What is Unrelated Business Taxable Income (UBTI)?
Unrelated business taxable income (UBTI) is the tax placed on the income derived from unrelated business activities of an otherwise tax-exempt entity.
How Does Unrelated Business Taxable Income (UBTI) Work?
For example, if an investor uses his Individual Retirement Account (IRA) open a bakery, this is a business clearly not related to the primary purpose of an IRA. The income from the bakery is considered UBTI and is taxable, even though the money is flowing into a tax-advantaged account.
If the investor qualified for a business loan through his IRA, any gain that comes as a result of the debt financing is also taxable. (note that securities purchased on margin are considered debt-financed property and those gains would generally be taxable in this scenario). There are certain deductions that can apply to UBTI, consequently reducing the tax liability. These deductions must be directly related to the property and its income.
The role of UBTI in this relationship is to prevent tax-exempt entities from engaging in businesses that are unrelated to their primary purposes. It includes most business operations’ income and excludes interest, dividends and capital gains from the sale or exchange of capital assets.
Why Does Unrelated Business Taxable Income (UBTI) Matter?
The IRS considers many distributions from REITs, master limited partnerships, and other pass-through entities as UBTI. There are a variety of ways some organizations seek to reduce the effects of UBTI on their investors.
For instance, REITs might attempt to eliminate UBTI for its investors by owning properties through a subsidiary but distributing income from the subsidiary as dividends, which are not considered UBTI. This action, however, does not let investors take advantage of any losses generated by the fund, nor can they take advantage of the foreign tax credit if the fund invests in foreign real estate.
Investors might also hold interests in an entity that in turn holds interests in the REIT. However, this risks being considered an investment company in the eyes of the Securities and Exchange and the IRS. Investors should work with a qualified tax professional to understand how UBTI might affect their investment decisions and tax liability.