Real Estate and UDFI Tax
Unrelated Debt-Financed Income (UDFI) Tax: What Real Estate Investors Need to Know
WHAT IS UNRELATED DEBT-FINANCED INCOME TAX (UDFI)?
Unrelated Debt-Financed Income Tax (UDFI) is a tax that applies to gains from an asset received by an IRA. UDFI is derived from debt financing used to obtain the asset. You might be thinking, “Doesn’t my IRA, a tax-advantaged account, prevent me from being taxed on my investments?” and you would generally be right if your IRA does not participate in any taxable activities. However, a few actions can cause a tax-advantaged account or entity to be taxed on its gains. Today we will concentrate on self-directed real estate investments that can be taxed.
As the name implies, Unrelated Debt-Financed Income Tax is a tax for tax-advantaged accounts or entities. Income attributable to gains obtained through debt financing is susceptible to UDFI. If you use debt to acquire an asset within a tax-advantaged account (such as a self-directed IRA), you have to pay UDFI on a portion of your net income from that asset. If you use a non-recourse loan to fund your IRA’s real estate purchase, you pay UDFI on that property’s gains. Learn more about non-recourse loans in a tax-advantaged account.
HOW IS UDFI CALCULATED?
Now that we know what UDFI is, we will learn how to calculate your estimated payment. We will also learn how to report it on your 990-T. You need to know three main figures. As mentioned before, UDFI is a tax that is applied when debt financing assists in you obtaining income. The ratio of equity to debt used to purchase the investment is the first key figure you need to know. In our example, let’s assume you buy a property worth $100,000 with $40,000 of financing in your self-directed IRA. In this example, 40% of the property is debt-financed. Consequently, 40% of all income from that property is directly attributable to that debt financing.
Next, we need to know your property’s net income attributable to the debt. We also need to know the UDFI tax rate you fall into that year. As a reminder, net income is your gross income minus your asset’s expenses and any applicable deductions. For our example, let’s say the total net income is $5,000. So, net income attributable to debt is $2,000 ($5,000 total net income x 40% debt to value ratio). You then apply any reductions in UDFI for which your retirement account may be eligible. Next, apply the appropriate UDFI tax rate to that figure. That will be the amount you will report on your 990-T when you file your taxes. That amount is your UDFI tax burden that year.
CAN I AVOID PAYING UDFI?
As mentioned before, UDFI tax rates can reach as high as 37% in one year. UDFI is something that deserves serious consideration for investors thinking about using leverage in their self-directed retirement accounts. Thankfully, options are available for certain investors to avoid paying UDFI altogether.
Internal Revenue Code Section 514(c)(9) outlines that Individual 401(k) (or Solo 401(k)) plans are exempt from paying UDFI. This exemption makes a self-directed 401(k) a powerful tool for investors looking to use leverage to purchase their investments. However, something worth mentioning is that not everyone is eligible to have an Individual 401(k). There are specific qualifications that need to be met to have an Individual 401(k). Learn more about Individual 401(k) plans and their qualifications.
Another method to avoid paying UDFI is to restructure your investment to exclude the use of receiving debt financing. You may consider loaning funds from your IRA to a non-disqualified party to purchase the property themselves. They can then issue principal and interest payments to your IRA to repay the loan. This method provides an indirect way to participate in the property’s future gains. The borrower repays your IRA, but you do not use debt to access these gains.
Several other strategies can reduce or eliminate your self-directed retirement plan’s UDFI tax burden. Ultimately, your individual circumstances will determine the method you choose. We recommend speaking with a CPA or financial advisor to discuss the strategy that works best for you.
If you are looking for information on self-directed IRAs or an Individual 401(k), www.midlandtrust.com is an excellent resource to start. Or, call us at (239) 333-1032. We would be happy to discuss our services with you and how you could incorporate self-directed IRAs or an Individual 401(k) into your investment portfolio.
MIDLAND TRUST IS NOT A FIDUCIARY: Midland’s role as the custodian of self-directed retirement accounts is non-discretionary and administrative in nature. The account holder or authorized representative must direct all investment transactions and choose the account’s investment(s). Midland has no responsibility or involvement in selecting or evaluating any investment. Nothing contained herein shall be construed as investment, legal, tax, or financial advice or as a guarantee, endorsement, or certification of any investments.