Many people are, understandably, excited and interested in establishing a self-directed IRA or 401(k). Good or bad, right or wrong, many individuals are concerned about having some or all of their retirement assets in the market and are looking for true ways of diversifying. With the ups and downs of Wall Street and concern of market manipulation, it shouldn’t come as a surprise that folks are looking for alternative options.
But, for those of you who are establishing a self-directed IRA and are intending on leveraging (e.g., utilizing borrowed funds) investments from the IRA through non-recourse lending, they may be in for a big tax surprise. It is UDFI…Unrelated Debt Financed Income.
Let’s break this down a bit. What is meant by non-recourse lending, UDFI and what tax surprise are we referring to?
Specifically, as many of you know, neither you or your retirement plan can benefit from each other based on self-dealing transactions. This includes the extension of credit (which is expressly prohibited) from the account owner to the IRA to secure lending. More simply, if your IRA wishes to secure lending, it has to qualify for the loan as if you were not there in any way, shape or form. This is non-recourse lending….where the plan secures a loan based solely on the value of the property, with no regard to the account owner. That’s right….if the property “goes south” the individual or lending entity cannot come after the account owner in any manner. They can only go after the property.
While that is a simplistic explanation of non-recourse lending, what is UDFI? What are the tax consequences?
Unrelated Debt Financed Income, or UDFI, refers to profits realized by an IRA using leveraged funding for the investment. In simple terms, you are responsible for taxes on the proportional share of profit realized by an IRA investment utilizing leveraged funds. Let’s use an example…if your IRA had or was using $50,000 to purchase a property valued at $100,000 and was securing non-recourse lending for the remaining $50,000 ($50,000 + $50,000 = $100,000), the IRA has potentially triggered UDFI. If the IRA is to later sell the property for $200,000 ($100,000 profit), taxes will be due on $50,000. This equates to leveraging 50% for the transaction and, therefore, owing taxes on 50% of the realized profit. In this hypothetical case, being taxed on 50% of the profit, or $50,000.
So, I think you have already figured out the tax consequence…..well, maybe not….
Let’s go back to the title of this blog post….Double Taxation of your IRA. How do you realize double taxation in the aforementioned example?
First, let’s assume that your IRA was a Traditional, pre-taxed IRA. We have explained the UDFI tax on the profit realized from the leveraged investment. So, where does the double tax come into play? Remember, with this Traditional, pre-taxed, IRA, you will pay taxes on the IRA upon taking out distributions. Yes, distributions will, most likely occur in retirement years and you will be taxed based on your tax bracket at that time. But, you WILL be taxed. So, in our example, not only will you be taxed by UDFI regulations for profit realized by your IRA by investing with leveraged funds, your IRA will further be taxed when you take out distributions. Double taxation.
Is this fair? It doesn’t matter. It is the current rule. Now, you may ask, do the same UDFI rules apply to 401(k) plan investments with leveraged funding? Generally speaking, as long as the investment is structured correctly….no. UDFI simply does not apply to 401(k) plans on investment made into real estate (only). So, where with the IRA you have the double taxation (taxation on both the front and back end, so to speak), you will only be taxed on your 401(k) when taking out distributions. Therefore, no double taxation.
This is a vitally important variable that you MUST consider, especially when considering making investments from your IRA with leveraged funds. Are you aware of UDFI? Maybe. Are you aware of the potential for taxation? Maybe not. But, the potential for double taxation is definitely there and, as such, you need to be aware of this.
As always, the information provided is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice. You must always consult your respective professional in all such respective matters.