These are the twin towers of tax possibilities when utilizing a Self Directed IRA or 401(k) for certain types of activity related to investments.
Because this is a complicated area of tax law, we strongly suggest that you consult with a knowledgeable tax attorney before engaging in activities that may produce this tax. Also, IRA investors should review IRA Publication 598 for more information.
UBTI – Unrelated Business Taxable Income
UBTI was first introduced into law in 1950. Prior to that, tax-exempt organizations had a competitive advantage over for-profit corporations. As a result of highly publicized incidents in which tax-exempt organizations undertook business activities in direct competition with for-profit businesses, Congress enacted a general tax on the “unrelated business income” of tax-exempt organizations.
The same rules for UBTI that apply to tax-exempt organizations also apply to your tax-exempt or tax-free retirement account. This tax is most likely to be generated by the gains received from investing into an active business such as a restaurant, or perhaps flipping houses, and can have a negative impact on overall returns on investment.
UDFI – Unrelated Debt Financed Income
Unrelated Debt Financed Income (UDFI) is income derived from any debt-financed property held to produce income (including gain from its disposition). When an investor leverages an IRA real estate investment through the use of a non-recourse loan, the IRA will be subject to unrelated business income tax (UBIT) by the unrelated debt financed income (UDFI) produced by the property.