Investing through a self-directed IRA without tripping over UBIT
Ricardo Sanabria, Founder & CEO
Published Last updated
Retirement money can buy a private real estate interest. What changes is that two IRS regimes written for tax-exempt entities start applying to you, and one of them can disqualify the entire account rather than the investment that caused it.
What changes when the buyer is your IRA
A self-directed IRA can hold a private multifamily partnership interest. That is the easy part and it is where most explanations stop. Two federal regimes written for tax-exempt entities then start applying to you, and one of them can disqualify the entire account rather than the investment that caused it.
Neither issue makes the investment inappropriate. Both are knowable before you subscribe, and both cost far less to plan for than to discover on a filing deadline.
| Regime | Trigger | Consequence |
|---|---|---|
| Unrelated debt-financed income | The partnership borrows, which nearly all of them do | Part of your return is taxable inside a tax-deferred account. Annoying, plannable |
| Prohibited transaction | Dealing between the IRA and a disqualified person | The account stops being an IRA and is treated as distributing everything. Not survivable |
Leverage creates taxable income inside a tax-free account
This is the one that surprises people, and the IRS states the trigger plainly: "Debt-financed property is any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness," and it expressly includes rental real estate.1 Section 514(c) defines acquisition indebtedness as debt incurred before, during or after the acquisition or improvement of the property.1
Almost every multifamily syndication uses a mortgage. So the share of partnership income attributable to the borrowed money is unrelated debt-financed income, and it is taxable to your IRA even though the IRA is otherwise exempt.
The taxable share is not arbitrary. It is derived from the average acquisition indebtedness against the average adjusted basis of the property, which means it falls as the loan amortizes and it is largest in the early years.2 A deal with 65 percent leverage produces a materially larger debt-financed fraction than one at 45 percent, and the sponsor knows that number before you wire.
| Factor | Direction | Ask the sponsor |
|---|---|---|
| Loan-to-value at acquisition | Higher leverage, larger taxable share | What is the LTV at closing? |
| Amortization | Principal paydown shrinks the share over time | Interest-only period, and for how long? |
| Refinancing | New debt can reset it upward | Is a refinance in the business plan? |
| Sale | Gain on disposition can also be debt-financed | What is assumed at exit? |
An interest-only loan is worth flagging. Because principal does not amortize during that period, the debt-financed fraction does not decline either. A deal structured for maximum early cash flow is also structured for maximum early UDFI.
Your IRA may have to file its own tax return
The mechanical consequence is one many investors have never heard. Per the Form 990-T instructions, trustees of IRAs must file where there is $1,000 or more of unrelated trade or business gross income.3 Note the word gross. The threshold is not measured on profit.
Each such account is treated as a separate trust for these purposes, and it needs its own employer identification number in order to file.34 That is a real administrative step: the return is the IRA's, not yours, the EIN is the IRA's, not yours, and the tax is paid from IRA assets rather than from your checkbook.
Paying it from personal funds is not a generosity the rules permit. Money moving from you into the IRA is a contribution, subject to contribution limits, which is how a well-meant payment becomes a second problem.
Your custodian may prepare the return, may charge for it, or may decline and leave you to arrange it. Which of those is true is a question to ask before you fund a subscription, not after the K-1 arrives.
The rate is the part that stings
An IRA is taxed at trust rates on unrelated business taxable income.5 Trust brackets compress far faster than individual brackets, so a modest dollar amount of UDFI can reach a high marginal rate at a level of income that would be taxed lightly on a personal return.
That inverts an assumption people bring to the question. The instinct is that a small amount of UDFI is a rounding error. In a compressed bracket structure, a small amount of income is exactly where the rate climbs.
There is a further wrinkle worth knowing. Depreciation flows through and reduces the debt-financed income, so the taxable amount is usually far smaller than the distribution, and in the early years of a heavily depreciated deal it can be nil. Publication 598 sets out the regime and the deductions allowed against it.5
The practical instruction: ask the sponsor for a projected UDFI figure in year one alongside the projected distribution. If they have modeled the deal properly they can produce it.
The rule that can end the whole account
The IRS describes prohibited transactions as "certain transactions between a retirement plan and a disqualified person," and lists among them selling, exchanging or leasing property, lending money or extending credit, and furnishing goods, services or facilities.6
For an IRA the disqualified persons include the owner's fiduciary and members of the family, which is defined as spouse, ancestor, lineal descendant, and any spouse of a lineal descendant.6 Note who is absent from that list: siblings, cousins, and friends are generally not disqualified persons, which surprises people in both directions.
The consequence is the part to sit with. If an IRA owner engages in a prohibited transaction, "the account stops being an IRA as of the first day of that year," and "the account is treated as distributing all its assets to the IRA owner at their fair market values on the first day of the year."6 Not the offending investment. The entire account.
That is why the standing advice is to keep the IRA at arm's length from anything you touch personally. Do not lend to the deal yourself. Do not guarantee its debt. Do not take a fee from it. Do not put your own labor into a property the IRA owns. A passive limited partnership interest in a sponsor unrelated to you is the ordinary, uncomplicated case, and it is uncomplicated precisely because none of those things are happening.
The custodian questions, asked before you wire
The custodian is not an adviser and will generally not warn you about any of the above. They are a recordkeeper executing your instructions, and the substantive questions are yours to ask.
Timing matters more than investors expect. Custodian processing on a subscription commonly adds one to two weeks, and a deal closing on a contractual date does not wait for paperwork. Start the process when you first read the offering, not when you decide.
The questions are: does the account already have an EIN, or will one need to be obtained; do you prepare Form 990-T and at what fee; what is your processing time for a subscription and for a capital call; what documents do you require from the sponsor; and how are distributions received and recorded. Each of those terms carries a specific meaning in a private offering, set out in the glossary of syndication terms.
Ask the last one specifically. A distribution paid to you personally rather than to the custodian is a distribution from the IRA, with the tax consequence that implies, and it is a clerical error with a real cost.
The exception that applies to a 401(k) and not to an IRA
This is the most consequential distinction in the whole subject and it is routinely absent from investor material, including material written by custodians.
Section 514(c)(9) carves an exception out of the debt-financed rules: "the term 'acquisition indebtedness' does not ... include indebtedness incurred by a qualified organization in acquiring or improving any real property."10 If your account is a qualified organization, leveraged real estate stops generating UDFI.
The list of qualified organizations includes "any trust which constitutes a qualified trust under section 401,"10 which reaches a solo 401(k). It does not include individual retirement accounts. An IRA is not on that list.
| Self-directed IRA | Solo 401(k) or qualified plan | |
|---|---|---|
| Qualified organization under 514(c)(9) | No | Yes, as a section 401 qualified trust |
| UDFI on mortgage debt | Yes | Potentially excluded, subject to the conditions |
| Form 990-T exposure | At $1,000 gross UBI | Reduced where the exception applies |
The exception is conditional, and the conditions are where this gets returned to a specialist. Subparagraph (B) disapplies it where the acquisition price is not fixed, where payments depend on the property's revenue or income, where the property is leased back to the seller or a related party, where a related person provides the financing, or where the property is held through a partnership that fails specified requirements.10
That last condition is the one that bites here, because a syndication is a partnership. Whether a given deal's structure satisfies it is a question for a tax adviser reading that partnership agreement, not a question to settle from a web page or from a custodian's sales sheet. What this section is for is knowing the exception exists, so you can ask.
Inside an IRA against outside one
The structural point most investors miss is that the two vehicles pull in opposite directions on the same deal.
| Inside a self-directed IRA | In a taxable account | |
|---|---|---|
| Depreciation | Largely wasted; the account is already tax-deferred | Shelters distributions, subject to the passive rules |
| Leverage | Creates UDFI, taxable at trust rates | No equivalent charge |
| Filing | The IRA may file its own 990-T under its own EIN | Reported on your own return from the K-1 |
| Losses | No personal benefit | Suspended, then released on full disposition |
| Prohibited transaction risk | Severe and account-wide | Not applicable |
Read that table as one argument: the tax-efficient feature of the asset and the tax-deferred feature of the account are fighting each other. Depreciation, which is the main reason a taxable investor holds leveraged real estate, does almost nothing inside a vehicle that already defers tax. The leverage that produces the depreciation still produces UDFI.7 Your share of all of it is reported on a Schedule K-1.8
None of which makes retirement money wrong for private real estate. Plenty of investors have no meaningful passive income to shelter and are indifferent to the depreciation. It does mean the comparison should be run rather than assumed.
Where this leaves an investor
Three numbers decide this, and none of them require you to be a tax specialist: the deal's expected leverage, your custodian's position on preparing Form 990-T, and your own tolerance for a return that is partly taxed inside a vehicle you assumed was not.
We are not licensed to tell you which account to use, and any sponsor who answers that question without seeing your return is selling rather than advising. What we will tell you is the leverage on any deal we sponsor, because you cannot evaluate the question without it.
Take the leverage figure, the projected year one UDFI, and this page to your own CPA. That conversation costs an hour and settles the question properly. Distributions and required minimum distributions from the account itself follow their own rules, set out in Publication 590-B.9
What to ask before funding from an IRA
- What is the expected loan-to-value, and does it amortize or is it interest-only?
- Will the partnership report unrelated business taxable income on the K-1, and in which box?
- Does my custodian prepare Form 990-T, at what cost, and does the IRA already have an EIN?
- Is any person connected to me receiving a fee or service from this deal?
- What is the projected UDFI in year one against the projected distribution?
What this is built on
- Internal Revenue Service, Unrelated business income from debt-financed property under IRC Section 514
- Internal Revenue Service, Publication 598, computation of debt-financed income
- Internal Revenue Service, Instructions for Form 990-T, Exempt Organization Business Income Tax Return
- Internal Revenue Service, Apply for an Employer Identification Number
- Internal Revenue Service, Publication 598, Tax on Unrelated Business Income of Exempt Organizations
- Internal Revenue Service, Retirement topics, prohibited transactions
- Internal Revenue Service, Publication 946, How To Depreciate Property
- Internal Revenue Service, Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits
- Internal Revenue Service, Publication 590-B, Distributions from Individual Retirement Arrangements
- Legal Information Institute, Cornell Law School, 26 U.S.C. 514(c)(9), real property acquired by a qualified organization
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No question matches that. Try another word, or ask the one that is not on this list.
Ricardo Sanabria · Grey Oaks Multifamily
Answering
Follow-up questions people ask after reading this.
Does my IRA really pay tax on a tax-deferred investment?
On the debt-financed portion, yes. The IRS treats income attributable to acquisition indebtedness as unrelated debt-financed income, and an IRA is taxed at trust rates on it. The rest of the return is unaffected.
Ricardo Sanabria, Grey Oaks Multifamily
How likely is it that a 990-T is required?
More likely than not in a leveraged deal. The filing threshold is $1,000 or more of unrelated trade or business gross income, and the account is treated as a separate trust needing its own EIN.
Ricardo Sanabria, Grey Oaks Multifamily
What is the worst case on a prohibited transaction?
The account stops being an IRA on the first day of that year and is treated as distributing all of its assets at fair market value. The consequence reaches the whole account, not just the investment that caused it.
Ricardo Sanabria, Grey Oaks Multifamily
Should I use an IRA or taxable money for this?
That depends on facts about you that we do not know and are not licensed to assess. The structural point is that depreciation is largely wasted inside a tax-deferred account while leverage still produces UDFI. Take it to your own adviser with the leverage figure in hand.
Ricardo Sanabria, Grey Oaks Multifamily
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