Understanding Unrelated Debt Financed Income in an IRA

Kelli Click — Wed, 28 Dec 2011 21:48:57 +0000

Part 2: UDFI

In Part 1 of Understanding Unrelated Business Taxable Income, we discussed UBIT. The second type of UBTI that a self directed IRA may generate is Unrelated Debt Financed Income, or UDFI. UDFI may be generated when a tax exempt or tax deferred entity owns property that is debt financed. If an IRA holds leveraged real estate or an interest in an LP or LLC which obtained financing, the portion of the profit realized through the debt may be subject to UDFI tax, and taxed at trust rates.

UDFI Defined
Unrelated Debt Financed Income is covered 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.”

UDFI is only applied to profit realized through debt. An IRA may owe tax if income is generated by a leveraged property, or if debt financed property is sold for a profit. UDFI would not apply if the debt is paid off 12 months or more prior to the sale.

Calculating UDFI
Taxes are based on the highest amount of leverage the self directed IRA carried in the past 12 months. UDFI is only applied to the gain or profit realized through debt. The formula below is used to find the amount of income that is taxable as UDFI:

Average Acquisition Indebtedness is the average outstanding principal indebtedness during the portion of the year the property is held. This amount is found by averaging the amount of outstanding principal for the first day of each month that the property is held.

Average Adjusted Basis is found by averaging the adjusted basis of the property for the first and last day of the year that the property is held.

Gross Income from Property may be able to have certain deductions taken before calculating UDFI, such as depreciation. However, deductions for depreciation can only be taken by using the Straight Line Method; all deductions must be clearly related to the income and property.

When selling the investment at a profit, the taxable amount may be determined by dividing the Average Acquisition Indebtedness by the Average Adjusted Basis.

UDFI Tax Filing
If your IRA does owe UDFI, it is best to consult a tax professional for preparation of IRS Form 990-T. Once complete, Form 990-T can be submitted to the IRA custodian with the authorization to file and instruction to pay the UDFI tax.

Summary
Keep in mind that most self directed IRAs that hold leveraged real estate will not owe UDFI tax for the first few years due to depreciation.

If you are considering an investment that may generate UDFI, your tax advisor should be consulted in advance. To learn more about Unrelated Debt Financed Income please view IRS Publication 598.

Understanding Unrelated Business Taxable Income (UBTI) in an IRA

Kelli Click — Tue, 27 Dec 2011 18:59:04 +0000

Part 1: UBTI

Making investments with funds from a self directed IRA provides a great tax advantage in that most income is tax free until distribution. However, there are certain situations in which a self directed IRA can generate taxable income in the form of Unrelated Business Taxable Income (UBTI) or Unrelated Debt-Financed Income (UDFI). UBTI is one of the more complicated areas of tax law, but the basic guidelines are fairly straightforward when it comes to UBTI generated by an investment held within an IRA.

UBTI Defined
According to IRS Publication 598, UBTI is “gross income derived by an organization from any unrelated trade or business regularly carried on by the exempt organization, less the deductions directly connected with carrying on the trade or business.” UBIT, or unrelated business taxable income is the tax that is paid on UBTI generated from a trade or business.

Publication 598 also states: “If an exempt organization regularly carries on a trade or business not substantially related to its exempt purpose, except that it provides funds to carry out that purpose, the organization is subject to tax on its income from that unrelated trade or business.”

There are exceptions, and most income generated by passive investments is exempt from paying UBIT, including income from dividends, annuities, royalties, interest from loans, and most rent generated from real estate.

Investments Generating UBTI
Investments most likely to generate UBTI include limited liability companies, limited partnerships, leveraged properties, and investments in active businesses.

In order for income to be subject to tax as UBTI the following must be true:
• The income is generated by a trade or business
• The trade or business activity is regularly carried on.
• The trade or business activity is not substantially related to the exempt status.

UBIT Tax Filing
At the end of the tax year investment sponsors will prepare and send out Schedule K-1. UBTI for the investment is shown under Section 20, Other Information. The amount of UBTI generated for the tax year is listed as Code V. If this figure exceeds $1,000, IRS Form 990-T would need to be filed to report and pay any UBIT due. Those required to complete Form 990-T will need to file for an Employer Identification Number (EIN), and can do so using Form SS-4

If your IRA does owe UBIT, it is best to consult a tax professional. A tax professional will ensure the registration and Tax Identification Number on the Schedule K-1 are correct, and prepare Form 990-T to submit to your IRA custodian. Once completed, you can then provide the Form 990-T to your IRA custodian with your authorization to file the form and pay the UBIT from your IRA account.

If you are considering an investment that may generate UBTI, your tax advisor should be consulted in advance. To learn more about Unrelated Business Taxable Income please view IRS Publication 598. This publication also covers Unrelated Debt Financed Income, which will be discussed in a later post.

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Understanding Unrelated Debt Financed Income in an IRA

Understanding Unrelated Business Taxable Income (UBTI) in an IRA