As with any tax or investment related question, it depends on your specific situation.
However, based on the Internal Revenue Code, income that is obtained from debt financing within a tax-exempt account like an IRA is considered unrelated debt financed income. It is therefore subject to the unrelated business income tax, otherwise known as UBIT.
When debt financing is involved in the purchase of the property, UBIT is based on the net income received from the debt financed portion of the property. This is considered unrelated debt financed income (UDFI), a subset of UBIT.
How Does UDFI Work?
UDFI applies to all leveraged debt within a tax-exempt account. Since the property was not purchased outright with cash from the IRA, the property is not 100% owned by the IRA and cannot benefit from the tax-exempt nature of the account on 100% of the profits. A portion of the investment was purchased with non-tax-exempt funds provided by the non-recourse lender and thus will be subject to UBIT.
As a result, the portion of the property that was debt financed must calculate the income, after all expenses and depreciation, to determine if any taxes are due. This must be done each year that the property is leveraged by debt.
For example, if 50% of a real estate purchase came from a non-recourse loan, then 50% of profit is subject to UBIT. As the loan is paid down, the portion that incurs UBIT will coincide with the debt-financed portion of the investment.
Write-Offs That Offset Income and UDFI
If a property is purchased outside of an IRA or other tax-exempt account, the investment considers all of the income received from the property. The expenses and depreciation are then deducted from the income to determine the profits for the property. The same rules that are used with investment property outside an IRA are used to determine any income that is obtained from the debt-financed percentage.
Debt-financed property is any property held to produce income, which has leveraged debt at some point in the investment process. If the debt remains on the property during a tax year or during the twelve-month period before the date of sale of the property, then UBIT will likely apply to the unrelated debt financed income (UDFI).
At the end of the year, the income that is received from the property is offset by any expenses. This might include repairs, maintenance, interest on the debt, management fees, etc. The income and expenses are divided in direct proportion to the percentage of the property that was debt financed to determine the net income that may be subject to UBIT.
It is in your best interest to consult with your CPA, financial advisor, and/or UBIT Professional to review and analyze your investment so that you can ensure that you are compliant with the IRS rules pertaining to UBIT.