What Investors Need to Know Before Using Retirement Accounts to Purchase Real Estate

And how Unrelated Business Income Tax (UBIT), Unrelated Debt-Financed Income (UDFI), and Prohibited Transactions can impact after-tax outcomes.

Using Retirement Accounts for Private Investments

Did you know that you can purchase real estate and private investments within retirement accounts like an IRA or 401(k)? In fact, when properly structured and located, self-directed retirement accounts can be a powerful tool for real estate and private business investors. Holding private investments in tax-deferred or tax-free accounts allows investors to diversify beyond public stocks and bonds and shelter income/rents by utilizing the IRA/401(k) wrapper. Just like other holdings within your retirement accounts, a well-structured real estate or business investment inside your IRA or Solo 401(k) can compound without annual tax drag.

We talk to many investors who read the prior paragraph and are immediately ready to sell everything in their Roth IRA and start buying properties. This is one of those instances where it’s extremely important to work with a professional as there are many nuances, traps, and tradeoffs to consider. While some assets are a perfect fit for retirement accounts, others that look almost identical may be a terrible fit.

Understanding where tax traps lie is an essential first step. In this article, we’ll discuss self-directed retirement accounts, investing in private assets, and successfully navigating the complexity associated with this strategy.

Can You Purchase Real Estate in an IRA?

Many investors don’t realize that a self-directed retirement account (ie. Self-Directed IRA (SDIRA) or a Solo 401(k)) can be used to purchase private investments beyond the typical mix of stocks, bonds, and mutual funds they may be accustomed to.

While you must choose the correct custodian and account type, these accounts can hold a variety of alternative assets, including private real estate, syndicated investments, promissory notes, private equity, and even some operating businesses. This could allow investors to align their retirement portfolio with investments they know and understand, which can be attractive for those looking to pursue higher returns, apply industry knowledge and due diligence, or reduce risk through diversification or inverse correlation.

However, while the potential is compelling, investing in private assets through a retirement account comes with its own set of rules, tax considerations, and prohibited transaction restrictions, making due diligence and proper structure of the utmost important prior to getting started.

The Core Concepts: Three Tax Traps to Know

Before making any investments in a self-direct retirement account, it's critical to understand three rules that govern these investments and can introduce taxes into a seemingly tax-free environment. While there is a bit of overlap, they address different issues.

1. Unrelated Business Income Tax (UBIT): This tax applies when a retirement account earns income from an active trade or business that is not substantially related to its tax-exempt purpose (which is simply to provide retirement benefits for its owner).

   
   

2. Unrelated Debt-Financed Income (UDFI): This is a specific subset of UBIT. It is triggered when a retirement account uses debt (ie. a mortgage) to acquire an asset (ie. a rental property). The income and gains attributable to the financed portion of the property would be subject to tax.

   
   

3. Prohibited Transactions (PT): These rules are designed to prevent self-dealing. They bar you, your spouse, children, parents, or other “disqualified persons” from personally benefiting from or providing services to an investment owned by your retirement account. This means you cannot self-manage or use an IRA-owned property yourself.

   
   

You may be asking yourself, why do these rules exist? The purpose of UBIT and UDFI is to level the playing field. Your IRA is a tax exempt entity (like a charity), and Congress did not want tax-exempt entities to use their tax advantages to compete unfairly with regular for-profit businesses. For example, if an IRA owns a hotel or uses debt to buy property, these rules ensure it pays tax on that income, just as a private investor would.

The table below clarifies the difference between UBIT, UDFI, and Prohibited Transactions:

	Unrelated Business Income Tax (UBIT)	Unrelated Debt-Financed Income (UDFI)	Prohibited Transaction (PT)
What is it?	A tax on net income from an active trade or business run inside a retirement account.	A subset of UBIT. A tax on income and gain from a property that was bought with debt (a loan).	A rule violation against self-dealing between the retirement account and a "disqualified person" (you, your spouse, etc.).
Primary Trigger	The nature of the activity. (Is it a business?)	The financing of the asset. (Was a loan used?)	The person performing the action. (Is it a disqualified person?)
Real Estate Example	Operating a short-term rental like a hotel with substantial services (daily cleaning, concierge).	An IRA using a mortgage to buy a long-term rental property.	You personally fix a leaky faucet or paint a wall in a rental property owned by your IRA.
Consequence	The retirement account owes income tax on the business profits. The account itself remains valid.	The retirement account owes income tax on the portion of income/gain attributable to the loan.	Catastrophic. The entire IRA is treated as distributed, becoming fully taxable and subject to penalties.
How to Avoid It	Focus on passive investments like long-term rentals. Avoid providing non-customary services.	Use a Solo 401(k) instead of an IRA for leveraged real estate, or pay all cash for the property.	Hire unrelated, third-party professionals for all work and management. Never mix personal and IRA activities.

Common Tax Triggers on Private Investments in Retirement Accounts

To better apply these concepts in practice, we’ve illustrated a few common triggers that may subject you to these tax traps.

1. Triggering UDFI by Using Debt - If your self-directed IRA takes out a non-recourse loan (ie. a mortgage) to buy a property, a portion of the net income and eventual capital gain will become taxable. That said, there is an exception applied to qualified plans like Solo 401(k)s. These plans are generally exempt from UDFI on debt used to acquire real estate which could be a huge benefit. This makes the Solo 401(k) an immensely powerful vehicle for real estate investment financed with a mortgage.

   
   

2. Triggering UBIT by Operating a Business - UBIT will apply when your retirement account's activity crosses the line from passive investing into direct operation of an active trade or business. As mentioned previously, the IRS wants to prevent tax-exempt entities from having an unfair advantage over regular, taxable companies.

   
   

Here are a few examples:

• Short-Term Rentals & Substantial Services: Managing a property like a hotel (or some AirBnB or VRBO properties) with a high turnover of guests can potentially trigger UBIT. If the average stay is 7 days or less, this is a strong indicator that there’s potential for “substantial services” to be provided. And if you provide substantial hotel-like services (daily cleaning, concierge, guest amenities), the IRS can view it as operating a hospitality business, not passively collecting rent. This would shift income from passive to active and thus be subject to UBIT.

  
  

• Property Development and Flipping: If your IRA regularly buys land or properties, develops them, and quickly sells them for a profit, this can be classified as a dealership or development business. The profits from these "fix-and-flips" would be considered active business income subject to UBIT. This differs from selling a long-term passive rental as that capital gain would not be subject to UBIT.

  
  

• Direct Business Ownership: If your IRA directly owns and operates an active enterprise (ie. a landscaping company, a car wash, or a retail store) that is structured sole proprietorship or an LLC, the net income generated is subject to UBIT.

3. Triggering UBIT and/or UDFI by Investing in Partnerships (K-1s) - Many investors are surprised to learn that UBIT/UDFI can apply even in a seemingly passive investment, like a real estate syndication or private equity fund. If the partnership uses leverage to acquire assets, that debt is passed through proportionally to all partners, of which your retirement account is one. Make sure to run due diligence prior to making an investment as you will often be able to ask about the partnership’s Schedule K-1 and potential UBIT-designated income which would create a tax liability inside your IRA or 401(k).

The Financial Impact of UBIT & UDFI on Returns

When triggered, these taxes completely change the math around the decision to make an investment or not. These taxes are assessed at trust tax rates, which are highly compressed and hit the top marginal rate much faster than personal income tax rates.

A Detailed Look at the Math on UDFI

Let's use a simple example to illustrate the concept. Your self-directed IRA buys a property for $500,000 using $250,000 of IRA cash and a $250,000 interest-only mortgage.

The first step is to calculate the debt financing percentage which can be found by taking the Average Adjusted Basis (ie. $500k) divided by the Average Outstanding Debt (ie. $250k). In this case the debt-to-value ratio, or debt financing percentage, is 50%.

Note: This percentage changes every year based on average annual values of both basis and outstanding debt.

Tax on Annual Net Income:

• Gross Operating Income: $40,000

• Operating Expenses: $15,000

• Depreciation: $10,000

• Net Operating Income: $15,000

• Taxable Portion (UDFI): $7,500 ($15k x 50% Debt-to-Value Ratio)

This $7,500 is subject to UDFI, and the tax must be paid directly from the IRA's cash.  

Five years later, assume you sell the property for $700,000. Under the 12-month lookback rule, the debt percentage is calculated using the highest loan balance during the 12 months prior to sale.

• Sale Price: $700,000

• Adjusted Basis: $450,000 (after depreciation)

• Total Gain: $700,000 - $450,000 = $250,000

• Taxable Portion of Gain: $125,000 ($250k x 50% Debt-to-Value Ratio)

Your IRA would owe income tax on $125,000 of the profit, significantly eroding the tax-advantaged return you were likely expecting.

Note: This shifts what would otherwise be classified as preferential capital gain tax if the property was bought in your personal name to condensed ordinary income tax trust rates.

Proactive Strategies to Mitigate UBIT and UDFI

At 24Acres, we constantly discuss the benefits of proactive, informed financial planning. Working with a professional can help you properly structure investments to legally avoid or minimize these taxes.

1. Choose the Right Account Type: For leveraged real estate, a self-directed Solo 401(k) is almost always superior to a self-directed IRA due to its statutory exemption from UDFI on acquisition debt.

   
   

2. Focus on Passive, Long-Term Rentals: Avoid UBIT by steering clear of properties requiring substantial services. Favor long-term leases over short-term rentals inside a retirement account.

   
   

3. Pay Off Debt Strategically: If using debt in an IRA, remember the 12-month lookback rule. To shelter 100% of the capital gain from UDFI, the loan must be paid off more than 12 months before the sale date.

   
   

4. Use a C-Corporation Blocker (Advanced): For larger investments in active businesses, the IRA can invest in a C-Corporation, which then holds the operating asset. The C-Corp pays corporate tax, and the dividends it sends to the IRA are considered tax-free portfolio income, not UBIT. This is a complex structure requiring professional advice.

   
   

5. Scrutinize K-1s Before Investing: When evaluating a syndication, ask the sponsor upfront if the fund uses leverage and if they anticipate generating UBIT. Review a prior-year K-1 if possible.

Compliance and Administration for Unrelated Business Income Tax

If your retirement account owes tax, you must adhere to the following:

• File Form 990-T: The Exempt Organization Business Income Tax Return is used to report and pay the tax.

  
  

• Get an EIN: Your retirement account must have its own Employer Identification Number (EIN) to file the return.

  
  

• Make Estimated Payments: If the tax liability is significant, the account may need to make quarterly estimated tax payments to avoid penalties.

  
  

• Check State-Level UBIT: Some states impose their own version of UBIT, which may require a separate state-level filing.

  
  

• Coordinate with Your Custodian: The IRA custodian or 401(k) plan administrator must be involved in submitting returns and paying the tax directly from the account.

Proper Financial Planning and Asset Location

Retirement accounts are an incredible tool, but they are not the right fit for every investment.

Best-Fit Investments for Retirement Accounts (Low UBIT/PT Risk):

• Publicly traded stocks, bonds, and funds.

• Triple-net commercial rentals held debt-free in an IRA.

• Leveraged long-term rentals held within a Solo 401(k).

• Passive equity in private real estate funds that do not use leverage.

• Private credit, lending, notes, and mortgage funds. (This is our favorite!)

Investments Often Better Held Personally:

• Residential and commercial property in which your competitive advantage is active participation.

• Real estate "fix-and-flips" that constitute a business.

• Properties where you intend to materially participate to qualify for Real Estate Professional Status (REPS) or Short-Term Rental Loophole.

• Highly leveraged properties held in an IRA (due to UDFI).

The key takeaway is proper planning and due diligence. By understanding the interplay between UBIT, UDFI, and prohibited transaction rules before you invest, you can structure your deals to maximize long-term, tax-advantaged growth and avoid costly surprises.

Make sure you’re working with a planner who understands how your private investments and retirement accounts all fit together.

Take the Next Step

This is one small example of how 24Acres applies expertise and proactiveness to make sure our clients are making the best decisions available to them. 

If you’d like a no-cost, no-obligation consultation on your financial plan and tax strategy, contact us.  

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