Utilizing a Self-Directed IRA (commonly referred to as a SDIRA) is an excellent option when investing in real estate. That is because the SDIRA allows investors to take advantage of the tax benefits of using their tax deferred or nontaxable retirement accounts. However, investors must understand that when using a SDIRA, they may still be subject to taxes on the income through a little known provision in the tax law called Unrelated Debt Financed Income (UDFI).
In this article, we are going to explore UDFI, how it is calculated, and ways to circumvent it.
What is Unrelated Debt Financed Income
UDFI is the result of income that is earned on an investment through a SDIRA with the use of debt. UDFI is an off shoot of the more commonly discussed Unrelated Business Taxable Income (UDTI) (which is income earned by a retirement account, or other tax-exempt entity, that is not related to the tax-exempt purpose of the entity), but is specific to the income generated as a result of debt.
Let’s use a simple example of investing in a mortgage fund that uses a credit line to manage the inflow and outflow of capital. In this scenario, the mortgage fund maintained an average outstanding balance equal to 25% of the total invested capital. As a result, the investors using a SDIRA would be subject to taxes on 25% of the distributed income.
How is UDFI calculated
The process of calculating UDFI is simple if the amount of debt used to finance the investment and the investment amount remains fixed over the year. You would simply divide the balance of the debt by the investment amount. You would then apply that ratio to the income generated over the year. For example, if you had invested in a mortgage fund that had maintained a fixed balance on the credit line of 25% of total investor capital over the year, 25% of the gains you earned would be taxable.
However, in a mortgage fund, rarely does the balance of the credit line remain fixed over the year. In fact, it fluctuates daily, so a more complex calculation is applied. In this instance, the average daily balance of the debt over the year is divided by the average daily balance of investor capital in the fund. That ratio is then multiplied against the total income earned by the investor to calculate the UDFI. Example, if the average balance of the debt was $1MM and the average total investor capital in the fund was $4MM, the ratio would be 25%. That 25% would be multiplied against the income earned by the investor to come up the UDFI.
How can a Mortgage Fund Eliminate UDFI
UDFI is very important to consider when making an investment in a mortgage fund. Many investors using their SDIRA to invest are unaware that they may be subject to income tax when they use their retirement funds. That is why it is highly recommended that investors ask the fund manager if they would be subject to UDFI.
One of the strategies to eliminate UDFI in a mortgage fund is to structure the fund as a Real Estate Investment Trust (REIT). These are often called REIT mortgage funds, Mortgage REIT, or MREIT. These funds are typically structured with a sub REIT where the actual loans are made through the REIT and the interest income flows from the REIT, to the actual fund, and then distributed to the investors as a dividend.
The benefit of the MREIT is that the dividends are not subject to UDFI. Per Provision 11011, Section 199A of the 2017 Tax Cuts and Jobs Act, passive income generated through a REIT is generally excluded from UBTI, unless the income is generated through the use of debt. However, a REIT transforms the income into dividends which is not subject to UBTI under the provision.
The Self Directed IRA (SDRIA) has become a very popular choice for investors that want to invest in real estate using their retirement accounts. The SDIRA allows investors to take advantage of the tax benefits associated with a retirement account but invest in alternative investments not commonly offered by conventional brokerages. However, investors must take into consideration some of the restrictions when investing with an SDIRA and the resulting tax consequences. One of those is Unrelated Debt Financed Income (UDFI) which taxes income generated from an investment through a SDRIA using debt.
About the Author
Brock VandenBerg, President of TaliMar Financial, manages TaliMar Income Fund I, a mortgage fund that focuses on funding residential and commercial real estate investment loans. The mortgage fund allows investors to pool their retirement and non-retirement funds and invest in a diversified portfolio of high interest mortgages. An investment in the mortgage offers investors a consistent monthly income, makes them eligible for the 20% Qualified Business Income tax deduction, and is semi-liquid for investors that are not interested in locking up their funds in a long term investment.
TaliMar Financial is committed to helping real estate investors increase their real estate cash flow in San Diego by meeting their financing requirements. Whether you take a passive real estate investing approach in San Diego or are directly involved in the investment process, the TaliMar team can tailor a lending solution to your specific needs. To learn more, call 858.242.4900.