Non-Recourse Loans, UBIT and UDFI

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Since investments held in an IRA are for the exclusive benefit of the IRA, applying for loans personally or personally guaranteeing loans on behalf of an SDIRA LLC are strictly prohibited. To navigate this restriction, some banks and investors provide SDIRA LLCs with non-recourse loan options, securing the loan solely with the real estate as collateral. 

Typically, rental income from real estate, dividends, investment income, and royalties are exempt from taxes, and these earnings flow back into the IRA tax-free or tax-deferred, depending on the account type. This exemption is a key reason why real estate is popular among self-directed IRA investors.  However, when an IRA utilizes a non-recourse loan to purchase real estate, any profit derived from the portion financed by debt may be subject to Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI). This includes the portion of profits attributable to the non-recourse loan's ownership share, which will also be taxed accordingly. UBIT and UDFI are tax concepts that apply to tax-exempt entities such as IRS. Consider the following: 

UBIT (Unrelated Business Income Tax):

• Tax-exempt entities, including IRAs with significant business income not related to their exempt purpose (such as regular business activities), are subject to UBIT.
• The rationale behind UBIT is to prevent tax-exempt entities from unfairly competing with taxable businesses. If a tax-exempt entity generates income from a trade or business that is not substantially related to its tax-exempt purpose, that income is subject to UBIT.
• For IRAs, this typically applies to income from activities like running a business or from debt-financed property (UDFI), which are considered unrelated to the IRA’s primary purpose of providing retirement benefits.

UDFI (Unrelated Debt-Financed Income):

• UDFI applies specifically to tax-exempt entities, including IRAs, when they use debt to finance the acquisition of income-producing property.
• The rationale is that income generated from the portion of the property that is debt-financed is considered unrelated to the exempt purpose of the entity. Therefore, this income is subject to UDFI.
• IRAs commonly encounter UDFI when they invest in real estate or other assets using borrowed funds, such as a mortgage. The income attributable to the financed portion of the property is subject to UDFI.

In 2022, a SDIRA with a non-recourse loan was subject to UBIT and was taxed at the following rates:

• $0 – $2,550 = 10% of taxable income
• $2,551 – $9,150 = $255 + 24% of the amount over $2,550
• $9,151 – $12,500 = $1,839 + 35% of the amount over $9,150
• Over $12,501  = $3,011.50 + 37% of the amount over $12,500 

In summary, UBIT and UDFI apply to tax-exempt entities to ensure fairness and to prevent these entities from engaging in activities that compete unfairly with taxable businesses or that generate income unrelated to their exempt purposes. For IRAs, understanding these rules is crucial when considering investments involving business activities or financed assets.

As a member, we can provide you with strategies on structuring a new entity to avoid  using non-recourse loans and avoiding UBIT and UDFI.