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How is the UBTI Tax on UDFI Calculated?

UBTI tax rate
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Unrelated Business Taxable Income (UBTI) is a tax that primarily applies to tax-exempt organizations, such as charities. The tax is in place to prevent tax-exempt organizations from competing unfairly with taxable organizations and to prevent such entities from engaging in a business that is unrelated to its primary business objectives.

Unrelated Debt Financed Income (UDFI) is a subset of the UBTI tax. UDFI can be triggered when an IRA holder uses a nonrecourse loan to purchase a piece of real estate property. The income that attributed to the financed portion of the property is taxed at the trust tax rate. When the debt-financed asset is sold, gain on the profit is also subject to UDFI unless the debt has been paid off more than 12 months before it is sold.

Generally, IRA holders do not have to be concerned about the UBTI tax or UDFI tax, as most investments with an IRA are tax-deferred or tax-free. However, there are three investments that can trigger UBTI tax:

  1.  Margin to buy stock
  2. Nonrecourse loan to buy real estate
  3. Investment in an active trade or business carried on through a pass-through entity, such as an LLC

Calculating UBTI Tax

Calculating the UBTI tax is the gross income “derived…from or on account of” debt-financed property is unrelated business income in an amount equal to the income multiplied by the following fraction (the “debt/basis percentage”):

Average acquisition indebtedness / Average adjusted basis

For example, if the average acquisition indebtedness is $50 and the average adjusted basis is $100, 50 percent of each item of gross income from the property is included in UBTI tax.

The debt/basis percentage is recomputed annually. Normally, the average acquisition indebtedness for any taxable year is the average of the acquisition indebtedness during the portion of the year when the organization owns the property. The average is computed by determining the amount of acquisition indebtedness on the first day during each month on which the organization holds the property, adding these amounts together, and dividing by the number of months and partial months during the year when the property is held.

Assume a Self Directed IRA LLC borrows $300 to purchase a building on July 10 of year one and makes principal payments on the debt of $20 on July 20 and on the twentieth day of each succeeding month during the year. Average acquisition indebtedness is $250 (sum of $300, $280, $260, $240, $220, and $200, divided by six). However, in determining the includable portion of gain or loss on a disposition of the property, the average acquisition indebtedness is the highest amount of acquisition indebtedness during the 12-month period ending with the date of the disposition.

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