What Is UDFI, and When Could UDFI Tax Apply to Your IRA?

UDFI stands for Unrelated Debt-Financed Income. When an IRA, or an LLC in which an IRA has an ownership interest, borrows money in order to purchase real estate (also known as using leverage or debt-financing), then the portion of the net profits that can be attributed to the borrowed money is considered unrelated debt financed income and is taxable.

UDFI falls under UBIT, or Unrelated Business Income Tax. The reason behind UDFI tax for a Self-Directed IRA is that since the IRA, directly or through its LLC, is profiting from borrowed money, then that money is “unrelated” to the IRA. Being that an IRA is a tax-exempt entity, the UBIT rules require the IRA to pay taxes on profits generated from that money.

For example, if an IRA’s LLC purchases a property and funds the purchase 60% with its own money and 40% from borrowed money, then 40% of the IRA’s share of net profits will typically be considered UDFI, since that portion of the profits was created from money that was not owned by the IRA’s LLC.

Here’s a practical example:

Let’s say that you have $50,000 in your Traditional Self-Directed IRA. You shop around for potential investments and find a property for $150,000. To facilitate the purchase, you have your IRA borrow $100,000. Your IRA then purchases the property. A year later, you find a buyer for the property. The sale price is $240,000. That means that your IRA just netted $90,000 on the deal. However, not all of that profit is due to tax-deferred IRA funds. Since you had to borrow two-thirds of the money to buy the property, only a third of the profit can be attributed to the IRA. The other two-thirds is attributed to the loan that the IRA took out to purchase the property. When tax time rolls around, the $30,000 profit that came from the IRA is tax-deferred, but the $60,000 that came from the loan will be subject to UDFI tax. The UDFI tax rate can be between 10% and 37%, depending on the amount subject to being taxed.

For real estate transactions, a Solo 401(k) is exempt from UDFI.