Hypothecation in SDIRA

[Angela Russo]

I was listening to a webinar replay that briefly touched on hypothecation to recapitalize from performing notes to increase speed of building a portfolio. It seemed the overall focus of the call was on SDIRAs, but there was only broad overviews of UBIT in the presentation.

If you used this strategy, would the transaction be subject to UDFI?   Is hypothecation really only an option with private lenders or are there banks that would use notes as collateral as well?

[Brian Eastman]

@Bob Malecki

No. UDFI stands for Unrelated Debt-Financed Income. UDFI is triggered when a tax-exempt entity uses any kind of debt-financing to acquire an asset - mortgages, margin trading, etc. Qualified employer plans - including the Solo 401(k) - are exempted from UDFI when the debt is used to acquire real property, but not for other forms of leverage. IRA plans have no exemption, so UDFI will be taxable even for real property debt.

When a tax-exempt entity engages in a trade or business, then UBTI applies (Unrelated Business Taxable Income).  Trade or business activities are non-passive income, such as flipping properties, new construction for sale, and any kind of just pure buy/sell.  Passive income such as interest, dividends, royalties, and rent from real property are not considered a trade or business, and therefore do not generate UBTI.

When a tax exempt generates either UDFI or UBTI, the tax is payed as UBIT (Unrelated Business Income Tax).

IRS Publication 598 will either educate you on this topic or more likely put you to sleep (-: