UBIT and UDFI: Using Leverage to Buy Notes in an IRA

An IRA normally pays no current tax on note interest. Borrow money to buy the note, though, and the share of the income that the borrowing paid for becomes unrelated debt-financed income (UDFI), which can be taxed inside the account as unrelated business taxable income (UBTI) under IRC 511 to 514. Buy with the account’s own cash and the question mostly goes away.

This page is general information about one narrow question: what happens to the tax picture when an IRA uses leverage to buy a note. The purchase itself, the custodian and the self-dealing rules are set out in buying notes in a self-directed IRA. The rules below are technical, they change, and the numbers that apply to you are for a CPA to work out.

The terms, in plain English

UBIT is the unrelated business income tax. Retirement accounts and charities are generally exempt from income tax, but Congress did not want them to run untaxed businesses in competition with taxable ones. So IRC 511 taxes their unrelated business taxable income, and IRAs are included.

UBTI is the income that tax falls on. IRC 512 defines it and also lists what is left out, and ordinary investment income such as interest, dividends and most gains is on that excluded list. That exclusion is why a note bought with an IRA’s own cash usually produces no UBTI.

UDFI is the exception that matters here. Under IRC 514, income from property bought with borrowed money, called debt-financed property, loses part of that exclusion. The debt is called acquisition indebtedness, and the part of the income that is pulled back into UBTI follows the share of the asset the debt paid for.

How leverage creates UDFI on a note

The mechanics are a ratio. Take the average acquisition indebtedness on the note during the tax year and divide it by the note’s average adjusted basis, which for a purchased note starts as roughly what the IRA paid. That percentage of the note’s income, less the same percentage of the expenses directly connected with it, is treated as UBTI.

Acquisition indebtedness is wider than a bank loan taken out on closing day. It can include:

• a loan the IRA takes to fund the purchase,
• seller financing, where the seller of the note lets the IRA pay part of the price later,
• a loan secured by the note itself, often called hypothecation,
• debt taken on after the purchase, if it would not have been incurred without it and could reasonably have been foreseen.

Borrowing against a note the IRA already owns is the case people miss. If you are weighing that, read what hypothecation of a note is with this tax point in mind.

The loan has to be non-recourse

Any loan to an IRA should be non-recourse, meaning the lender can look only to the asset that secures it, never to you. If you sign a personal guarantee for a debt the IRA owes, that is generally a prohibited transaction under IRC 4975, and the consequences of that are far worse than a UBIT bill. Lenders who make non-recourse loans to IRAs are a specialist group and usually lend a smaller share of the price, at a higher rate, than a loan you would sign for yourself.

A worked example

The figures below are round and illustrative, and the calculation is simplified. A real return uses monthly averages and the actual expenses for the year.

IRC 512 allows a small specific deduction before tax is figured, and the remaining UBTI is generally taxed at the rates for trusts, which climb quickly. Check the current deduction and rate brackets with your CPA rather than relying on a figure you saw online.

Two things change as the years pass. As the IRA pays the loan down, the debt-financed share falls, and so does the taxable slice. And if the note pays off or is sold while debt is still outstanding, part of the gain on the discount can be caught too, because the ratio for a sale looks back at the debt carried during the year before it.

Who files, and who pays

When an IRA has enough gross UBTI to cross the filing threshold, a return is due on Form 990-T. The IRA is the taxpayer, so the tax is paid from the account, not from your own pocket. Paying it personally would be the IRA’s expense paid by you, which is the self-dealing problem in another form.

In practice the custodian signs or files the 990-T, often based on figures you or your CPA prepare. Custodians handle this differently, and some charge for it, so ask how yours does it before the IRA borrows. Find out too whether the IRA needs its own employer identification number for the filing.

When an IRA can owe UBIT without borrowing

Leverage is the usual cause, but not the only one. If an IRA’s note activity starts to look like a lending business rather than an investment, for example regularly originating loans, rather than buying existing notes now and then, the income may be argued to be business income in its own right. Where that line falls depends on the facts, and it is a question for a CPA or tax attorney before the activity grows, not after.

Holding notes through an LLC or partnership owned by the IRA does not avoid UDFI. Debt at the entity level generally flows through to the IRA’s share.

Ways investors keep the question simple

• Buy only with cash the IRA already holds, accepting a smaller position.
• Buy part of a note instead of the whole. A partial lets the account own a run of payments at a lower price, without borrowing, and buying partials as an investor sets out how that works.
• If you do borrow, plan to pay the loan down, and keep the cash reserve the account needs for servicing, legal costs and the tax itself.
• Keep records of the debt balance month by month, so the averages can be calculated.

Whichever route you take, tell the seller or broker early that the buyer is an IRA and whether any part of the price is financed. We ask for that when investors join the buyer list, because custodian sign-off and lender approval both take time before a closing.

Is leverage worth it inside an IRA?

Run the numbers after tax, not before. Borrowing raises the amount of note income the account controls, but the lender’s interest, the UBIT on the debt-financed slice, the 990-T preparation and the custodian’s charges all come out of that extra income. If the note’s return on the borrowed portion barely exceeds the loan rate, the tax can turn a thin gain into a loss, and a default on a leveraged note hurts twice, because the loan still has to be serviced while the note pays nothing.

The same tax applies whether the account is a traditional IRA or a Roth, which surprises Roth owners who assumed everything inside it was tax-free. Take this page, your account statements and the loan terms to a CPA who works with self-directed accounts, and get a projection for your own figures before the IRA signs anything.

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