Unrelated Debt Financed Income Tax and Self-Directed IRAs
Unrelated Debt Financed Income (UDFI) tax generally applies to Self-Directed IRAs when the IRA owner receives a loan to purchase real estate property. Under Internal Revenue Code Section 514, an exempt organization, such as an IRA that owns a debt-financed asset must allocate a portion of each item of gross income from the property, and a like portion of all related deductions are included in the Unrelated Business Taxable Income (UBTI). This is the case whether the income is in the form of rent, interest, gain on disposition of property, or some other character.
As a result, when you use an IRA (tax-exempt entity), be aware of the UDFI tax that will be applied to debt-financed portion of the property.
Calculating Sale on a Debt-Financed Asset
When a debt-financed asset is sold, a special rule applies for the purpose of calculating the taxable gain. The property’s average adjusted basis is the average of the adjusted basis as of the first day during the year in which the property is held by the organization and on the day the property is sold or disposed of. The percentage of gain taxed is the percentage that the average adjusted basis on sale or other disposition of debt-financed property is of the highest amount of acquisition indebtedness with respect to the property during the twelve-month period ending with the date of the sale or other disposition. The regulations permit adjustments to basis that include decreases in basis for depreciation for periods since the acquisition of the property and increases in basis for capitalized improvements or additions.
The UDFI rules are important to remember when selling a debt-financed asset within your Self-Directed IRA LLC.