Beware of UBIT Lurking in Your IRA—It Causes Double Taxes , 2025
When you invest in a traditional individual retirement account (IRA), you get a tax deduction for the money you put in and then pay taxes when you take the money out. Money inside the IRA grows tax-free (or tax-deferred, technically, because it’s taxable when you take it out of a traditional IRA). But here is one big exception: some IRAs have to pay UBIT.
What Is UBIT?
UBIT is short for “unrelated business income tax.” It is a tax imposed on tax-exempt entities, such as IRAs, that engage in certain types of businesses. It was originally enacted in 1950 for tax charities—501(c)(3) organizations—that ran businesses unrelated to their charitable purposes. Congress felt it was unfair to require ordinary businesses to compete with tax-exempt organizations. UBIT helps level the playing field. For example, a non-profit museum that runs a bakery would have to pay UBIT on its profits just like other bakery owners do.
Most people are unaware that UBIT can also apply to IRAs, including traditional IRAs, Roth IRAs, SEP-IRAs, and SIMPLE IRAs. This is because IRAs are tax- exempt trust entities whose purpose is to help individuals save for retirement, not allow them to engage in business on a tax-free basis.
UBIT is a punishing tax. For you as an IRA owner, the UBIT is often a surprise—and expensive. Your IRA pays the UBIT at the same rate as for trusts. The top rate is 37 percent, the same as for personal income tax, but there are only four brackets, and you reach the top 37 percent bracket with income of $15,651:
| 0% | $0-$3,150 |
| 24% | $3,151-$11,450 |
| 35% | $11,451-$15,650 |
| 37% | $15,651 and higher |
If your traditional IRA pays the UBIT, your IRA suffers double taxation: First, the IRA pays the UBIT at trust rates. Second, when you take money out of the traditional IRA, you pay tax at ordinary income rates.
Example: Your traditional IRA has income that suffers the UBIT. If it has $100,000 taxed at 37 percent, that leaves $63,000 for you ($100,000 – $37,000). If you are in the top rate, you pay 37 percent individual income tax when you take the money out of the IRA. That’s a tax of $23,310 (37 percent x $63,000). You pocket $39,690.
Double taxation is not a problem with Roth IRAs because withdrawals are not taxable after five years. In the example above, you would have paid zero tax on your withdrawal of the $63,000, but your IRA would have paid the $37,000 tax.
Income Not Subject to UBIT
Fortunately, the income most IRAs earn is exempt from UBIT. This includes:
- Interest from the lending of money;
- Dividends from C corporations where the company paid corporate tax;
- Royalties from intangible property rights such as intellectual property, and from oil and gas and mineral leasing activities;
- Rents from real property; and
- Capital gains from the sale, exchange, or disposition of assets.
Most IRAs invest in stocks, bonds, mutual funds, exchange-traded funds, money market funds, CDs, and Treasury bills. The income from such assets falls within the interest, dividend, and capital gains exemptions. But income generated from an unincorporated business and/or from debt is subject to UBIT. For example, if you use funds from your IRA to start and run a bakery, you’ll have to pay UBIT on the bakery’s profits. Unpleasant UBIT tax issues typically arise when IRAs engage in the following types of investments.
Income Subject to UBIT
Pass-Through Businesses
No UBIT is due when your IRA buys stock in a C corporation that pays corporate taxes. But IRAs can become subject to UBIT when they invest in pass-through entities that operate active businesses.
These include S corporations, limited partnerships, regular partnerships, and limited liability companies (LLCs) taxed as partnerships or sole proprietorships. Unlike corporations, these entities pay no taxes—they pass through their income and losses to their partners or members.
Being a partner in such businesses—and thereby the direct recipient of their untaxed flow-through profits—is not generally within the exempt purpose of an IRA; therefore, the income received can constitute unrelated business taxable income upon which the IRA pays UBIT.
Private Equity and Hedge Funds
Investments by IRAs in private equity funds or hedge funds that are formed as limited partnerships or LLCs can result in UBIT.
Master Limited Partnerships
Investments in master limited partnerships are the most common source of unrelated business taxable income for IRAs. Master limited partnerships, which typically involve energy-related businesses, are publicly listed limited partnerships that trade on national securities exchanges and can be purchased through a conventional IRA (that is, you don’t need a self-directed IRA to buy into them).
Master limited partnerships have general partners who run the business, and many limited partners (the investors) who provide capital in return for cash distributions from the master limited partnership’s operations.
Although master limited partnership interests (called “units”) trade on exchanges like corporate stock, they are not the same as corporate stock. IRAs that invest in master limited partnerships become limited partners in the business. Since master limited partnerships are pass-through entities that pay no taxes, the limited partners are treated as if they are directly earning a share of the master limited partnership’s income. An IRA is subject to UBIT on its share of the master limited partnership’s taxable business income, minus its share of depreciation and other business deductions. These are reported on the master limited partnership’s annual Form K-1.
But IRAs don’t always owe UBIT on their master limited partnership units. Often, depreciation and other deductions reduce the taxable income passed through to the IRA to less than the $1,000 annual UBIT exemption.
The C Corporation Blocker Strategy
One strategy IRA owners use to minimize UBIT when they purchase an interest in a pass-through business is to use a C corporation blocker. This only works with a self-directed IRA. The self-directed IRA forms a C corporation and invests IRA funds in the corporation. The corporation then invests the money in the master limited partnership or other pass-through business. Since the self-directed IRA is not directly investing in an active pass-through business, no unrelated business taxable income is generated.
The C corporation must pay corporate tax on its income, but this is at the 21 percent flat tax rate—much lower than the maximum 37 percent UBIT that kicks in with income of only $15,651.
No UBIT is due on any dividends paid to the self-directed IRA by the blocker corporation, since dividend income is not subject to UBIT.
Unrelated Debt-Financed Income
UBIT commonly arises when an IRA, directly or through a partnership or LLC investment, utilizes debt to acquire real estate or other income-producing assets such as corporate stock or master limited partnership units. Ordinarily, you can do this only with a self-directed IRA since conventional IRA custodians usually don’t permit these kinds of debt-financed investments.
When an IRA uses debt financing, it generates unrelated debt-financed income (UDFI), which is subject to a form of UBIT. The tax on the UDFI is paid at UBIT rates on the profits that are returned to the IRA as a result of the debt.
You calculate UDFI based on the percentage of the property that is debt financed. For example, if your IRA buys a rental property worth $500,000 with $250,000 of debt financing, 50 percent of the rental income from the property is subject to UDFI tax. If the income is $30,000, $15,000 is subject to UBIT.
To determine your UDFI tax, you deduct the property’s operating expenses, interest expense, property tax, and depreciation in proportion to the debt percentage. For example, if your IRA borrowed 50 percent of the property’s cost, you may deduct 50 percent of these expenses from UDFI. As a result, often no UDFI tax is due or the tax is quite small.
UDFI tax most often poses a problem when debt-financed real property held in an IRA is sold. UDFI tax on any profit earned must be paid at capital gains rates. If the property has significantly increased in value, the tax could be substantial. UDFI at the time of sale is calculated by taking the prior 12-month average debt to determine the debt percentage.
Example: Your self-directed IRA purchased property with 50 percent debt financing several years ago. Its adjusted basis is $200,000, and it sells for $500,000. The remaining average debt is $100,000. Your debt percentage is $100,000 debt ÷ $200,000 basis = 50 percent. Fifty percent of your $300,000 gain from the sale— $150,000—is UDFI. You may subtract from this amount $20,000 in deductions for annual expenses and depreciation. This leaves $130,000 in UDFI subject to the 20 percent long-term capital gains rate, for a total tax of $26,000.
Planning point: Your self-directed IRA can avoid paying UDFI tax on property sales if the debt on the property is paid off more than 12 months before the sale. UDFI tax at the time of sale is calculated by taking the prior 12-month average debt to determine the leverage ratio. If there is no debt over this period, the debt percentage is zero and there will be no UDFI.
Paying UBIT
IRAs get a UBIT exemption of $1,000. The exemption is for each IRA you own—for example, if you have three IRAs, you get three $1,000 exemptions. If any single IRA generates more than $1,000 in unrelated business taxable income, it must file Form 990-T electronically and pay UBIT.
The IRA custodian files the form. It is not part of your personal income tax return. It’s due April 15, but you can get a six-month extension. Your IRA must have its own taxpayer ID number. UBIT must be paid by the IRA from its own assets, not from the IRA owner’s personal funds. An IRA must also make quarterly estimated tax payments if it expects to owe $500 or more in UBIT for the year. You can use the Form 990-W (Worksheet) to determine the amount of estimated tax to pay.
Key point: Your IRA custodian may not always be aware of its filing responsibility when UBIT is due. It’s a good idea to make sure that a Form 990-T is filed and UBIT is paid. The IRS assesses penalties and interest against your IRA.
Takeaways
Here are five takeaways from this article:
- Traditional IRAs, Roth IRAs, SEP-IRAs, and SIMPLE IRAs don’t have to pay tax on conventional investments such as stocks, bonds, mutual funds, exchange-traded funds, money market funds, CDs, and Treasury bills. Income from such investments in an IRA is exempt from tax.
- IRAs can be required to pay UBIT when they invest in pass-through entities that operate active businesses such as S corporations, limited partnerships, regular partnerships, and LLCs taxed as partnerships or sole proprietorships. This is because IRAs that invest in such entities become direct partners in the business.
- The most common investment that results in UBIT for IRAs are investments in master limited partnerships, which are publicly listed limited partnerships typically involved in the energy sector that trade on national securities exchanges. IRAs that purchase units in master limited partnerships must pay UBIT on their share of the master limited partnership’s income as shown on Form K-1.
- IRAs also must pay UBIT on the UDFI they earn when they use debt financing to purchase real estate or other assets. UDFI income is calculated based on the percentage of the property that is debt financed.
- There is an annual $1,000 UBIT exemption. IRAs that earn more than $1,000 in unrelated business taxable income or unrelated business debt income must pay UBIT at the tax rate for trusts. The IRA custodian must file Form 990-T, and the UBIT amount due must be paid from IRA funds.
At Provident CPAs, we specialize in helping clients adapt to changing economic conditions. Whether you’re a business owner or an individual looking to optimize your tax strategy, our team is here to guide you through the complexities of today’s tax landscape. Contact us today to learn more about how we can help you achieve financial independence, even in the face of economic uncertainty.