Did you know the Solo 401k is exempt from paying UDFI, or the mortgage tax? Unrelated Debt Financed Income (UDFI) and Unrelated Business Income Tax (UBIT) can quickly become complicated tax subjects. If you invest in leveraged real estate with your IRA, you will have to pay this tax. Therefore, it may be useful for you to understand how a Solo 401k better insulates your retirement account.
One of the main complicating factors are all of the different scenarios that may or may not trigger the UDFI tax. I’m limiting the scope here to self-directed IRAs and Solo 401ks.
A Short Understanding of UDFI
To understand the complexities, read the origination and IRS examples of UDFI. However, all you really need to know about the origination of UDFI is that Congress added the Unrelated Business Income Tax regulations to the IRS code in 1950 as a way of eliminating “unfair competition” between for-profit businesses and tax-exempt organizations engaged in similar business activities.
An example of this is a non-profit museum making retail sales from a gift shop. Gift shop sales are taxable because the sales don’t relate to the non-profit mission. The mission is making history, culture, collections, etc. available to the public. Not selling candy. Untaxed sales of candy bars, bottled water, and knickknacks would give the museum a competitive advantage over the tax paying convenience store across the street. However, sales of educational items related to the non-profit mission would not be taxable income.
How UDFI Applies to Solo 401k and IRA
A main reason for investing in your self-directed IRA or Solo 401k are the tax-advantages. You are essentially entering into business as a non-profit with the possibility of generating Unrelated Business Taxable Income (UBTI) and/or Unrelated Debt Financed Income (UDFI).
Solo 401k Exemption from UDFI. When a self-directed IRA buys real estate using a mortgage, it creates UDFI – a type of Unrelated Business Taxable Income that is taxable. The UBTI tax is approximately 35%. However, with a Solo 401k plan you can use a non-recourse mortgage without being subject to the UDFI rules and UBTI tax. This exemption provides significant tax advantages by using a Solo 401k plan instead of an IRA to purchase real estate.
How UDFI Works. When your self-directed IRA uses debt to buy property, tax is applied to the portion of income (rents or capital gains) in proportion to the amount borrowed. In simplified terms, your self-directed IRA might buy a property with a 40% down payment and borrow 60% of the purchase cost. The 60% of income is taxable. Income from the 40% directly purchased with your self-directed IRA funds passes to your IRA tax-deferred.
As debt is repaid, an increasing amount of the income passes tax-free to your self-directed IRA. The actual tax calculation is made using IRS form 990-T. Tax is applied based on the average debt for the tax year.
This is important. In accordance with Internal Revenue Code Section 514(c)(9), a Solo 401k is not subject to the UDFI rules. This means there is no UBIT tax when non-recourse leverage is used to buy real estate (UDFI is a subset of UBIT). Non-recourse loans are the only loan type a Solo 401k can legally obtain.
Solo 401k Advantage with UDFI
With the UBTI tax rates at approximately 35% for 2019, the Solo 401 Plan provides real estate investors a huge tax advantage.
“When an IRA buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (UDFI), a type of UBTI on which taxes must be paid. However, with a 401(k) plan, you can use leverage without being subject to the UDFI rules and UBTI tax. This exemption under IRC 514(d)(9) provides significant tax advantages for using a 401(k) plan versus an IRA to purchase real estate.” – Forbes.com, How To Buy Real Estate With Leverage In A 401(k) Plan
UDFI Example
Here is a basic scenario. An IRA accountholder makes a $150,000 rental investment. He puts down $50,000 of IRA funds and gets a mortgage for the remaining $100,000. The IRA pays UDFI tax on the investment income generated from the debt-financed portion (the borrowed $100,000). However, the IRA takes normal expenses and depreciation in determining the UDFI tax. Also tucked away in the tax law is the first $1,000 of debt-financed income is tax exempted. Plus, there is no tax if the debt is paid off at least 12 months before the sale of the property.
This means there are ways to minimize how much UDFI an IRA pays but it will still owe UDFI on debt-financed income.
After depreciation and expenses, let’s assume an adjusted cost basis is $148,000. Of that, $100,000 is borrowed. But part of the loan is repaid during the year. The average debt for the year comes to $99,340.91.
Dividing $99,341 by $148,000 gives us a debt-financing ratio of .67.
The $1,800 monthly rent generates $21,600 in annual income. Multiplying $21,600 X .67 = $14,472 of debt-financed income.
Account for Expenses and Repairs
After accounting for other allowable expenses such as mortgage interest, property taxes, repairs, etc. the operating expenses for the property are about 25% of gross rents ($5,400).
You then multiply the $5,400 by the .67 ratio to come up with $3,618 in expenses related to debt financing. Subtracting the $3,618 in expenses from $14,472 of debt-financed income leaves a taxable amount of $10,854. You then subtract the first $1,000 of debt financed income to arrive at $9,854 in net taxable income.
Using a UBTI rate of 35%, the tax owed is $3,448.90. A CPA might charge $300 to complete the 990-T return. That makes your total tax associated cost $3,748.90.
And yes, the IRA has to complete a tax return to account for its UDFI tax.
Conclusion
When UDFI applies, the tax payment comes from the IRA. You do not owe it personally because the IRA owns the investment. The down side is that is still money that could have gone into your Solo 401k that is not subject to UDFI.
There are possible scenarios when a Solo 401k is not exempt from UDFI. These tend to be situations with “active” business income rather than “passive” income. Although there is no hard rule from the IRS, Solo 401k accounts might be subject to UDFI if multiple houses are flipped during a tax year (rather that rented). The passive rental income is generally safe from UDFI when non-recourse loans are used.
However, with a Solo 401k plan you can take your UDFI tax rate to 0% which puts more money in your pocket and ultimately, your retirement nest egg.
No one cares about your money more than you do – nor should they!
Have questions about your Solo 401k? Solo 401K experts at Nabers Group will help you get your retirement funds into your control, where they belong.
15 Responses
Are the capital gains that are realized on the sale of leveraged real estate in a solo 401k subject to the UDFI tax?
Hi Alexander, when a Solo 401k sells a property (even at a profit), capital gains are not realized because the 401k is a tax-deferred structure. Additionally, the Solo 401k is exempt from UDFI on leveraged real estate (unlike an IRA). So, if your 401k sells a property that has used leverage, no capital gains or UDFI is charged to the 401k. Happy Investing!
Thank you for the response can you give me the section in the irs code so I can give it to my accountant?
Sure thing. You can direct your tax preparer here to learn more about UDFI: https://www.law.cornell.edu/uscode/text/26/514
Thank you for the help. I have one more question on the subject, my 401k is a member in an LLC that sold the leveraged property at a gain, ( part of a syndication) is my 401k’s portion of the capital gains still exempt from the UDFI tax?
Yes, that should still be the case.
Seems like it’s hard to get away from UBIT tax. Would UBIT tax be due from a Solo 401K when it invest in real estate (equity) syndications? What CAN a Solo 401K invest it that doesn’t trigger UBIT?
Hi Julie. With a Solo 401k, it’s quite easy to get away from UBIT tax. First, a Solo 401k doesn’t incur the type of UBIT (UDFI) that comes from debt leveraged real estate. So most real estate syndications in which an IRA would owe UDFI/UBIT tax, a Solo 401k would not.
The remaining type of UBIT that a Solo 401k would incur is if it invested directly in an active business that is structured as a pass through entity (such as an LLC or LP). In practice, most active businesses that raise capital from investors are structured as a C Corp and therefore UBIT does not apply.
So actually a better question is what CAN’T a Solo 401k invest in that doesn’t trigger UBIT? Answer: An active unincorporated business.
Hi Jeff, Real estate syndications are held using LLCs. My understanding is in that case it still pays UBIT (but not UDFI). Does that sound correct?
That sounds correct, generally. By default a multi-member LLC is taxed as a partnership (pass through entity), which would be subject to UBIT if a member is a tax exempt entity. However, if the LLC elects to be taxed as a C Corporation, there should be no UBIT because it is paying C Corp taxes instead. Always check with your attorney 😉
Interesting… All 6 of the real estate equity syndicators (all across the country) that I’ve spoken to say that a LLC is created specific to each project. And that the profits and depreciation flow through to each LP investor. Seems like that would be triggering the UBIT.
If the investments are done through a Solo 401k, UBIT should not be triggered in this instance as the Solo 401k is exempt from UDFI when investing in debt-leveraged real estate.
I’ve read about using a mysterious “blocker C-corporation” to avoid UBIT in solo 401K (and SDIRAs). But I don’t know how that works since investing in a corporation (C or S) that the investor *controls* is a prohibited transaction.
Hi there. Great thread!
What are the rules regarding UFDI and self-directed solo ROTH 401K plans? The same, or different compared with a self-directed solo 401k plan?
Many thanks,
Michael
Great question, Michael! The SAME rules apply with respect to UDFI + Solo (Roth) 401k. You are exempt when your (Pretax or Roth) 401k invests in leveraged real estate!