Is Your Self-Directed IRA Subject to UDFI and UBIT? Understanding the tax implications of certain alternative assets in a self-directed retirement plan

Published on September 3, 2025

Although self-directed IRAs (SDIRAs) are tax-advantaged accounts, certain types of alternative investments may trigger two types of tax liabilities: unrelated debt-financed income (UDFI) which is based on the account’s earned income (often, from real estate holdings) and unrelated business income tax (UBIT).

Let’s break each one down.

• UDFI in an IRA is income generated by a financed asset, which is why it is often associated with real estate. For example, if you hold vacation rental property in your SDIRA and used a non-recourse loan to finance part of that investment (in addition to IRA funds), the rent payments are considered unrelated debt-financed income because the IRA-held property was at least partially financed. If you made the investment completely with funds from your IRA, UDFI does not apply.
• UBIT in an IRA is a tax that’s applied on earnings of $1000 or more on an investment that is at least partially financed. In this scenario, the earnings can be considered unrelated debt-financed income which are subject to UBIT. The taxes are paid on the portion of the property that was financed.

Three common scenarios that trigger UBIT

1) debt-financed income (as noted above regarding real estate)

2) auxiliary income earned by the investment from truly unrelated business activity (such as when a business in which your IRA has invested leases out equipment to another party during a slow period), and

3) income generated from an unincorporated business in which the SDIRA has invested (usually a small operation that is a sole proprietorship or general partnership).

Important considerations regarding UDFI and UBIT

If your IRA sells property in its portfolio and there are capital gains, earnings from that property are subject to a UDFI tax at the UBIT rate.

UBIT applies if the investment is an ordinary income-producing business. In real estate this includes investing in an LLC or LP (limited partnership) that engages in new construction, real estate developments held for sale, or other business activities such as fix-and-flip endeavors.

Passive income investments are exempt from UBIT. Most real estate private funds are structured to earn passive income. In fact, most earnings within a self-directed IRA are tax exempt until distribution and don’t trigger UBIT; these include interest income, rental income from properties that are NOT partially financed, capital gains, income from royalties, and dividends from C-corporations.

In addition, self-directed 401(k)s, solo 401ks, and other employer-based plans are exempt from UDFI on leveraged real estate investments.

You must pay UBIT or UDFI taxes or pay penalties; these include a 5% late penalty for every month the amount goes unpaid up to a maximum of 25% of the unpaid UBIT.  Failure to pay can jeopardize your SDIRA.

The importance of understanding the ins and outs of alternative assets

Given how it can be easy to wind up paying tax on unrelated debt-financed income or trigger unrelated business income tax—even with certain alternative assets held within a self-directed IRA—it is so important that investors truly do their full due diligence and research before making a nontraditional investment. This is also why the team at Next Generation Trust Company strongly recommends that our clients consult a trusted tax advisor before making the investment, so as to best plan for and minimize the financial impact of any tax event.

We invite to download our white paper about real estate investing through a self-directed IRA if you are new to self-direction, or contact our team with questions at NewAccounts@NextGenerationTrust.com or 888.857.8058.