When it comes to tax-advantaged retirement accounts, many investors assume they won’t owe taxes until they start making withdrawals. But that’s not always true, especially when alternative investments are involved. A little-known tax called Unrelated Business Taxable Income (UBTI) can trigger unexpected tax bills inside accounts that are supposed to be tax-deferred, like IRAs and 401(k)s.

Traditional investments like stocks and bonds typically don’t raise any red flags. But self-directed IRAs that venture into private equity, real estate partnerships, or businesses with debt financing may generate unrelated business taxable income UBTI, even if no distributions are taken. And when that happens, your retirement account could suddenly owe taxes in the current year.

In this article, we’ll break down what UBTI is, how it works, which investments tend to trigger it, and what strategies you can use to reduce or avoid it—especially if you’re using a retirement account to invest in alternative assets.

Table of Contents

  1. What qualifies as unrelated business taxable income
  2. The $1,000 threshold and form 990-T filing requirements
  3. Identifying UBTI through K-1 statements
  4. Common investments that generate UBTI
  5. Strategies to minimize UBTI tax consequences
  6. Proactive tax planning for alternative retirement investments

Key takeaways

What qualifies as unrelated business taxable income

The IRS makes an important distinction between passive investment income and income earned from operating a business. If your IRA or other tax-exempt retirement account generates income from running a business that’s unrelated to retirement savings, that income is considered unrelated business taxable income (UBTI)—and it’s subject to tax, even inside a supposedly tax-sheltered account.

For example, imagine your IRA owns a local coffee shop. While the long-term goal may be funding retirement, selling lattes and pastries is an active business with no direct connection to retirement savings. Because of that, the net income from this activity is treated as UBTI and taxed accordingly.

Fortunately, most traditional forms of passive income—like interest, dividends, royalties, and capital gains—are exempt from UBTI. But there’s an important caveat: if your retirement account uses borrowed money to generate that income (such as a mortgage to buy real estate), you could still trigger UBTI under the debt-financed income rules.

This is why alternative investments require extra care. Private equity funds, real estate development projects, and master limited partnerships often involve active business operations—or use debt—that can easily create UBTI exposure. Even real estate that looks passive on paper can become taxable if the property was purchased with a loan.

The $1,000 threshold and form 990-T filing requirements

Once UBTI exceeds $1,000 in any tax year, retirement accounts must file IRS Form 990-T. This obligation typically falls to the account trustee or custodian, though the ultimate responsibility lies with the account owner to ensure the filing is proper.

The timing mirrors individual tax returns—Form 990-T must be submitted by April 15. Those needing more time can request an extension until October 15 through Form 8868. But here is where it gets interesting: the tax payment must come directly from retirement account assets.

Personal funds cannot cover these tax obligations. The IRA or retirement plan itself must maintain sufficient cash to pay the UBTI tax bill. This creates an often-overlooked drag on investment returns, as assets that could be growing tax-deferred instead go to the IRS.

For accounts generating substantial UBTI, the IRS requires quarterly estimated tax payments when the expected annual liability tops $500. This necessitates careful cash flow management within the retirement account to avoid forced liquidation of investments at inopportune times.

Identifying UBTI through K-1 statements

An image of someone writing in a notebook whilst holding money. Sitting up at a table.

If your IRA invests in partnerships, especially private equity funds or master limited partnerships (MLPs)—UBTI exposure often shows up on the Schedule K-1 tax form. One key area to check is Box 20, Code V, which reports the amount of unrelated business taxable income (UBTI) that applies to tax-exempt investors like IRAs and retirement plans.

MLPs, in particular, can create complications. If your retirement account sells an MLP interest, the portion of the gain classified as “ordinary income” is treated as 100% UBTI—and must be reported on Form 990-T. There are no preferential tax rates or exemptions here, and the entire ordinary gain is subject to tax.

To figure out how much tax is actually owed, you’ll need to add up all positive UBTI amounts from various investments. From that total, your IRA can subtract eligible deductions—including a standard $1,000 deduction allowed for UBTI. The remainder is taxed at trust tax rates, which are steeper and kick in much sooner than individual rates—meaning even modest amounts of UBTI can lead to a sizable tax bill.

Common investments that generate UBTI

Certain types of alternative investments are far more likely to trigger unrelated business taxable income—often catching retirement investors off guard.

Limited partnerships and  master limited partnerships are frequent culprits, especially when they use debt in their operations. Even if the income seems passive, leverage within the fund structure can convert it into taxable UBTI for retirement accounts.

Self-directed IRAs that invest directly in active businesses—like restaurants, retail shops, or service companies—face near-certain UBTI exposure. Because the business is actively earning income unrelated to retirement savings, the IRS treats all operating profits as taxable.

Real estate investments can also generate UBTI when debt is involved For example, if an IRA buys a $1 million property with 40% mortgage financing, then 40% of its rental income (and potentially its gain on sale) could be taxed as unrelated debt-financed income.

Private equity and hedge funds often trigger UBTI through a combination of factors—business activities, use of leverage, and complex entity structures. Even if you’re a few layers removed from the operating business, UBTI can still pass through and land on your account’s tax return. That’s why due diligence and careful review of offering documents and K-1s are essential when investing through a retirement account.

Strategies to minimize UBTI tax consequences

An image a close up of someone using the calculator on a table.

While UBTI can create unexpected tax bills in retirement accounts, smart planning can help reduce its impact—or avoid it altogether.

Roth IRAs offer one useful advantage. Although Roths are still subject to UBTI taxes when triggered, any post-tax growth remains untaxed upon withdrawal. That means you’ll avoid a second layer of taxation later, making Roths a more UBTI-friendly option for long-term alternative investing.

Some investors take a more advanced route by using a C-corporation blocker, which sits between the investment and the retirement account to absorb UBTI. While this structure can reduce direct tax exposure, it adds complexity, costs, and its own layer of corporate tax, so it’s best used with professional guidance.

A simpler approach is to choose UBTI-free investment vehicles. Many ETFs, REITs, and fund structures are intentionally designed to avoid passing UBTI through to investors. These can offer exposure to private markets, real estate, or commodities—without triggering tax consequences inside your IRA.

It’s also smart to keep adequate cash reserves inside the retirement account. If UBTI is triggered, taxes must be paid from within the account itself. Having liquidity on hand helps you cover the tax bill without selling off illiquid or long-term holdings at the wrong time.

Proactive tax planning for alternative retirement investments

The complexities of UBTI demand more than casual attention from retirement investors exploring alternative assets. Small structural decisions in how investments are held can dramatically impact after-tax returns.

Professional guidance proves invaluable in navigating these waters. The right tax advisor brings both technical expertise in UBTI rules, practical experience implementing tax-efficient investment structures, and this combination helps investors avoid compliance pitfalls while maximizing the benefits of tax-advantaged retirement accounts.

If you’re exploring alternative investments through a retirement account, professional guidance can make a major difference. Get started with a Harness tax advisor to structure your portfolio in a way that minimizes UBTI while still aligning with your investment goals.

Disclaimer:

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