added to the Internal Revenue Code in 1950 to eliminate an unfair competitive advantage enjoyed by exempt organizations and entities (later amended to include IRAs) over their taxpaying counterparts in the non-exempt world.
UBTI and UBIT are often used interchangeably. The one represents the type of income that is taxable; the other is the actual tax that is owed based on the income received within the tax-exempt account or entity.
The result of the Revenue Act of 1950 (and its subsequent application to entities such as IRAs) is that certain investments owned within a retirement account such as a Roth IRA, Traditional IRA, SIMPLE IRA, SEP IRA, or other tax-exempt entity must consider UBIT depending on the investment choices. To learn more about why UBIT was instituted, please visit Why Do I Have to File?.
UBIT, Unrelated Business Income Tax, is the tax that the IRS imposes on certain investments that meet the guidelines within the IRS Rules for accounts that would otherwise be tax exempt. Businesses that are conducted within a tax-exempt retirement account (such as limited partnerships and LLCs) and real estate that is debt financed are the two most common events that trigger UBIT within a retirement account.
If a retirement account contains investments that generate what is considered unrelated business income, the IRS requires annual filings and taxes paid on the profits from those investments if the net income is $1,000 or more, or you wish to carry forward or backward a net operating loss.
UBTI, Unrelated Business Taxable Income, is the actual income that is taxed. UBTI will relate to the net income received from an entity or investment which is deemed by the IRS to be unrelated to the primary purpose of the account. Income is offset by the expenses incurred in the operation of the business and the tax is based on the remaining profits. Net UBTI of $1,000 or more requires UBIT to be filed.
UDFI, Unrelated Debt-Financed Income is primarily used in the context of IRA investments with income that is derived from debt-financed real estate or other property. The UDFI is subject to Unrelated Business Income Tax (UBIT). The amount of the loan on the property is what causes the investment to incur UBIT, not the rents received or the gains from the sale. This can also be a factor if debt is incurred in the purchase of a business that is contained within an IRA.
Debt financed income is calculated in direct proportion to the percentage of the real estate or business that is leveraged by debt. The percentage that was paid in cash from the IRA is not subject to UBIT.
Having the ability to leverage property within an IRA or other retirement account enables investors to expand their portfolio more rapidly than if all purchases were required to be entirely made with cash from the account. The tax incurred is often times well worth the increased investment opportunities made available via debt financing.