When dealing with self-directed IRAs you may come across phrases that you haven’t heard before. We want you as informed as possible so that you can make wise decisions with your self-directed IRA. UBIT and UDFI are the two key phrases we will be talking about today.
UBIT stands for Unrelated Business Income Tax and is associated with an IRA running an active business. UDFI stands for Unrelated Debt Financing Tax. It’s related to an IRA receiving a loan for the purchase of property or other business activity.
Looking at an example may make this a bit clearer as to what each actually means. If an IRA forms an LLC to buy and operate a dry cleaner or gas station, businesses obviously unrelated to the primary purpose of an IRA, the net income will be taxed as UBIT (at the trust tax rate because an IRA is considered a trust under the tax code for this purpose). The change in the code was intended to level the playing field between tax-exempt organizations, and for-profit organizations conducting the same businesses.
In addition, whenever debt is used by a tax-deferred or tax-exempt entity (with some exceptions), the tax is applied to that portion of the gain that is debt-financed. This income is called unrelated debt-financed income or UDFI, which is a subset of UBTI. Taxes on both are calculated and reported on IRS form 990-T.
Any property held to produce income is debt-financed property. That is if at any time during the tax year, there was acquisition indebtedness outstanding for that property. When any property held for the production of income by a tax-exempt organization, or IRA or Roth IRA, is disposed of at a gain during the tax year, and there was acquisition indebtedness outstanding for that property at any time during the 12-month period before the date of disposition, the property is debt-financed property.
In general, average acquisition indebtedness for any tax year is the average amount of the outstanding principal debt during the part of the tax year the property is held by the entity or IRA.
To calculate the average amount of acquisition debt, determine the amount of the outstanding principal debt on the first day of each calendar month during that part of the tax year that the organization holds the property. Add these amounts together. Now divide the result by the total number of months during the tax year that the organization held the property.
The amount of income taxable as UDFI, for any tax year, is the total income, multiplied by a fraction. The numerator is the average amount of acquisition debt. The denominator is the average of the adjusted basis at the beginning and at the end of the year. Also, note that any capital gains attributed to the debt financing will be taxed as capital gains on a pro-rate basis.
Before calculating the net income, certain deductions can be taken into consideration. Exactly as they are when you purchase property outside of an IRA. For example, depreciation can be deducted, if applicable, but only on the straight-line method.
For example, say the depreciation of an IRA-held building is $20,000 and the property is 70 % debt-financed. As a result, 70% of the $20,000 overall depreciation (or $14,000) can be deducted from gross income, before calculating UDFI tax. To be directly connected with debt-financed property or income derived from it, the deduction must be clearly related to the property and its income.
An IRA purchased a residential rental property that produced $10,000 of gross rental income last year. Say the average adjusted basis of the rental during the year was $100,000. The average indebtedness (e.g., bank mortgage), with respect to the rental property, was $50,000. The relevant fraction is 50% and therefore the unrelated debt-financed income was $5,000 (50% of the $10,000).
If you would like any information regarding self-directed IRAs we are happy to talk to you. Talk with your tax accountant if you need more specific information regarding tax questions.
Author: Ben Barker, Self-Directed IRA Professional