Understanding UDFI Tax Impact in Multi-Family Real Estate Syndications: Part 1
Multi-family real estate syndications have been one of the hottest asset classes for savvy IRA investors for the last several years.
Participating as a limited partner in a professionally-run real estate project that is larger in scale provides many benefits. For busy professionals looking to put retirement money to work in a hands-off manner that provides a good mix of principal security and solid return potential, real estate syndications are hard to beat.
Most of these deals use a combination of investor capital and mortgage debt to acquire properties. This use of debt-financing produces exposure to tax on Unrelated Debt Financed Income (UDFI) for an IRA investor.
Queue the panic button!
Taxes will kill your IRA return!
The sky is falling!
Wrong, wrong, and, um…wrong.
Many investors and even a lot of syndicate general partners approach the topic of UDFI taxation with fear. That fear is misplaced and largely based on lack of good information.
We wanted to take a little bit of time to put this topic in proper perspective.
What is UDFI?
When an IRA uses debt-financing, it brings non-IRA money into the picture to increase the performance of the IRA’s investment. Section 514 of the tax code designates a tax on this Unrelated Debt-Financed Income.
Such taxation first became applicable in 1969, and is a means to prevent certain types of abusive transactions via tax-exempt structures.
UDFI is the portion of the income that an IRA receives based on the use of the borrowed funds. In a property with a 65% LTV loan, that would mean 65% of the gross income produced by the property is considered UDFI.
The IRA can apply the same 65% ratio of normal deductions such as depreciation, interest on the note, and operating expenses to offset the taxable income. The net taxable amount left after deductions is used to determine the tax owed by the IRA.
Taxation on UDFI applies to rental income produced by a debt-financed property. The gain on sale of a property that still has debt-financing in place is also considered to be UDFI and taxable.
At the end of the day, the IRA pays what is usually a nominal amount of tax in order to benefit from the higher cash-on-cash returns that leverage produces. The benefits of leverage will still very much be realized, just with a small amount of friction.
So, if generating higher net returns for your IRA is of interest, read on.
The Solo 401(k) Exemption
As a qualified employer retirement plan, a Solo 401(k) is exempted from UDFI when the debt-financing is used for the acquisition of real property. Other types of debt-financing, such as leveraged stock trading, are taxable as UDFI in a Solo 401(k).
In most syndicated real estate partnerships where income and losses are attributed to all limited partners equally, this exemption will still apply — even though the real estate is indirectly held and financed.
A Solo 401(k) could lose UDFI exemption if the partnership is shifting depreciation solely to investors using non-retirement funds. Such unequal allocation of losses violates the “fractions rule” of IRC section 514(c)(9)(E), and voids the qualified plan exemption to UDFI.
For those investors who are eligible for a Solo 401(k), that platform provides an advantage in terms of simplicity and higher profitability when investing in leveraged multi-family syndications.
A Sample Multi-Family Syndication
Let’s examine how UDFI impacts an IRA investor in a typical multi-family syndication.
In this project, the promoter is acquiring a 216-unit apartment complex for $25M using $10M down and a loan in the amount of $16.25M. The total acquisition cost will be $26.25M, allowing for transactional costs and capital improvements to the property.
Limited partner investors will provide $9M, and the general partner will have skin in the game by providing $1M.
The project plan is to upgrade the property and management to increase rents and occupancy rates, thereby improving the performance of the apartment. After a 10-year hold, the property will be sold, with a projected value of about $34.5M.
An IRA investor bringing $100K to this project will have a 1% equity stake as a limited partner in the LLC that will hold and operate the property.
When the investor is looking at their income and applicable taxation, everything is fractionalized to their IRA’s 1% level of ownership. So instead of this being a $25M project with $10M of investor capital down, it essentially becomes a $250K project with the IRA investor’s $100K down.
The promoter’s pro-forma projections for cash flow indicate that a 1% limited partner can expect a distribution from the LLC annually. The following amounts exhibit the increase over time as property performance increases.
- Year 1: $7,119
- Year 5: $10,769
- Year 10 $11,395
At the end of the 10-year hold when the property sells, the investor should receive their capital back, plus their percentage of the gain on sale. Our $100K investor with 1% participation could expect around $92K in proceeds from the future sale if the $34.5M goal is met.
When examining UDFI, there are 3 key values used:
1. Average Acquisition Indebtedness
This is the average monthly balance on the loan during that portion of a given tax year during which a property is held.
2. Average Adjusted Basis
This is the average cost basis of the property over the period during a given tax year when the property is held. The initial cost basis starts with the price paid for the property, as well as closing costs and the cost of any property improvements completed at acquisition or reasonably foreseen as necessary at the time of purchase.
The cost basis is reduced each year by the full amount of straight-line depreciation on the property. Averaging the beginning and ending cost basis values for the year provides the average adjusted basis value used for UDFI calculations.
3. Debt Financing Ratio
This is the result of dividing the average acquisition indebtedness by the average adjusted basis. This ratio is then applied to gross income produced by the property to determine the amount of UDFI.
Likewise, the same ratio is used to determine deductions for applicable expenses like interest, depreciation, and operating expenses such as property taxes, management, etc.
A $1,000 exemption against UDFI applies per taxpayer.
The net income deemed to be UDFI after the exemption and deductions is then run through the trust tax table to determine the taxable amount.
An IRA is a form of trust, thus the use of the trust table. 2019 trust tax rate brackets range from 10% on amounts below $2,550 to 37% on amounts over $12,500.
The potential of some income being taxed at a 37% rate is intimidating, and a big reason why many folks become deterred from debt-financed investments. As we continue, you’ll see that only a fraction of real income is subject to taxation, and the effective tax rate an IRA will pay is generally quite low.
UDFI – Rental Income
For sake of brevity, we’ll skip over the details of the math for determining our average adjusted basis and average acquisition indebtedness.
When we run the numbers on this deal we end up with a debt-financing ratio after the first year of .63. This means that 63% of the gross income is considered taxable as UDFI.
The property will generate $2.43M in rents, so our 1% shareholder IRA will be allocated $24,326. 63% of that value is $15,309 which is our gross UDFI income amount.
The allowable deductions include mortgage interest, depreciation, property taxes, property management, etc. The 63% allocation of these write-offs equals $15,376.
Wait, that is higher than our debt-financed income!
Due to the lower performance of the property in the initial years, we’ll have more allowable expenses than income. There will be no UDFI tax in year one even though the IRA received $7,119 of net income.
Likewise, in year two, the IRA will take home $8,719 and have no tax obligation.
The tax losses are negligible, and therefore not worth doing a return in order to carry losses forward to offset taxes in future years. This would be a viable strategy with larger tax losses.
Each year the values shift a bit and that changes the tax implications. With an interest-only loan such as this project uses, cash flow is boosted in the early years.
The trade-off with respect to UDFI is that the average acquisition indebtedness is not reduced each year by principal payments on the loan. The average adjusted basis does become lower each year as the full amount of depreciation on the property is applied.
This causes the debt-financing ratio to increase over time, making more of the income taxable. By year 10, the debt-financing ratio is .81.
In a loan normally amortized on a principal plus interest basis, the debt-financing ratio will trend consistently near the initial value until dropping in the last few years of the loan.
Following are the top line numbers for a few landmark years of the project.
- Year 3 is the first year with tax liability.
- Year 5 is the last year of the interest-only loan.
- Year 7 reflects increased mortgage payments once the interest-only period expires.
- Year 10 is the last year of the project prior to sale.
- All values reflect the 1% share our IRA investor has in the larger deal.
|Year 3||Year 5||Year 7||Year 10|
|Gross Income||$ 28,394.00||$ 30,415.00||$ 32,268.00||$ 35,260.00|
|Operating Expenses||$ (12,151.00)||$ (12,624.00)||$ (13,136.00)||$ (13,774.00)|
|Lender Reserves||$ (432.00)||$ (432.00)||$ (432.00)||$ (432.00)|
|Sponsor Fees||$ (902.00)||$ (902.00)||$ (902.00)||$ (902.00)|
|Debt Service||$ (5,687.52)||$ (5,687.52)||$ (8,756.40)||$ (8,756.40)|
|Net Cash to Partners||$ 9,221.48||$ 10,769.48||$ 9,041.60||$ 11,395.60|
|UDFI Tax Amount||$ 33.80||$ 156.37||$ 324.82||$ 917.67|
|Effective Tax Rate||0.37%||1.45%||3.59%||8.05%|
|Tax Preparation||$ 350.00||$ 350.00||$ 350.00||$ 350.00|
|Net Tax Cost||$ (383.80)||$ (506.38)||$ (674.85)||$ (1,267.75)|
|Post-Tax Return Amt||$ 8,837.68||$ 10,263.10||$ 8,366.75||$ 10,127.85|
|UDFI Return Reduction||0.38%||0.51%||0.67%||1.27%|
Summing it Up
The impact of UDFI on the overall returns for this project is negligible. The sky is not, in fact, going to fall.
Over the 10-year period covered in the sponsor’s projections, the IRA’s $100K investment would produce $89,313 of net, after UDFI cash flow. That is an annualized ROI of 8.93%
Taxation on UDFI plus the cost of tax preparation would only reduce the overall return by an average of .58% per year.
A key income component of multi-family real estate syndications is the gain on sale. In Part 2, we explore the exit phase of this project, and the overall return the IRA can expect >
Disclaimer: The examples provided in this article are for education purposes only and should not be construed as tax guidance. Several assumptions have been taken for simplicity of illustration such as full tax-year holdings of the property in the initial and final years. Each opportunity is unique, and many factors such as the design of a partnership can impact a participant using retirement plan funds. You should always seek qualified, licensed tax counsel when evaluating an investment using debt-financing.
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