A subset of UBIT is the Unrelated Debt-Financed Income (UDFI) tax. Under IRC § 514, the IRS will assess a tax on any income that is derived from the use of “acquisition indebtedness” in passive Self Directed IRA investments. For example, if your Self Directed IRA uses $30,000 of its own funds and also borrows $70,000 (using a non-recourse note, of course) to purchase a $100,000 rental property that generates $10,000 annual rent, the IRS would assess UDFI tax on about $7,000 of the profit (since 70% of the investment came from leverage). It is “about $7,000” because it is not simply a one-time fraction of loan-to-value. When calculating your UDFI tax percentage, you use the average indebtedness of the past 12 months and divide that by the adjusted basis in the property (typically, the original purchase price). So, as you pay down the mortgage each year, the UDFI tax percentage becomes less. One year after paying your final mortgage payment, the UDFI tax disappears altogether. When selling passive investments for a profit, the UDFI fraction will determine the taxable amount. Then, appropriate capital gains rates are applied to that amount (trust rates for short-term gains; capital gain rates for long-term gains. [See IRS Pub. 598.]
Remember that UDFI rules apply only to passive investments. If your IRA makes an investment, regardless of leverage, in an active (pass-through) business, including any active real estate business (flipping, rehabbing, developing raw land, etc), then the net income (above $1,000) is subject to UBIT.
This brief discussion of prohibited transactions and UBIT/UDFI is not intended to be relied upon as legal or tax advice. It is very general information and is designed only to make you aware of some issues you might not have thought of and may need to discuss with your advisors. These rules can be very complex. Some of the rules have exceptions (and even exceptions to the exceptions!) and rules can and do change