Understanding UDFI Tax Impact in Multi-Family Real Estate Syndications: Part 2
In Part 1 of this series, we introduced some of the basic concepts behind investing in a multi-family real estate syndication with your IRA. Since most of these projects use debt-financing in addition to investor capital, this generates exposure to tax on Unrelated Debt-Financed Income (UDFI) for an IRA investor.
What we learned is that the impact of UDFI taxation on operating rental income from a syndicate is generally minimal. Using leverage in an investment can improve the overall performance of the project.
While an IRA is subjected to some taxation on the percentage of income derived from the borrowed capital, the tax cost represents only a small fraction of the benefits that leverage brings to the table. An IRA investor can still expect very solid returns in such projects.
In this article, we want to address how UDFI taxation impacts the exit phase of the project when the property is sold.
When UDFI Applies to a Property Sale
If mortgage debt is still in place when a property is sold, then the gain on sale is treated as debt-financed and subject to UDFI.
The UDFI calculation uses the highest acquisition indebtedness value during the 12 months prior to the sale. If a property is fully paid off a full 12 months prior to sale, there is no UDFI implication.
In most syndicated deals, the property is sold long before retiring the debt, so there’s likely going to be a taxable gain for the IRA investor.
How UDFI is Applied to Sales
All tax calculations for UDFI hinge on the debt-financing ratio.
The debt-financing ratio results from dividing acquisition indebtedness by the adjusted cost basis of the property. At the disposition of property, the highest amount of acquisition indebtedness in the 12 months prior to the sale is used.
This is a different formula than the average debt balance over the course of the year we used when dealing with operating income.
The formula for average adjusted basis is the same as that used for operating income. The beginning and ending values for adjusted costs basis during the portion of the year the property was held are averaged.
Each year, the full value of straight-line depreciation on the building is applied to reduce the beginning-of-year basis.
At the time of sale, the debt-financing ratio is determined by dividing the highest acquisition indebtedness over the last 12 months by the average adjusted basis during the period the property is held during the final tax year.
The debt-financing ratio is applied to the capital gain. Capital gains are calculated using the same logic as in a non-qualified property sale, including the recapture of depreciation.
Our Sample Multi-Family Project
Here is a refresher on the real estate deal we are using for our analysis.
- 216-unit apartment
- Purchase price of $25M
- Acquisition cost total of $26.25M with commissions, closing costs, etc.
- $10M down, consisting of $1M from the general partner and $9M from investors as limited partners
- 10-year hold, with the goal of improving performance and thereby raising both rents and occupancy rates
- Sales price after 10 years projected at $34.5M
- A $100K limited partner investor will have a 1% equity stake in this deal
Review of Rental Income
During the 10-year hold period, the projections for income would produce the following return on our hypothetical $100K IRA investment into this project.
Cash Distributions from Partnership$95,63.40Tax on UDFI$5,750.33Net income to IRA$89,313.07Return on Investment8.93%
The Property Sale
Let’s assume the property sells as projected for $34.5M. That means our 1% IRA investor’s stake will represent $345K.
Sales costs of 4% are typical in these types of deals, allowing for broker commissions and transactional fees. This means a $13,800 cost of sales and a net sales price of $331,200.
The outstanding share of debt is $145,757.60.
After a return of originally invested capital, the net gain from the sale is $85,442.40.
Because there is still outstanding debt, UDFI will apply to the gain.
Project Performance Review
This project looks to have the potential to be a good investment for the IRA. It may generate better than average returns in an investment backed by the security of real property.
The fact that tax on UDFI will apply to the gains doesn’t diminish the overall positive results. The use of leverage in the transaction boosts the return, and your IRA certainly benefits.
When comparing this opportunity to other investments the IRA may take part in, it will be difficult to find something that is as secure and predictable, with a 14% return.
Supercharging the Opportunity
As we have seen, an IRA can expect solid returns from participation in a well-executed multi-family real estate partnership. In fact, the returns are considerably better than most folks regularly achieve with their IRA.
But what if we were to make the same investment using a Solo 401(k), with immunity to UDFI taxation?
Most anyone can establish a self-directed IRA and have the opportunity to invest in a more diversified fashion. Investors who are self-employed and have no-full time employees may be eligible for a Solo 401(k).
As a qualified employer retirement plan, a 401(k) is exempted from taxation on UDFI in specific cases per IRC Section 514(c)(9).
- Only debt-financed income produced when the debt is associated with the acquisition of real property is exempted.
- When investing in real estate indirectly via a partnership, the income and costs of the partnership must be allocated equally, meaning that depreciation cannot be shifted only to partners not using retirement funds for example.
So, what would this deal look like for an investor with a Solo 401(k)?
An investor with a Solo 401(k) would make an extra $33,491 on this very same opportunity.
Not everyone qualifies for a Solo 401(k), and we caution about trying to force qualification, but when there is a good fit for the Solo 401(k), it’s clearly a better tool for the job.
In Summary
Not many investments available to an IRA or 401(k) investor have the potential to produce 14% returns consistently over a 10-year period. Of course, there is also the real difference between the pro-forma projections of an investment sponsor and the real outcome of a project.
Like all investments, you must do your homework and diligence to create the best possible pathway to success.
The fact that an IRA investor will be subjected to tax on a debt-financed real estate partnership is neither here nor there at the end of the day. A good investment is a good investment, and the overall mix of risk and reward is what really matters.
In our experience, most investors will take a 14% return on a leveraged investment with exposure to UDFI instead of a 9% return on a non-leveraged investment.
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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Quick answers to common questions
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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.
