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In 1950, the IRS code was amended to include a provision called
unrelated business taxable income or 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 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:
- Before the property was acquired or improved, if the debt was incurred because of the acquisition or improvement of the property; or
- After the property was acquired or improved, if the debt was incurred because of the acquisition or improvement, and the organization could reasonably foresee the need to incur the debt at the time the property was acquired or improved.
Example 1:
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 2:
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).
See IRS Pub. 598 (www.irs.gov)
for additional rules for debt-financed property and income tax.
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