Insights
The tax that can follow your IRA
A tax-advantaged account is not always a tax-free one. Two rules — UBIT and UDFI — can hand your IRA a bill.
Investors open retirement accounts to defer or escape tax. So it comes as an unpleasant surprise that an IRA can owe tax on certain income — paid not by you, but by the account itself. Two provisions do the work, and both tend to arrive uninvited.
Why a tax-exempt account can owe tax
Congress did not want tax-exempt accounts to gain an unfair edge by running active businesses or investing with borrowed money. The unrelated-business-income rules (Internal Revenue Code Sections 511–514) are the result.
UBIT
Unrelated business income tax applies when an IRA earns income from an active trade or business — often through a pass-through entity such as an LLC or limited partnership. Passive income — interest, dividends, most rents, and capital gains — is generally excluded. It is operating income, not investment income, that draws the tax.
UDFI
Unrelated debt-financed income tax applies when the account buys an asset with borrowed money, most commonly leveraged real estate. The portion of income and gain attributable to the debt can be taxable. Because an IRA generally must use a non-recourse loan, the debt-financed share is where the exposure lives.
How it gets paid
The tax is calculated on Form 990-T and filed and paid by the IRA itself, from account funds — another reason to keep cash on hand. A filing is generally required once the account’s gross unrelated business income crosses the threshold. This applies whether the IRA is Traditional or Roth.
The bottom line
UBIT and UDFI are not reasons to avoid alternatives; they are reasons to model the tax before you leverage or buy into an operating business inside a retirement account. Passive, unleveraged investments sidestep the issue entirely. When they don’t fit, bring a tax professional in before the deal, not after the notice.
This article is general information, not individualized investment, legal, or tax advice. Sources referenced include the Internal Revenue Service, Department of Labor, Securities and Exchange Commission, and FINRA. Consult a qualified professional about your circumstances.
Educational only. This page is general information, not individualized investment, legal, or tax advice. Rules depend on your account type, transaction, tax year, and circumstances — consult a qualified professional.