Tax Consequences Of Using Debt Financing To
Acquire Real Estate In A Self-Directed IRA
The act of borrowing money itself in a self-directed IRA is not a taxable event. However, using borrowed funds (debt financing) to acquire or improve rental properties can subject the IRA to taxes on unrelated debt-financed income (UDFI), which is a form of unrelated business taxable income (UBTI). This means the IRA may owe taxes on the portion of rental income or gains attributable to the debt even though IRAs are generally tax-deferred.
Key Rules and Considerations
- Debt-Financed Property in IRAs: Under IRS rules (IRC Section 514), when an IRA uses debt to finance investments like real estate, a proportional share of the income from that property (e.g., rent or sale proceeds) becomes UDFI and is treated as UBTI. This overrides the usual exclusion for passive rental income, which would otherwise be tax-free in an IRA. The tax applies only to the leveraged portion—not the entire investment.
- How UBTI is Calculated for Debt-Financed Real Estate:
- Determine the debt/basis percentage: This is the average acquisition indebtedness (outstanding loan balance) divided by the average adjusted basis of the property (original cost plus improvements, minus depreciation).
- Apply this percentage to the gross income from the property (e.g., rental income) to find the UDFI amount.
- Subtract allowable deductions (e.g., interest on the debt, property taxes, depreciation using the straight-line method, maintenance) allocated to the debt-financed portion.
- The result is the UBTI, which is taxed at trust rates (up to 37% for amounts over $15,200 in 2025) if it’s $1,000 or more in gross UBTI for the year. Negative results can create a net operating loss (NOL) carryover to future years.
Example: Suppose your IRA buys a $200,000 rental property with $100,000 of its own funds and a $100,000 non-recourse loan. The debt/basispercentage is 50%. If the property generates $20,000 in annual rent (after expenses), $10,000 of that income is UDFI and potentially subject to UBTI tax.
Applying to Acquisitions or Improvements:
- Acquiring Properties: Borrowing to buy new rental properties triggers UDFI on the debt-financed share of future income or gains.
- Improving Existing Properties: If you borrow to make capital improvements (e.g., renovations), this creates acquisition indebtedness, subjecting a portion of the property’s income to UDFI based on the new debt. Routine maintenance funded by cash wouldn’t trigger this.
Important Requirements and Exceptions:
- The loan must be non-recourse (lender can only claim the property, not personal assets or IRA guarantees) to avoid a prohibited transaction, which could disqualify the entire IRA and trigger immediate taxation plus penalties.
- No UBTI if the property is bought outright without debt.
- The tax is paid by the IRA itself (via Form 990-T), not you personally. If UBTI is under $1,000, no filing is needed. Estimated taxes may be required if liability is $500 or more.
- Exceptions are rare for rental properties but could apply if the real estate serves an exempt purpose (unlikely for standard rentals) or under the “neighborhood land rule” for future exempt use.
Roth IRA Nuance
Even though Roth IRAs are generally tax-free, UDFI/UBIT still applies to leveraged real estate within them. That means even Roth IRAs can owe UBIT on the debt-financed portion of income.
Conclusion
The above can reduce the tax advantages of holding real estate in an IRA, so many investors don’t use IRAs, or avoid leverage when using a self-directed IRA to minimize UBTI exposure. Consult one of our tax professionals or an IRA custodian for your specific situation, as rules can be complex.
The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.
