Unrelated Debt Financing Income (UDFI) is a complex and often misunderstood issue. But we will try to make it is to understand. In this post we will answer the question – what is unrelated debt financing income and how is it calculated?
When it comes to understanding self-directed IRA (“SDIRA”) tax issues, most folks have heard of UBTI. It occurs when an SDIRA generates income from a trade or business that is regularly carried on.
But another tax issue that is not understood as much is income generated from debt-financed property. This is commonly known as Unrelated Debt-Financed Income (“UDFI”). Before an IRA invests in any alternative assets, it is critical to understand the implications of these two.
I have covered UBTI elsewhere. But in this post I want to cover UDFI.
What is Unrelated Debt Financing Income (UDFI)?
UDFI is a form of UBTI. Specifically, it looks to investments that are held in the production of income for which there is acquisition indebtedness at any time during the tax year. It also applies to any gains from the sale of such property.
UDFI can apply to a variety of investments including corporate stock and tangible personal property. But the issue is commonly seen in real estate. This is where it can get sticky.
So what does “debt-financed property” really mean? With certain exceptions, it relates to any property that is held to produce income in which there is “acquisition indebtedness” at any time during the taxable year.
The production of income would include dividends, interest, royalties and capital gains. But in most situations, I see it as it relates to rental income. I know this can be a little challenging but stay with me.
How is UDFI Calculated?
Let’s look at a simple example to see how this works.
Let’s assume an SDIRA acquires a rental home for $200,000 with a $50,000 down payment. Accordingly, there is a loan on the property of $150,000. Since the loan represents 75% of the purchase price, then 75% of the income generated by the property would be subject to UDFI.
The above example is simplistic, but the UDFI calculation is a little more involved. It is actually calculated as the percentage of average acquisition indebtedness for a given tax year divided by the property’s average adjusted basis for the year (average debt/average basis).
UDFI is very challenging for the average person. Fortunately, most SDIRAs that hold leveraged real estate will not owe UDFI tax for the first few years as a result of depreciation expense. In fact, most CPAs have never completed the calculation. But you will need a tax professional to review the calculation with you.
So what are the tax filing requirements? A tax filing is only required if there is gross income from UDFI of $1,000 or more. Assuming this criteria is met, Form 990-T, Exempt Organization Business Income Tax Return, must be filed and the tax paid accordingly.Unfortunately, IRAs are taxed at trust tax rates which are steep. Any income above $11,950 is taxed at the rate of 39.6%. State taxes should also be considered.
Is an IRA subject to unrelated debt financing income (UDFI)?
Yes, it is. Also, it applies to partnerships and LLC shares. This can include various real estate partnerships and real estate crowdfunding. Real estate can be structured differently so make sure you understand the structure.
Is a 401k subject to unrelated debt financing income (UDFI)?
Fortunately, it is not. Unlike an IRA, 401ks are exempt from UDFI.
If an investor is looking to acquire real estate using non-recourse leverage is generally more tax advantageous to use a 401k rather than an IRA. But make sure you can satisfy the list of prohibitions under IRC 514(c)(9). Make sure to involve your CPA in the process because of the complexity.
So when planning investments with your retirement accounts, make sure that you consider UDFI. It is often overlooked. Even though retirement plans have a lot of flexibility in what they can invest in, there can be immediate tax consequences. As always, make sure you review any transaction with your CPA or tax professional to make sure that you do not have a UDFI issue.