What is UDFI? Tax on Debt-Financed Investments
The general principle is that the tax-exempt entity’s investment is fully sheltered from taxation, but the portion of the income generated via the borrowed, non-exempt funds is taxable.
Topics surrounding UDFI are outlined in IRC 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.”
The tax is applied to any profit generated through the use of acquisition indebtedness, such as rental income from real estate or gains on the sale of financed property. UDFI no longer applies once the debt has been paid off for a total of 12 months.
When a tax-exempt entity has UDFI, the tax paid by the entity is referred to as Unrelated Business Income Tax or UBIT.
A separate aspect of UBIT known as Unrelated Business Taxable Income (UBTI) applies when a tax-exempt entity engages in a trade or business on a regular or repeated basis.
What Activities Generate UDFI?
Any investment income to a tax-exempt retirement plan that is generated from the use of debt-financing will create UDFI. Common examples include:
- Rental income received from real property that is mortgaged
- Proceeds from the sale of an asset on which debt-financing is outstanding at the time of sale
- Income received from an entity like a partnership, LLC or LLP, when that entity uses debt-financing in addition to partner capital
- Gains from equities traded using margin
The Solo 401(k) Exemption
In the case of acquisition indebtedness associated with the purchase of real property, a 401(k) plan is exempted from UDFI. A Solo 401(k) is not exempted when receiving other forms of debt-financed income, however.
Firstly, the Average Acquisition Indebtedness is calculated. This represents the average monthly balance of the note or other debt instrument over that portion of the year in which the property was held.
Next, the Average Adjusted Basis of the property is determined. This value is the average value of the cost basis of the property on the first and last day of the year in which the property was held. The initial cost basis will include the total cost of the property as well as any transaction costs like closing fees or any repairs and upgrades that were either completed prior to the property was put in service or reasonably foreseen as necessary at the time of purchase. This value is then reduced by the full amount of straight-line depreciation on the property for the year, if applicable.
The Average Acquisition Indebtedness is then divided by the Average Adjusted basis to determine the Debt-Financing Ratio for the year.
The Debt-Financing Ratio is first applied to the gross income produced by the property.
The same Debt-Financing Ratio is the applied to any allowable deductions against income, such as interest on the debt, property taxes, etc.
A $1,000 exemption for UDFI is then applied to further reduce the income and produce the Net Taxable Income subject to UBIT.
The Net Taxable Income amount is then run through the trust tax table to determine the tax amount due. Applicable trust rates are from 15% to 39.6% based on income brackets.
Example – Rental Income
Let’s start with a simple round number of $150,000 as the acquisition cost of a property, including the purchase price, closing costs, and any repairs necessary to put the property in service.
The adjusted cost basis calculation would reduce then reduce the initial cost by ½ of the straight-line depreciation in a year where the property was in service for a full 12 months. Residential property is depreciated over 30 years under the 2017 Tax Cut and Jobs Act, so half that amount would equal $2,500, bringing the adjusted cost basis to $147,500.
If you borrowed $95,000 to purchase the property at 6% interest on a 25 year fixed rate loan, the average acquisition indebtedness for the first 12 months would be $93,850.
Dividing $93,850 by $147,500 gives us a debt-financing ratio of .64.
If the property was rented for $1,750 per month or $21,000 per year, then by applying the .64 debt-financing ratio, there is $13,440 of debt-financed income from the property.
We then add up the allowable deductions, including interest on the note, depreciation, property taxes, repairs, etc. If the operating expenses for the property are about 30% of gross rents, then the deductible expenses including mortgage interest would total $11,931. Adding depreciation of $5,000 brings the total deductions to $16,931. Multiplying these expenses by the debt-financing ratio of .64 produces a net taxable income amount of $10,837.
By subtracting the deductions of $10,837 from the debt-financed income value of $13,440, we are left with a taxable amount of $2,603.
The first $1,000 of debt financed income is exempted from taxation, leaving a net-taxable amount of $1,603. When this value is run through the trust tax table, the amount due as UBIT equals $240.45.
If your CPA charged you $350 for preparing the 990-T return, your total tax associated cost would be $590, or a mere 2.8% of the income produced by the property. The benefits of leverage and the higher cash-on-cash return that will result are going to far outweigh this small cost that comes with the ability to use debt-financing inside of an IRA.
Example – Sale of a Property
If financing on a property has been fully paid off 12 months prior to the time of sale, there will be no UDFI exposure.
Let’s run the numbers and see what the impact of UDFI generated UBIT will be on the sale of the property.
If the property appreciated at 3% per year, the sales price after 5 years would be $174,000.
The remaining balance on the 25-year mortgage at 6% would be $79,700.
If you factor in 8% total for sales commissions and closing fees, the actual cash-on-closing value would be $80,380.
The average acquisition debt in the last year would be $82,416. The average adjusted cost basis after 5 years of depreciation would be $127,500. As such, the debt-financing ratio will be .65.
For purposes of a sale, the cost of sales is subtracted from the adjusted costs basis, and then the prior year’s depreciation is recaptured, so the following formula applies:
Cost Basis of $127,500 less Sales Cost of $13,920 = $113,580. Add $25,000 for 5 years of recaptured depreciation for an adjusted basis of 138,580. When you subtract the adjusted basis from the gross sales cost, the resulting taxable gain is $35,420.
UBIT on the sale of an asset held over the long term for passive income is taxed
at a flat 20% capital gains rate, so the cost of UBIT on the sale would be $7,084. When you subtract this tax amount from the cash-on-closing value from the sale, the net after-tax income to the IRA would be $73,296. This represents a 48% overall return on the initial investment in the property simply based solely on equity growth (appreciation plus debt pay-down). When you add the cash flow over 5 years, the overall returns for this project are very good indeed.
A return must be filed if the total income generated through debt-financed income exceeds $1,000 for the year. UBTI is calculated and reported by the IRA or 401(k) using IRS form 990-T, and is not associated with your personal return. This return has an April 15th filing deadline. If the total tax liability will exceed $500 for the year, quarterly estimated tax payments may be required.
It is not uncommon when folks hear that the use of debt-financing creates tax exposure inside an IRA that their first impulse is to avoid that at all costs. The mere thought of taxation inside of an IRA simply scares people. When you sit down and run the numbers, however, it becomes clear that the small cost of being able to use outside (borrowed) capital as leverage within your IRA is far outweighed by the significant boost in return on investment your IRA can receive as a result. Leverage can be a powerful tool indeed.
IRS Publication 598 – Tax on Unrelated Business Income of Exempt Organizations