In Part 1 of Understanding Unrelated Business Taxable Income, we discussed UBTI. The second type of UBTI that a self-directed IRA may generate is unrelated debt-financed income or UDFI. UDFI may be generated when a tax-exempt or tax-deferred entity owns property that is debt-financed. If an IRA holds leveraged real estate or interest in an LP or LLC which obtained financing, the portion of the profit realized through the debt may be subject to UDFI tax and taxed at trust rates.
Unrelated debt-financed income is covered in IRC Section 514 which defines debt-financed property as “any property which is held to produce income and with respect to which there is acquisition indebtedness at any time during the taxable year.”
UDFI is only applied to profit realized through debt. An IRA may owe tax if income is generated by a leveraged property, or if a debt-financed property is sold for a profit. UDFI would not apply if the debt is paid off 12 months or more prior to the sale.
Taxes are based on the highest amount of leverage the self-directed IRA carried in the past 12 months. UDFI is only applied to the gain or profit realized through debt. The formula below is used to find the amount of income that is taxable as UDFI:
Average Acquisition Indebtedness is the average outstanding principal indebtedness during the portion of the year the property is held. This amount is found by averaging the amount of outstanding principal for the first day of each month that the property is held.
Average Adjusted Basis is found by averaging the adjusted basis of the property for the first and last day of the year that the property is held.
Gross Income from Property may be able to have certain deductions taken before calculating UDFI, such as depreciation. However, deductions for depreciation can only be taken by using the Straight Line Method; all deductions must be clearly related to the income and property.
When selling the investment at a profit, the taxable amount may be determined by dividing the Average Acquisition Indebtedness by the Average Adjusted Basis.
UDFI Tax Filing
If your IRA does owe UDFI, it is best to consult a tax professional for preparation of IRS Form 990-T. Once complete, Form 990-T can be submitted to the IRA custodian with the authorization to file and instruction to pay the UDFI tax.
Keep in mind that most self-directed IRAs that hold leveraged real estate will not owe UDFI tax for the first few years due to depreciation.
If you are considering an investment that may generate UDFI, your tax advisor should be consulted in advance. To learn more about unrelated-debt financed income please view IRS Publication 598.