Is a Solo 401k Subject to UBTI or UDFI?

Even though a solo 401k can invest in most things, certain investments can trigger immediate tax concerns. The two main concerns for solo 401ks relate to income from a trade or business that is regularly carried on and income generated from debt-financed property. These are called: (1) unrelated business taxable income (or “UBTI”); and (2) unrelated debt financed income (or “UDFI”).

Unrelated Business Taxable Income

UBTI is generally defined as the gross income derived from any unrelated trade or business regularly conducted by the exempt organization (the 401k trust), less any deductions associated with carrying on the trade. The business or trade itself needs to be “regularly carried on” in order to trigger UBTI.

So in most situations, UBTI occurs when a solo 401k owns a portion of an actual operating business (service business, manufacturer, retailer, etc). Rental income from real estate is specifically excluded in computing UBTI, but may be subject to UDFI (discussed next). Interest income, dividends, royalties, annuities and other investment income are also typically exempt from UBTI but can be subject to other limitations such as UDFI.

Unrelated Debt-Financed Income

UDFI is another important concern. It is generally defined as any property held to produce income for which there is acquisition indebtedness at any time during the tax year. It also includes gains from the disposition of such property. UDFI applies to corporate stock and tangible personal property, but it is most often encountered when investing in real estate.

In practice this means that if your solo 401k acquires a rental home for $200,000 with a $50,000 down payment and obtains a $150,000 loan to finance the property, approximately 75% of the income generated by the property itself would be subject to UDFI. The UDFI calculation uses the percentage of average acquisition indebtedness for a tax year divided by the property’s average adjusted basis for the year (average debt/average basis).

But here’s a big difference between an IRA and a solo 401k. When an IRA buys leveraged real estate it creates UDFI and taxes must be paid pursuant to Internal Revenue Code Section 514 (subject to limitations). But a solo 401k is generally exempt from UDFI.

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