Understanding The UDFI Exception for Solo 401(k) Real Estate Investors

If you’re a real estate investor using retirement funds, avoiding unnecessary taxes is key. While Self-Directed IRAs can face the UBTI tax when using a loan to buy property, Solo 401(k) plans benefit from a powerful exemption that can keep your investment gains tax free. This is known to the UDFI exception for real estate investments.

What Is UBTI?

Unrelated Business Taxable Income (UBTI) is a tax that applies when a tax-exempt retirement plan earns income from certain types of activities — including:

• Using margin to buy stocks
• Owning an active business via an LLC or partnership
• Using a non-recourse loan to buy real estate (known as UDFI)

Let’s focus on the third point — using debt to buy property.

What Is UDFI?

Unrelated Debt-Financed Income (UDFI) is a type of income generated when a retirement account buys property using a loan. Under IRC Section 514, this income becomes taxable through UBTI, even if the rest of the plan’s income is tax-deferred.

This rule was created to prevent tax-exempt organizations from unfairly competing with taxable businesses by using borrowed funds for profit-generating ventures — including real estate.

Are Retirement Accounts Affected?

Yes. Even though retirement accounts like IRAs and 401(k)s are considered tax exempt, they must follow the same UBTI rules as nonprofits under IRC Section 501.

That means if you use debt to buy property inside your retirement account, some of the income could be taxed — unless an exception applies.

When Does a Property Trigger UBTI?

A retirement plan investment in real estate could trigger UBTI if:

• The property was acquired using a non-recourse loan (mortgage).
• The property produces rental income, capital gains, or other revenue.
• The retirement account is an IRA or a plan that doesn’t qualify for an exception.

The UDFI Exception

Here’s where things change. Under IRC Section 514(c)(9), certain retirement plans — including Solo 401(k)s — are exempt from UBTI on real estate purchased with a loan. This means:

• You can use leverage (a loan) to buy real estate in your Solo 401(k).
• You don’t pay UBTI on the rental income or sale profits from that property.

Setting Up a 401(k) for Real Estate Investing

The most flexible way for an individual investor to take advantage of this rule is to set up a Solo 401(k) plan. This is a retirement plan designed for self-employed individuals or small business owners with no full-time employees other than themselves and their spouse.

To create a Solo 401(k), you need a legitimate trade or business. The IRS doesn’t require you to have revenue immediately, but there must be evidence that you are engaged in ongoing business activity with a profit motive.

Examples of valid business indicators include:

• Registered LLC or corporation
• EIN obtained from the IRS
• Business bank account
• R&D or startup expenses
• Business tax return (even showing a loss)

You do not need to earn income in the year you set up the plan. However, you must have earned income (W-2 wages or net self-employment income) to make contributions to the plan. Until then, you can still form the plan and use it as the investment vehicle.

Conditions to Qualify for the Exemption

To avoid UBTI, the real estate investment must meet these rules:

• The purchase price is fixed when the deal is signed.
• The loan payments can’t be based on income or profits from the property.
• The property isn’t leased to the seller or anyone related.
• The seller and lender can’t be the same party (or related parties).
• The property is held directly by the Solo 401(k) or a qualified entity.

As long as these criteria are met, your Solo 401(k) can use leverage without triggering UBTI.

Why IRAs Don’t Qualify

Unfortunately, IRAs do not qualify for the exemption under IRC 514(c)(9). The rule was added in 1980 to benefit pension and 401(k) plans — not IRAs. That means if you use a non-recourse loan in a Self-Directed IRA to buy real estate, you will likely owe UBTI on a portion of the income.

A Note on Controlled Group Rules

If you own multiple businesses, the IRS’s controlled group rules could affect whether your 401(k) is truly “solo.” If your business is deemed part of a controlled group that includes other companies with employees, those employees may need to be included in the plan—disqualifying the Solo 401(k).

For real estate professionals with multiple LLCs or active/passive ventures, it’s critical to analyze common ownership, control, and affiliated service groups to ensure compliance. Failing to do so could invalidate the plan’s status or create significant penalties.

Bottom Line: Go Solo If You Want to Use Leverage

If you’re eligible for a Solo 401(k), it’s the clear choice for real estate investing — especially if you want to use a non-recourse loan. You can grow your investment without triggering UBTI, which means more tax-free gains in your retirement account.

Pro Tip: To qualify for a Solo 401(k), you must have self-employment income and no full-time employees (other than a spouse).

Ready to Invest Smarter?

Using the right retirement structure can save you thousands in taxes. If you’re a real estate investor thinking about using leverage, the Solo 401(k) might be your most powerful tool. Talk to a retirement expert today to find out if you’re eligible — and how to get started.

Frequently Asked Questions