UBTI & UDFI

Unrelated Business Taxable Income & Unrelated Debt-Financed Income Tax as they relate to real estate purchase

In 1950, the IRS code was amended to include a provision called unrelated business taxable income or RE_UBTI. The tax on such income is called unrelated business income tax (UBIT).

Essentially, if a tax exempt entity (e.g., non-profit) engages in a business that is unrelated to its primary purpose, any income derived from such business will be subject to UBIT. IRAs are also subject to UBIT if they conduct unrelated businesses that produce profits.

For example, if an IRA forms an LLC to buy and operate a dry cleaner or gas station, businesses obviously unrelated to the primary purpose of an IRA, the net income will be taxed as UBIT (at the trust tax rate because an IRA is considered a trust under the tax code in this purpose). The change in the code was intended to level the playing field between tax-exempt organizations and for-profit organizations conducting the same businesses.

In addition, whenever debt is used by a tax-deferred or tax-exempt entity (with some exceptions), tax is applied to that portion of the gain that is debt-financed. This income is called unrelated debt financed income or UDFI, which is a subset of RE_UBTI. Taxes on both are calculated and reported on IRS form 990-T.

Any property held to produce income is debt-financed property if at any time during the tax year there was acquisition indebtedness outstanding for the property. When any property held for the production of income by a tax-exempt organization or IRA or Roth IRA is disposed of at a gain during the tax year, and there was acquisition indebtedness outstanding for that property at any time during the 12-month period before the date of disposition, the property is debt-financed property. In general, average acquisition indebtedness for any tax year is the average amount of the outstanding principal debt during the part of the tax year the property is held by the entity or IRA.

To calculate the average amount of acquisition debt, determine the amount of the outstanding principal debt on the first day of each calendar month during that part of the tax year that the organization holds the property. Add these amounts together, and divide the result by the total number of months during the tax year that the organization held the property.

The amount of gain or income taxable as UDFI for any tax year is the total income, multiplied by a fraction. The numerator is the average amount of acquisition debt, and the denominator is the average of the adjusted bases at the beginning and at the end of the year.

Before calculating the net income, certain deductions can be taken into consideration, just as they are when you purchase property outside of an IRA. For example, depreciation can be deducted, if applicable, but only on the straight-line method. For example, if the depreciation of an IRA-held building is $20,000 and the property is 70 % debt-financed , then 70% of the $20,000 overall depreciation (or $14,000) can be deducted from gross income, before calculating UDFI tax. To be directly connected with debt-financed property or income derived from it, the deduction must be clearly related to the property and its income.

Securities purchased on margin are considered debt-financed property.

Acquisition indebtedness is the outstanding amount of principal debt incurred by the organization to acquire or improve the property:

• Example I

  An IRA purchased a residential rental property that produced $10,000 of gross rental income last year. The average adjusted basis of the rental during the year was $100,000, and the average indebtedness (e.g., bank mortgage) with respect for the rental property was $50,000. Thus, the relevant fraction was 50% and therefore the unrelated debt-financed income was $5,000 (50% of the $10,000).

• Example II

  The same property is sold at the end of the year and the average indebtedness was $50,000 over the twelve months prior to sale. Assuming the basis remained at $100,000, and that the property was sold for $140,000, and because the debt/basis ratio remains 50%, then 50% of the $40,000 gain or $20,000 will be subject to tax. Because the gain is a capital gain, the tax on this percentage of the gain will be determined according to the usual rules for capital gains and losses (e.g., long term gain tax is currently 15% after a one year holding period).