Most people believe that money in their traditional IRAs generates no tax liability until the money is taken out, or that their Roth IRAs grow entirely tax-free, forever.

That’s not quite true.

Why? Because of a little-known tax issue called “unrelated debt income tax,” or UDIT. Really, the only folks who have much experience with it are the people who have self-directed retirement accounts and use leverage in them (largely real estate investors, small business owners and commodity and FOREX investors) and people who run tax-exempt entities, where this concept comes up occasionally. But tax professionals are well-familiar with it, by and large.

In a nutshell, the IRS considers income you earn from money from within the IRA itself to be non-taxable in the current year, either under Roth or traditional IRA rules.  But if you borrow money, well, that’s a different story: The IRS considers money your IRA borrows to come from outside the IRA. And therefore it will generally consider any income attributable to that borrowed money to be taxable as income.

Here’s an example:

Suppose an investor holds a house in his IRA that kicks off $10,000 per year in rental income. The IRA spent $100,000 on the house. The average debt level the IRA had for the year on the house was $50,000. The IRS will consider 50 percent of all rental income and 50 percent of all gains on the sale of the house to be subject to income tax. The other 50 percent is tax-deferred or tax-free, according to the terms of the account. Essentially, if you have 50 percent equity, the house is 50 percent taxable.

The IRS then levies a tax on unrelated debt-financed income, or UDFI.

The formula they use to calculate UDFI is this:

(Average acquisition indebtedness/average adjusted basis) x gross income = UDFI

By the way, if you ever buy stocks on margin in your IRA account, the same principle applies: The IRS will consider the portion of profits attributable to margin borrowing as UDFI, and for the same reason.

For details on how this concept applies to you, see IRS Publication 598.

You do get the benefit of depreciation: Remember that residential properties are typically depreciated over 27.5 years under MACRS rules. For the purposes of calculating your UDFI, you have to use the straight line method.*

Now … some good news for flippers: Typically, the depreciation deduction is enough to offset any rental income you earn on a property in the early years of a 30-year loan. So UDIT is little to nothing for a few years. But if you make some money on the flip – and I hope you do – you will have some tax due on the gain within the property. Capital gains in an IRA attributable to debt financing are taxed at the same income rate that trusts pay. To report it – and I strongly discourage any investor from trying to work through this themselves, but instead recommend using a tax professional – you need to use an IRS Form 990-T .

Self-Directed Solo 401(k)s are Exempt From UDIT

If you plan on using a self-directed retirement account to own real estate or anything else you want to buy with leverage, consider a self-directed 401(k), if you qualify. Why? Two reasons: The 401(k) has higher contribution limits than either a Roth or traditional IRA – and in some circumstances higher than even a self-directed SEP IRA.  Second, a self-directed 401(k) is not subject to unrelated debt income tax, according to Jim Hitt, principal of AmericanIRA, LLC. a third-party administrator specializing in self-directed tax-advantaged account investing in Asheville, N.C.

What if You’re a Dealer?

If you flip enough, the IRS will classify you as a dealer, rather than an investor. This means they basically consider you to be a retailer, like anyone else who buys inventory wholesale and sells it retail. When that happens, the IRS is basically flipping three switches on you:

Capital gains are taxed as income, like any income you would receive from any other business.

Your gains attributable to borrowed money are assessed an unrelated business income tax (UBIT), which you have to pay in the current year.

You don’t get to do Section 1031 “like kind” exchanges, either, under dealer rules, but that’s not an issue within retirement accounts anyway.

Clear as Mud?

Trust me. Get a tax professional working through this for you: preferably one who routinely assists people in self-directed accounts and real estate.

For more information specific to dealer rules and flipping properties, see my previous article on taxation of real estate flipping .

* In the straight-line depreciation method, your depreciation = (cost residual value) / useful life of the property. In this case, 27.5 years for residential property. 

Jason Van Steenwyk is a veteran financial industry journalist who has been fighting to make the world safe for the retail investor since 1999. He lives at Ground Zero of the real estate bubble in Fort Lauderdale, Florida.

Good Morning.

Great article. Have you any recommendation as to who I might select to assist me in setting up a self directed IRA with my original IRA?