Unrelated Business Income Tax

UBIT stands for Unrelated Business Income Tax. This is a tax that applies to the profits of an active business owned by a self-directed retirement account. Most investors never run into it, because the types of investments favored by the self-directed platform are normally passive in nature and thus are tax deferred, (or tax-free in the case of a Roth account).

There are a few investments, however, that are subject to taxation. If a tax-exempt entity, such as a not-for-profit organization or an IRA/Solo 401k, engages in, or invests in an unincorporated active business, (e.g. the operation of a gas station, dry cleaner, grocery store, etc.) then the net profit of the business would be subject to Unrelated Business Income Tax. The more common investments, such as real estate, tax-liens, private placements, mortgages, securities, etc., are typically exempt from UBIT.

The reason why Congress originally instituted UBIT was to level the playing field between for-profit organizations and not-for-profit organizations that were operating the same types of businesses. Without UBIT, the not-for-profit organization would have an unfair advantage by not having to pay any income taxes and thus be able to charge less for the same products and services than the for-profit organization.

Another potentially taxable situation comes with gains attributable to a Solo 401k’s borrowing (e.g., margin trading). These are considered “unrelated debt-financed income,” and are generally taxed under the heading of UDFI. An important exception is a Solo 401k’s gains on a leveraged real estate purchase, which are not treated as “unrelated debt-financed income” and are therefore not taxable to your Solo 401k.

One common UBIT question that arises is that of flipping properties. Although real estate is normally considered a passive investment, if an investor engages in active property flipping, that could be subject to UBIT. So how would you know if your property transactions are considered active or passive?

The generally accepted distinction is that properties that are sold after being held for a year or longer are not considered “flipped”. Those held for less than a year and then sold would be considered “flipped”. Another factor to take into consideration is the amount of your property investing that involves flipping. If the majority of your properties are held for the requisite length of time, then an occasional flip will not nullify their passive investment status. In all cases, you should ask a financial professional as to the details of your specific case.