IRS Rules
UDFI
What is UDFI?
Unrelated Debt-Financed Income, or UDFI, occurs when an IRA investment generates income derived from a debt-financed asset owned by an IRA. A common case where UDFI takes place is when an IRA borrows money to purchase real estate and that property generates income (such as rental income.) The net profits attributable to the leveraged portion are considered UDFI and are subject to tax. For example, if a real estate property is purchased with 70% IRA funds and 30% borrowed money, 30% of the total profit earned is subject to UDFI tax.
UDFI is a subset of UBIT (Unrelated Business Income Tax). If your investment is subject to UDFI tax, it pays the UBIT tax rate. Since the same income is being taxed, only one payment is due, even if UBIT and UDFI tax are required.
IRAs were created in order to encourage people to save for retirement. Therefore, any activity completed for a reason other than saving for retirement is characterized as “unrelated”. For example, if your IRA invests in a business such as a grocery store, the income generated by the store is considered unrelated to the purpose of an IRA according to the IRS. There are a few types of income that are generated by your IRA that are not taxable such as interest, dividends, rents, royalties, capital gains from a sale of a property, and profits under $1,000.
It is understandable that most people try to avoid taxes at all costs. However, incurring UDFI tax is not necessarily a bad thing; it means your investment is doing well. If you owe UDFI tax, your investment is generating more than $1,000 in profits. You’re obviously getting a great return!
The Takeaways
- UDFI – Unrelated Debt-Financed Income – is a tax that must be paid for any retirement assets that were purchased using a loan.
- UDFI is not applied to the entire value of the asset, but rather just for the percentage that was purchased using leverage.
- UDFI is paid using IRS Form 990-T and must be submitted by the tax deadline of April 15.
How do I calculate UDFI?
First find out the percentage of debt as compared to the total value of the property. Then, apply that percentage to the income generated by the property (after expenses are deducted.) The answer will tell you how much of the income or profit is taxable.
To calculate UDFI, follow these steps:
- Calculate the ratio of debt versus the cost of the property. To do this, divide the amount of funds borrowed to purchase the property by the cost of the property.
- In this scenario, the ratio of debt versus the cost of the property is 40% ($80,000/$200,000 = 0.4 or 40%).
- Determine the amount of income subject to UDFI tax (before deductions).
- Multiply net profit by the ratio of debt versus the cost of the property ($60,000 x 40% = $24,000).
- $24,000 is subject to UDFI, before deductions.
- Calculate the amount of income subject to UDFI (after deductions)
- Subtract $12,000 from $24,000.
- $12,000 is subject to UDFI tax.
- Use the IRS tax rate schedule for trusts and estates to calculate your tax bill (refer to page 5 on Form 990-W).
- $1,921 + (0.35)(12,000) = $6,121 taxes are owed.
2021 Tax Rate Schedule for Trusts
| Annual Income subject to UDFI | UDFI Tax Rate |
|---|---|
| $0 - $2,650 | 10% |
| $2,650 - $9,550 | $265.00 + 24% |
| $9,550 - $13,050 | $1,921.00 + 35% |
| Over $13,050 | $3,146.000 + 37% |
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How do I file for UDFI?
If UDFI tax is due, the account holder must prepare Form 990-T by April 15. There may also be separate forms to file based on the state your IRA LLC is filed in.
It is recommended to consult an accountant or tax preparer to determine whether UDFI taxes are owed. A discussion with a financial professional should also take place to discuss the rules and regulations involved in a Self Directed IRA investment. For more information, reach out to a Self Directed IRA LLC Specialist.
FAQ
If you purchased the rental property with just your IRA funds, you do not owe UBIT or UDFI tax. Rent and gains from property sold are exempt from UBIT. However, if you leveraged debt to purchase the property, you may owe UDFI tax on income generated over $1,000.
Your IRA funds, not your personal funds, are used to pay the tax. In order to fill out form 990-T, you will need an EIN (Employer Identification Number) under your IRA’s name. Keep in mind contribution limits for the year to make sure you have enough funds to pay any expenses and taxes.
In this case, you can rollover or transfer from another tax-advantaged account into your IRA.