Solo 401k vs SDIRA UDFI Rules: Which Account Avoids Real Estate Taxes?

TL;DR: When a self-directed IRA buys real estate with a loan, part of the income is taxed as Unrelated Debt-Financed Income (UDFI), at trust tax rates, on Form 990-T. A Solo 401(k) can usually make the same leveraged real estate purchase with no UDFI, because Section 514(c)(9) excludes real estate debt taken on by a qualified 401(k) trust. That exception has conditions and covers only real property. Inside an IRA, depreciation lowers UDFI only on the straight-line method, so bonus depreciation does not help there.

Why does a retirement account need a non-recourse loan?

Because you cannot guarantee a loan to your own retirement plan. Section 4975(c)(1)(B) makes "lending of money or other extension of credit between a plan and a disqualified person" a prohibited transaction, and a personal guarantee is an extension of credit. That rule applies to IRAs and 401(k) plans alike.

So the loan has to be non-recourse, meaning the lender's only remedy in a default is the property. Non-recourse lenders underwrite the property itself, and they usually ask for a larger down payment than a standard mortgage. Ask lenders for current terms before you plan around a number.

Money in an old employer 401(k) can often be rolled into a self-directed account that buys real estate. Which kind of account you roll it into decides how the loan is taxed.

How is UDFI calculated on leveraged property?

By the ratio of the loan to the property's basis, measured each year. Section 514(a)(1) taxes the same percentage of the property's income as "the average acquisition indebtedness" is of "the average amount ... of the adjusted basis of such property."

Say an IRA buys a $100,000 property with $30,000 of its own cash and a $70,000 non-recourse loan. In the first year, about 70 percent of the property's net income counts as UDFI. As the loan is paid down, that share falls. IRAs are subject to the unrelated business income tax under Section 408(e)(1), and that tax is figured at trust rates under Section 511(b)(1). There is a $1,000 specific deduction under Section 512(b)(12), and the Form 990-T instructions require an IRA with "$1,000 or more of unrelated trade or business gross income" to file.

What is the Solo 401(k) exception for real estate debt?

It is a statutory carve-out for qualified retirement plans. Section 514(c)(9)(A) says acquisition indebtedness "does not ... include indebtedness incurred by a qualified organization in acquiring or improving any real property," and a qualified organization includes "any trust which constitutes a qualified trust under section 401." IRAs are not on that list.

The exception is not automatic, and it is limited to real property. Section 514(c)(9)(B) takes it away when, among other things:

• the price is "not a fixed amount";
• the debt payments are "dependent ... upon any revenue, income, or profits" of the property;
• the property is leased back to the seller or a related party;
• the plan buys the property from, or leases it to, certain disqualified persons; or
• such a person "provides the qualified organization with financing."

To have a one-participant 401(k), the IRS describes the plan as covering "a business owner with no employees, or that person and his or her spouse." If you have self-employment income and no other employees, it is worth asking your tax professional whether a Solo 401(k) fits before you put leverage inside an IRA.

What can depreciation do for UDFI inside an IRA?

Less than most investors expect. Section 514(a)(3) says depreciation on debt-financed property "shall be computed only by use of the straight-line method," and Treasury Regulation 1.514(a)-1(b)(2)(ii) repeats it. Bonus depreciation is not straight-line, so it does nothing here. Only the debt-financed share of the depreciation counts, the same percentage used to figure how much of the income is taxable.

Does a cost segregation study help at all? At the margin, maybe. The statute sets the method, not the recovery period, and whether components from a study can be written off straight-line over their shorter lives is a question to settle with your tax professional before you count on it. Do not buy a study to erase UDFI. It will not do that. Cost segregation does its real work on property you own outside a retirement account.

IRA or Solo 401(k) for leveraged real estate?

If you qualify for a Solo 401(k) and the deal fits the Section 514(c)(9) conditions, it can borrow for real estate without UDFI. An IRA cannot. That difference turns on your employment situation and the deal terms, so run both with your tax professional. Daniel Tercey covered account setup and the prohibited transaction rules on our self-directed IRA episode.

If you own real estate outside your retirement accounts and want to know what depreciation could do there, call me at 770-224-8504, option two. No obligation and no pitch.

This article is educational and is not tax, legal, or accounting advice. Every situation is different; work with a qualified tax professional before acting on any strategy described here.