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UDFI is short for Unrelated Debt Finance Income is generated when an IRA receives income from “debt-financed” property. Many times you will find a property to purchase and you may not have enough funds in your IRA to but the property all cash. Therefore, you have to get a non-recourse to “debt finance” the remainder of the deal. A non-recourse loan is one where only the property is recourse if the loan is not paid and not personally guaranteed (look for the blog article titled “What Is A Non-Recourse Note?”). This is required since disqualified individuals (in this case you the IRA account holder) cannot be personally liable for debts according to the IRS rules.

For example, if an IRA purchases a piece of rental real estate using partial debt-financing (either seller financing or bank financing), UDFI will be triggered. However, because UDFI only applies to the percentage of income resulting from the debt-financed portion of the property, UDFI will generally result in less tax being owed than in the UBTI situation discuss above. This makes logical sense because the percentage of income resulting from the capital invested by the IRA (rather than the amount borrowed) should normally result in tax-exempt income.

Let’s look at an example with numbers. Lets say the an IRA investment earned $40,000 in gross income on a 30% debt financed property then $12,000 would be subject to UBIT. If we then calculated any allowable deductions directly related to the property of $5,000 (after the 20% allocation) for example, $7,000 would be the unrelated business taxable income before the specific deduction allowable. After the specific deduction of $1,000, the remaining unrelated business taxable income of $6,000 would then be subject to UBIT. Applying the trust 2011 tax rate applicable the tax would be $1,286.50.

How does this compare to the scenario where the real estate investment was made with outside your IRA. If you had made the real estate investment outside of the IRA with discretionary funds, your taxable income would be 100% of gross income earned not just the debt-financed portion. The gross income would be included in your Federal and State adjusted gross income and you would owe income tax at that marginal bracket. This tax could range anywhere from 15% to 35% depending on your filing status and other taxable income and would end up to be higher than UBIT of $1,286.