Unrelated Debt Financed Income (UDFI)


Many people start going down the path of creating a self-directed IRA and have never heard of the term Unrelated Debt Financed Income (UDFI).  And, when they visited with the company that established their self-directed IRA, the concept of Unrelated Debt Financed Income may not have even come up.  I mean, if an IRA is not planning on financially leveraging an IRA investment, there may not have been any reason for the establishing company do discuss UDFI.  But, if UDFI leveraging does occur, it would be critical for the IRA owner to discuss unrelated debt financed income with their tax professional.

Tax professional?  Yes, tax professional.  You see in any self-directed plan there are various rules (e.g., IRS Prohibited Transactions) and nuances of those rules that can become complicated very quickly.  As the IRA LLC is self-directed, the IRA account owner (who is also typically the manager of the IRA LLC managing the investments on behalf of the IRA) has a tremendous responsibility to adhere to all such rules.  Whether it be unrelated debt financed income or other issues, it is incumbent upon the manager of the IRA LLC to actively engage their tax professional.

Unrelated Debt Financed Income

So, speaking of a tax professional, Rich Bingaman CPA has experience with unrelated debt financed income and noted that an IRA account owner has a responsibility to report unrelated debt financed income to the IRS.  Bingaman noted, “unrelated debt financed income is created in an IRA when investment assets are purchased with non-recourse indebtedness and you are required by the Internal Revenue Service to report the IRAs debt-financed income on Form 990-T.”

But, what about the tax implications in having unrelated debt financed income?  Bingaman continued, “the portion of income in the IRA related to the indebtedness may be subject to taxation.”  Bingaman continued by noting that the tax due on unrelated debt financed income is due the 15th day of the fourth month following each tax year.

Now, getting back to accountability and responsibility.  An IRA LLC manager may understand that, generally speaking, an IRA LLC could purchase a piece of real estate.  And, the IRA LLC could potentially purchase this investment with non-recourse funding, thus leveraging the investment.  And, subsequently, the IRA LLC could receive unrelated debt financed income and the IRA LLC manager may have no clue that a taxable event occurred….the IRA LLC manager may believe that everything was done in compliance with IRS regulations and not realize that the IRA LLC has failed to report taxable income.  While totally innocent in the manner it occurred, it would still create a problem.  All due to failure to ask and seek appropriate guidance.

When unrelated debt financed income is realized, the LLC must prepare and file the Form 990-T.  In order to prepare this Form 990-T, the LLC must have a proper accounting of its financial transactions for the tax year including a balance sheet and a statement of income.

So, keep in mind that if this situation applies to an IRA account owner and the IRA LLC, it is critical for you to realize the reporting  responsibility by ensuring you have a sufficient accounting for investment activity in the LLC owned by your self-directed IRA.

As always, the information is provided is intended to be educational and informational.  It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice.  You must always consult with your respective professional in all such matters.