What is UDFI? Tax on Debt-Financed Investments
When a tax-exempt entity such as a non-profit or IRA receives income from property that has been financed, a tax is applied on the resulting Unrelated Debt-Financed Income (UDFI).
The general principle is that the tax-exempt entity’s investment is fully sheltered from taxation, but the portion of the income generated via the borrowed, non-exempt funds is taxable.
Topics surrounding UDFI are outlined in IRC 514, which defines debt-financed property as:
“any property which is held to produce income and with respect to which there is acquisition indebtedness at any time during the taxable year.”
The tax is applied to any profit generated through the use of acquisition indebtedness, such as rental income from real estate or gains on the sale of financed property. UDFI no longer applies once the debt has been paid off for a total of 12 months.
When a tax-exempt entity has UDFI, the tax paid by the entity is referred to as Unrelated Business Income Tax or UBIT.
A separate aspect of UBIT known as Unrelated Business Taxable Income (UBTI) applies when a tax-exempt entity engages in a trade or business on a regular or repeated basis.
What Activities Generate UDFI?
Any investment income to a tax-exempt retirement plan that is generated from the use of debt-financing will create UDFI. Common examples include:
- Rental income received from real property that is mortgaged
- Proceeds from the sale of an asset on which debt-financing is outstanding at the time of sale
- Income received from an entity like a partnership, LLC or LLP, when that entity uses debt-financing in addition to partner capital
- Gains from equities traded using margin
The Solo 401(k) Exemption
In the case of acquisition indebtedness associated with the purchase of real property, a 401(k) plan is exempted from UDFI. A Solo 401(k) is not exempted when receiving other forms of debt-financed income, however.
UDFI Calculations
Unrelated Business Income Tax liability generated by UDFI is calculated using the following logic:
Firstly, the Average Acquisition Indebtedness is calculated. This represents the average monthly balance of the note or other debt instrument over that portion of the year in which the property was held.
Next, the Average Adjusted Basis of the property is determined. This value is the average value of the cost basis of the property on the first and last day of the year in which the property was held. The initial cost basis will include the total cost of the property as well as any transaction costs like closing fees or any repairs and upgrades that were either completed prior to the property was put in service or reasonably foreseen as necessary at the time of purchase. This value is then reduced by the full amount of straight-line depreciation on the property for the year, if applicable.
The Average Acquisition Indebtedness is then divided by the Average Adjusted basis to determine the Debt-Financing Ratio for the year.
The Debt-Financing Ratio is first applied to the gross income produced by the property.
The same Debt-Financing Ratio is the applied to any allowable deductions against income, such as interest on the debt, property taxes, etc.
A $1,000 exemption for UDFI is then applied to further reduce the income and produce the Net Taxable Income subject to UBIT.
The Net Taxable Income amount is then run through the trust tax table to determine the tax amount due. Applicable trust rates are from 15% to 37% based on income brackets.
Example – Rental Income
Following is a simplified example of how UDFI generated UBIT might be incurred on a typical rental property.
Let’s start with a simple round number of $150,000 as the acquisition cost of a property, including the purchase price, closing costs, and any repairs necessary to put the property in service.
The adjusted cost basis calculation would reduce then reduce the initial cost by ½ of the straight-line depreciation in a year where the property was in service for a full 12 months. On the building is depreciated, not the land, so lets assume a building value of $110,000 Residential property is depreciated over 27.5 years, so half the annual amount would equal $2,000, bringing the adjusted cost basis to $148,000.
If you borrowed $95,000 to purchase the property at 6.5% interest on a 25 year fixed rate loan, the average acquisition indebtedness for the first 12 months would be $94,289.
Dividing $94,289 by $148,000 gives us a debt-financing ratio of .64.
If the property was rented for $1,750 per month or $21,000 per year, then by applying the .64 debt-financing ratio, there is $12,432 of debt-financed income from the property.
We then add up the allowable deductions, including interest on the note, depreciation, property taxes, repairs, etc. If the operating expenses for the property are about 30% of gross rents, then the deductible expenses including mortgage interest would total $12,429. Adding depreciation of $4,000 brings the total deductions to $16,429. Multiplying these expenses by the debt-financing ratio of .64 produces a net taxable income amount of $10,514.
By subtracting the deductions of $10,514 from the debt-financed income value of $12,432, we are left with a taxable amount of $1,918.
The first $1,000 of debt financed income is exempted from taxation, leaving a net-taxable amount of $918. When this value is run through the trust tax table, the amount due as UBIT equals $91.
If your CPA charged you $350 for preparing the 990-T return, your total tax associated cost would be $441, or a mere 2.1% of the income produced by the property. The benefits of leverage and the higher cash-on-cash return that will result are going to far outweigh this small cost that comes with the ability to use debt-financing inside of an IRA.
Example – Sale of a Property
If you then decided to sell your rental property 5 years down the road, there will still be debt-financing in place on that 25-year mortgage. As such, the sale will generate UDFI.
If financing on a property has been fully paid off 12 months prior to the time of sale, there will be no UDFI exposure.
Let’s run the numbers and see what the impact of UDFI generated UBIT will be on the sale of the property.
If the property appreciated at 3% per year, the sales price after 5 years would be $174,000.
The remaining balance on the 25-year mortgage at 6.5% would be $85,439.
If you factor in 8% total for sales commissions and closing fees, the actual cash-on-closing value would be $74,641.
The average acquisition debt in the last year would be $87,146. The average adjusted cost basis after 5 years of depreciation would be $132,000. As such, the debt-financing ratio will be .66.
For purposes of a sale, the cost of sales is subtracted from the adjusted costs basis, and then the prior year’s depreciation is recaptured, so the following formula applies:
Cost Basis of $132,000 less Sales Cost of $13,920 = $118,080. Add $20,000 for 5 years of recaptured depreciation for an adjusted basis of $138,080. When you subtract the adjusted basis from the gross sales cost, the resulting taxable gain is $35,920.
UBIT on the sale of an asset held over the long term for passive income is taxed
at a flat 20% capital gains rate, so the cost of UBIT on the sale would be $7,184. When you subtract this tax amount from the cash-on-closing value from the sale, the net after-tax income to the IRA would be $67,457.
his represents a 45% overall return on the initial investment in the property simply based solely on equity growth (appreciation plus debt pay-down). When you add the cash flow over 5 years, the overall returns for this project are very good indeed.
Reporting
A return must be filed if the total income generated through debt-financed income exceeds $1,000 for the year. UBTI is calculated and reported by the IRA or 401(k) using IRS form 990-T, and is not associated with your personal return. This return has an April 15th filing deadline. If the total tax liability will exceed $500 for the year, quarterly estimated tax payments may be required.
In summary
It is not uncommon when folks hear that the use of debt-financing creates tax exposure inside an IRA that their first impulse is to avoid that at all costs. The mere thought of taxation inside of an IRA simply scares people. When you sit down and run the numbers, however, it becomes clear that the small cost of being able to use outside (borrowed) capital as leverage within your IRA is far outweighed by the significant boost in return on investment your IRA can receive as a result. Leverage can be a powerful tool indeed.
Resources:
IRS Publication 598 – Tax on Unrelated Business Income of Exempt Organizations
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Quick answers to common questions
We’ll take you through a simple, step by step process designed to put your investment future into your own hands…immediately. Everything is handled on a turn-key basis. You take 100% control of your Retirement funds legally and without a taxable distribution.
YES! In 1974, Congress passed the Employee Retirement Income Security Act (ERISA) making IRA, 401(k) and other retirement plans possible. Only two types of investments are excluded under ERISA and IRS Codes: Life Insurance Contracts and Collectibles (art, jewelry, etc.). Everything else is fair game. IRS CodeSec. 401 IRC 408(a) (3)
It’s actually pretty simple. Early on, regulators let the securities industry take the lead in educating the public about retirement accounts. Naturally, brokers and banks promoted stocks, bonds, and mutual funds—giving the impression that those were the only allowed investments. That was never true... and still isn’t. You can probably guess why they kept the rest under wraps.
It is possible to use funds from most types of retirement accounts:
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
- Keogh
- 401(k)
- 403(b)
- Profit Sharing Plans
- Qualified Annuities
- Money Purchase Plans
- and many more.
It must be noted that most employer sponsored plans such as a 401(k) will not allow you to roll youraccount into a new Self-Directed IRA plan while you are still employed. However, some employers will allow you to roll a portion of your funds. The only way to be completely sure whether your funds are eligible for a rollover is by contacting your current 401(k) provider.
A Solo 401(k) requires a sponsoring employer in the format of an owner-only business. If you have a for-profit business activity – whether as your main income or as a side venture – and have no full-time employees other than potentially your spouse, your business may qualify. The business may be a sole-proprietorship, LLC, corporation or other entity type.
A self-directed retirement plan is a type of IRA or 401(k) that gives you greater control over how your retirement funds are invested. Unlike traditional accounts held at banks or brokerage firms that limit you to stocks, bonds, and mutual funds, self-directed plans allow you to invest in a wide range of alternative assets including real estate, private businesses, precious metals, cryptocurrency, and more.
These plans still follow the same IRS rules and maintain the same tax-deferred or tax-free benefits as conventional retirement accounts. The difference is simply in how and where you choose to invest.
No. Moving to a self-directed IRA or Solo 401(k) does not trigger any taxes, as long as your funds are eligible for rollover.
Self-directed retirement plans maintain the same tax-advantaged status as traditional plans offered by banks or brokerage firms. The key difference is flexibility—our plans are designed to give you greater control and allow for a wider range of alternative investments beyond stocks, bonds, and mutual funds.
A prohibited transaction is any action between your retirement plan and a disqualified person that violates IRS rules and can lead to serious tax consequences. Under IRS Code 4975(c)(1), prohibited transactions include:
- Selling or leasing property between your plan and a disqualified person Example: Your IRA cannot purchase a property you already own.
- Lending money or extending credit between the plan and a disqualified person Example: You cannot personally guarantee a loan your IRA uses to buy real estate.
- Providing goods or services between your plan and a disqualified person Example: You can’t use your personal furniture to furnish a rental property owned by your IRA.
- Using plan income or assets for the benefit of a disqualified person Example: Your IRA cannot buy a vacation home that you or your family use.
- Self-dealing by a fiduciary (using plan assets for their own benefit) Example: Your CPA shouldn't loan your IRA money if they’re advising the plan.
- Receiving personal benefit from a deal involving your IRA's assets Example: You can’t pay yourself from profits your IRA earns on a rental.
If a transaction doesn’t clearly fall within the allowed guidelines, the IRS or Department of Labor may review the situation to determine if it qualifies as a prohibited transaction.
Disqualified persons are individuals or entities that are prohibited from engaging in certain transactions with your IRA or 401(k). Doing so could trigger a prohibited transaction, which may result in taxes and penalties.
Here’s who is considered a disqualified person:
- You (the account holder)
- Your spouse
- Your parents, grandparents, and other ancestors
- Your children, grandchildren, and their spouses
- Any advisor or fiduciary to the plan
- Any business or entity owned 50% or more by you or another disqualified person, or where you have decision-making authority
These rules exist to prevent self-dealing and ensure your retirement plan remains in compliance with IRS regulations.
(Reference: IRC 4975)
Understanding and following these rules can be tricky, but it’s very doable. The best way to stay compliant is to work with professionals who specialize in self-directed retirement plans. They can help you navigate IRS guidelines and avoid prohibited transactions.
If an IRA holder is found to have engaged in a prohibited transaction with IRA funds, it will result in a distribution of the IRA. The taxes and penalties are severe and are applicable to all of the IRA’s assets on the first day of the year in which the prohibited transaction occurred.
Yes. While self-directed retirement plans allow for a wide range of investments, there are a few important restrictions.
You cannot invest in collectibles or life insurance contracts, and you must avoid prohibited transactions—activities that benefit you personally rather than the retirement plan. These include things like buying or selling property to yourself or family members, using plan assets for personal gain, or self-dealing in any way.
Violating these rules could cause your entire IRA to lose its tax-advantaged status. To protect your account, it’s essential to work with professionals who understand IRS regulations and can help you stay compliant.
This is a common misconception. In many cases, professionals may simply be unfamiliar with self-directed retirement plans, as they fall outside their usual scope of work. CPAs and tax preparers are trained to file taxes, not necessarily to advise on alternative retirement strategies. Financial advisors and brokers often work for firms that focus on traditional investments like stocks and mutual funds—and may not benefit from or support alternative options like real estate or private lending.
Self-directed retirement investing is legal under IRS rules—but like any specialized area, it requires working with professionals who understand how it works.
The IRS has rules in place to make sure your IRA is used only for the exclusive benefit of the retirement account—not for personal gain or to help family members. These rules can get complicated because there are many ways a conflict of interest can occur, even unintentionally.
For example, if your IRA buys a house and rents it to your mother, you might be reluctant to evict her if she stops paying rent. That emotional connection creates a conflict between what’s best for your IRA and your personal relationships, something the IRS aims to prevent.
These rules help ensure your retirement account stays compliant and protected. (See IRC 408)
Yes. Most tax-deferred retirement accounts—such as Traditional IRAs, old 401(k)s, 403(b)s, and TSPs—can be rolled over into a self-directed IRA or Solo 401(k), depending on your eligibility. Roth IRAs cannot be rolled into these accounts.
You can contribute directly from earned income, subject to annual IRS contribution limits. The method and amount depend on the type of plan you have (e.g., Solo 401(k) vs. IRA).
To take a distribution, you'll request funds through your custodian or plan administrator. Distributions may be taxable depending on your account type and age. Early withdrawals may be subject to penalties.
For 2025, the Solo 401(k) max contribution limit is $81,250 if age 60-63, $77,500 if age 50-59 or 69+, and $70,000 if under 50. Traditional and Roth IRAs have a limit of $7,000 ($8,000 if age 50+). Limits are subject to IRS adjustments.
Yes. IRA contributions are typically due by your personal tax filing deadline (e.g., April 15). Solo 401(k) contributions follow your business tax filing deadline, including extensions.
IRS reporting requirements vary depending on the type of self-directed retirement plan you have. Here’s a quick breakdown of what you need to know
Please note: Our team can help you understand what’s required for your specific account, but we don’t provide tax or legal advice. We always recommend working with a qualified tax professional to ensure full IRS compliance.
Self-Directed IRA (Traditional or Roth)
- Form 5498 – Filed by your custodian each year to report contributions, rollovers, and the fair market value (FMV) of your account.
- Form 1099-R – Issued if you take a distribution or move funds out of your IRA.
- Annual Valuation – You'll need to provide updated FMV for any alternative assets held in the account, such as real estate or private placements.
Solo 401(k)
- Form 5500-EZ – Required if your plan assets exceed $250,000 as of year-end. Must be filed annually by the plan participant.
- Form 1099-R – Required if you take a distribution or roll funds out of the plan.
- Contribution Tracking – Keep records of employee and employer contributions. These are not filed with the IRS but may be needed for tax reporting or audits.
SEP IRA
- Form 5498 – Filed by your custodian to report contributions and FMV.
- Form 1099-R – Filed by your custodian. Issued for any distributions.
- Employer Contributions – Must be reported on your business tax return (and on employee W-2s, if applicable).
Health Savings Account (HSA)
- Form 5498-SA – Filed by your HSA custodian to report contributions.
- Form 1099-SA – Filed by your HAS custodian. Issued for any distributions.
- Form 8889 – Must be included with your personal tax return to report contributions, distributions, and how funds were used.
