Triggering UDFI in a Partnership

By Jordan Sheppherd

Life Settlements in a Retirement Account? Think Again.

Most of you are probably familiar with the Unrelated Debt Financed Income (UDFI) rules, which apply any time a retirement account has “acquisition indebtedness” on a given asset, or in plain English, anytime the retirement account uses leverage to purchase an asset. Anything from financing property to using margin to purchase stock will trigger this UDFI tax.

401(k)s interestingly enough are exempt from UDFI on leveraged real estate transactions. IRAs, on the other hand, are subject to UDFI for any leveraged transaction of any kind.

There is a way though, that UDFI can be triggered that many times slips by people. I’m talking about a retirement plan investing into a partnership, where the partnership acquires debt.

Typically I’ve seen this sort of thing pop up where a company is offering real estate investments on a large scale, such as apartment buildings or shopping malls. A limited partnership is set up, and units in the partnership are offered to investors.

It can be easy to think that since the retirement plan is a limited partner, it will be exempt from the UDFI rules. After all, the loan was made to the partnership, not to the retirement plan. Unfortunately, that is incorrect. Section 514 of the Internal Revenue Code lays out, among other things, the extent to which income derived from financed property through a partnership is taxable as UDFI, to partners that are exempt organizations.

In plain English, it means that if a partnership uses leverage to purchase property or other assets, the “acquisition indebtedness” passes through the partnership and back to the retirement plan, even if you have an IRA LLC. For purposes of UDFI, the IRS treats it as if the retirement plan itself leveraged the transaction.

Translation: the retirement plan has engaged in a leveraged transaction and owes UDFI taxes.

Now the good news.

There are some exemptions in Section 514 that can be used in structuring these partnerships, so that UDFI is not triggered to underlying partners.  So, if you are planning on making an investment into a real estate deal that is structured as a partnership, or if you’ve already made an investment, you should contact the company who is offering the investment and ask them what steps they’ve taken to ensure UDFI will not be triggered to retirement plans who own a partnership interest. I’d suggest going a step further and ask them to provide a legal opinion on the matter, as I’ve seen a number of situations where companies either aren’t aware these rules exist, or have structured their affairs in such a way that they don’t actually meet some of the exemptions in Section 514.

In fact, a real estate company I know of was two or three years into a large real estate deal with a large number of retirement plans as partners in a limited partnership, before realizing UDFI was going to be triggered on all profits for those clients. I don’t think they had much fun writing the letter to all their investors, explaining the situation.

On the bright side, anyone with a 401(k) doesn’t have to worry about these UDFI rules, so long as they’re leveraging real estate. Another reason many clients prefer the Solo 401(k) over the IRA LLC.

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