Unrelated Debt Financed Income
When an IRA or LLC in which an IRA has an ownership interest borrows money to purchase real estate (also known as using leverage or debt-financing), then the portion of the net profits attributable to the borrowed money is considered Unrelated Debt Financed Income and is taxable.
UDFI is a subset of UBIT. The theory behind UDFI is that since the IRA, directly or through its LLC, is profiting from money that is not its own, then that money is “unrelated” to the IRA. Being that an IRA is a tax-exempt entity, the UBIT rules require the IRA to pay taxes on profits generated from that money. For example, if an IRA’s LLC purchases a property and funds the purchase 60% with its own money and 40% from borrowed money, then, in general, 40% of the IRA’s share of net profits will be considered UDFI because that portion of the profits was created from money that was not owned by the IRA’s LLC.
Here's a practical example:
Let’s say you have $50,000 in your IRA. You shop around for potential investments and you find a property for $150,000. To facilitate the purchase, you have your IRA borrow $100,000. Your IRA then purchases the property. A year later you find a buyer for the property. The sale price is $240,000. That means that your IRA just netted $90,000 on the deal. However, not all of that profit is due to tax-deferred IRA funds. Only a 1/3 of it can be attributed to the IRA. The other 2/3 is attributed to the loan that the IRA took out to purchase the property. Then, as it does every year, tax time rolls around. The $30,000 profit that came from the IRA is tax deferred. The $60,000 that came from the loan has to pay UDFI.
A Solo 401(k) is exempt from UDFI.