Understanding UDFI Tax Impact in Multi-Family Real Estate Syndications: Part 1
Multi-family real estate syndications have been one of the hottest asset classes for savvy IRA investors for the last several years.
Participating as a limited partner in a professionally-run real estate project that is larger in scale provides many benefits. For busy professionals looking to put retirement money to work in a hands-off manner that provides a good mix of principal security and solid return potential, real estate syndications are hard to beat.
Most of these deals use a combination of investor capital and mortgage debt to acquire properties. This use of debt-financing produces exposure to tax on Unrelated Debt Financed Income (UDFI) for an IRA investor.
Queue the panic button!
Taxes will kill your IRA return!
The sky is falling!
Wrong, wrong, and, um…wrong.
Many investors and even a lot of syndicate general partners approach the topic of UDFI taxation with fear. That fear is misplaced and largely based on lack of good information.
We wanted to take a little bit of time to put this topic in proper perspective.
What is UDFI?
When an IRA uses debt-financing, it brings non-IRA money into the picture to increase the performance of the IRA’s investment. Section 514 of the tax code designates a tax on this Unrelated Debt-Financed Income.
Such taxation first became applicable in 1969, and is a means to prevent certain types of abusive transactions via tax-exempt structures.
UDFI is the portion of the income that an IRA receives based on the use of the borrowed funds. In a property with a 65% LTV loan, that would mean 65% of the gross income produced by the property is considered UDFI.
The IRA can apply the same 65% ratio of normal deductions such as depreciation, interest on the note, and operating expenses to offset the taxable income. The net taxable amount left after deductions is used to determine the tax owed by the IRA.
Taxation on UDFI applies to rental income produced by a debt-financed property. The gain on sale of a property that still has debt-financing in place is also considered to be UDFI and taxable.
At the end of the day, the IRA pays what is usually a nominal amount of tax in order to benefit from the higher cash-on-cash returns that leverage produces. The benefits of leverage will still very much be realized, just with a small amount of friction.
So, if generating higher net returns for your IRA is of interest, read on.
The Solo 401(k) Exemption
As a qualified employer retirement plan, a Solo 401(k) is exempted from UDFI when the debt-financing is used for the acquisition of real property. Other types of debt-financing, such as leveraged stock trading, are taxable as UDFI in a Solo 401(k).
In most syndicated real estate partnerships where income and losses are attributed to all limited partners equally, this exemption will still apply — even though the real estate is indirectly held and financed.
A Solo 401(k) could lose UDFI exemption if the partnership is shifting depreciation solely to investors using non-retirement funds. Such unequal allocation of losses violates the “fractions rule” of IRC section 514(c)(9)(E), and voids the qualified plan exemption to UDFI.
For those investors who are eligible for a Solo 401(k), that platform provides an advantage in terms of simplicity and higher profitability when investing in leveraged multi-family syndications.
A Sample Multi-Family Syndication
Let’s examine how UDFI impacts an IRA investor in a typical multi-family syndication.
In this project, the promoter is acquiring a 216-unit apartment complex for $25M using $10M down and a loan in the amount of $16.25M. The total acquisition cost will be $26.25M, allowing for transactional costs and capital improvements to the property.
Limited partner investors will provide $9M, and the general partner will have skin in the game by providing $1M.
The project plan is to upgrade the property and management to increase rents and occupancy rates, thereby improving the performance of the apartment. After a 10-year hold, the property will be sold, with a projected value of about $34.5M.
An IRA investor bringing $100K to this project will have a 1% equity stake as a limited partner in the LLC that will hold and operate the property.
When the investor is looking at their income and applicable taxation, everything is fractionalized to their IRA’s 1% level of ownership. So instead of this being a $25M project with $10M of investor capital down, it essentially becomes a $250K project with the IRA investor’s $100K down.
The promoter’s pro-forma projections for cash flow indicate that a 1% limited partner can expect a distribution from the LLC annually. The following amounts exhibit the increase over time as property performance increases.
- Year 1: $7,119
- Year 5: $10,769
- Year 10 $11,395
At the end of the 10-year hold when the property sells, the investor should receive their capital back, plus their percentage of the gain on sale. Our $100K investor with 1% participation could expect around $92K in proceeds from the future sale if the $34.5M goal is met.
UDFI Calculation
When examining UDFI, there are 3 key values used:
1. Average Acquisition Indebtedness
This is the average monthly balance on the loan during that portion of a given tax year during which a property is held.
2. Average Adjusted Basis
This is the average cost basis of the property over the period during a given tax year when the property is held. The initial cost basis starts with the price paid for the property, as well as closing costs and the cost of any property improvements completed at acquisition or reasonably foreseen as necessary at the time of purchase.
The cost basis is reduced each year by the full amount of straight-line depreciation on the property. Averaging the beginning and ending cost basis values for the year provides the average adjusted basis value used for UDFI calculations.
3. Debt Financing Ratio
This is the result of dividing the average acquisition indebtedness by the average adjusted basis. This ratio is then applied to gross income produced by the property to determine the amount of UDFI.
Likewise, the same ratio is used to determine deductions for applicable expenses like interest, depreciation, and operating expenses such as property taxes, management, etc.
A $1,000 exemption against UDFI applies per taxpayer.
The net income deemed to be UDFI after the exemption and deductions is then run through the trust tax table to determine the taxable amount.
An IRA is a form of trust, thus the use of the trust table. 2019 trust tax rate brackets range from 10% on amounts below $2,550 to 37% on amounts over $12,500.
The potential of some income being taxed at a 37% rate is intimidating, and a big reason why many folks become deterred from debt-financed investments. As we continue, you’ll see that only a fraction of real income is subject to taxation, and the effective tax rate an IRA will pay is generally quite low.
UDFI – Rental Income
For sake of brevity, we’ll skip over the details of the math for determining our average adjusted basis and average acquisition indebtedness.
When we run the numbers on this deal we end up with a debt-financing ratio after the first year of .63. This means that 63% of the gross income is considered taxable as UDFI.
The property will generate $2.43M in rents, so our 1% shareholder IRA will be allocated $24,326. 63% of that value is $15,309 which is our gross UDFI income amount.
The allowable deductions include mortgage interest, depreciation, property taxes, property management, etc. The 63% allocation of these write-offs equals $15,376.
Wait, that is higher than our debt-financed income!
Due to the lower performance of the property in the initial years, we’ll have more allowable expenses than income. There will be no UDFI tax in year one even though the IRA received $7,119 of net income.
Likewise, in year two, the IRA will take home $8,719 and have no tax obligation.
The tax losses are negligible, and therefore not worth doing a return in order to carry losses forward to offset taxes in future years. This would be a viable strategy with larger tax losses.
Each year the values shift a bit and that changes the tax implications. With an interest-only loan such as this project uses, cash flow is boosted in the early years.
The trade-off with respect to UDFI is that the average acquisition indebtedness is not reduced each year by principal payments on the loan. The average adjusted basis does become lower each year as the full amount of depreciation on the property is applied.
This causes the debt-financing ratio to increase over time, making more of the income taxable. By year 10, the debt-financing ratio is .81.
In a loan normally amortized on a principal plus interest basis, the debt-financing ratio will trend consistently near the initial value until dropping in the last few years of the loan.
Following are the top line numbers for a few landmark years of the project.
- Year 3 is the first year with tax liability.
- Year 5 is the last year of the interest-only loan.
- Year 7 reflects increased mortgage payments once the interest-only period expires.
- Year 10 is the last year of the project prior to sale.
- All values reflect the 1% share our IRA investor has in the larger deal.
Summing it Up
The impact of UDFI on the overall returns for this project is negligible. The sky is not, in fact, going to fall.
Over the 10-year period covered in the sponsor’s projections, the IRA’s $100K investment would produce $89,313 of net, after UDFI cash flow. That is an annualized ROI of 8.93%
Taxation on UDFI plus the cost of tax preparation would only reduce the overall return by an average of .58% per year.
A key income component of multi-family real estate syndications is the gain on sale.
Disclaimer: The examples provided in this article are for education purposes only and should not be construed as tax guidance. Several assumptions have been taken for simplicity of illustration such as full tax-year holdings of the property in the initial and final years. Each opportunity is unique, and many factors such as the design of a partnership can impact a participant using retirement plan funds. You should always seek qualified, licensed tax counsel when evaluating an investment using debt-financing.
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It is possible to use funds from most types of retirement accounts:
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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.
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- You (the account holder)
- Your spouse
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- Your children, grandchildren, and their spouses
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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.
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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)
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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.
