Self Directed IRA, UDFI (Unrelated Debt Financed Income Tax)

7 Replies

Hi BPer,

For those with self directed IRA experience, can you explain what is the UDFI (Unrelated Debt Financed Income Tax) impact on real estate investment using self directed IRA?

Thanks,

-Chan-

Hey @Chan K.  

UDFI is a type of UBTI (Unrelated Business Taxable Income) and is assessed when your IRA purchases investment property using leverage. Portion of your income from the rental property that is generated from the leveraged portion of the property will be subject to UBIT (unrelated business income tax) at the rate of about 35%.

When you use leverage to purchase investment property in a Solo 401k however, it will be exempt from UDFI.

@Dmitriy Fomichenko is there a trade off for having a solo 401k compared to a traditional IRA? That UDFI exemption is attractive.

Who can open a solo 401k?

I'm trying to understand why more people don't have solos. 

Fortunately the 35% rate is the top rate.  Unfortunately you only need $11,000 in income to get up to that rate.

A subtle aspect of UDFI is that it is based on the "debt financed fraction".  That's "debt/basis".  Debt goes down slowly at first because the payments are mostly interest.  Basis, OTOH, goes down linearly as you take (or are allowed) depreciation.  So, this fraction can actually increase during the early years of ownership.

@Danny Duran  

I outlined all of the advantages of the Solo 401k plan in one of my recent blog articles HERE on BP blog. There is really no trade off - Solo 401k is better vehicle for several major reasons. I also explain eligibility requirements in the same article. 

@Dmitriy Fomichenko  I read the blog. It mentions that you have to be self-employed and work less than 1000 hour to qualify. It also mentions that you don't need a custodian. I am assuming in term of financing, it also has to be non-recourse loan.

If you have money in tradition IRA, how do you start the solo 401k process?

Who do you contact, a local bank?

How do you submit qualification application? 

It sounds like if you qualify, you can roll money into solo 401k. Then use a checkbook to buy investment property, and no custodian involvement during the transaction. 

On the other hand, if you are not self-employed and did not qualify for solo 401k, the only alternative is self-directed IRA. If leverage is used for financing, then 35% tax hit could not be avoided.

The Solo(k) participant must be self employed, or earn 1099 income, but there is no limit to the hours worked. You can be employed full-time and still qualify. Any income deferred into the Plan, and any profit sharing contributions, have to come from the income earned from that company. For example, if you have a full time job elsewhere, working for a major corporation, and your own little side LLC that does yard work for people on the weekends, your salary deferrals and profit sharing can only come from the income earned by the yard work company. You cannot contribute any earnings from your other full time job.

The 1000 hour limitation is for any employees your wholly owned company may have.

If you have an LLC or sole proprietorship and you are the only employee, then you can have a Solo(k). If, however, you own a larger company, have several full-time employees (working more than 1,000 hours per year), then you would not qualify for a Solo(k).

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