UDFI is related to the portion of a property that was debt-financed to acquire the real estate investment in your self-directed IRA. This type of transaction (your IRA borrowing funds to invest) caused the account to acquire what is called acquisition indebtedness—because, without debt-financing your IRA would not have acquired the asset.
In this instance, any tax that may be owed is calculated based on the percentage of debt in comparison to the value of the investment property. For instance, if your IRA purchases a piece of real estate by making a 40 percent down payment and obtaining a non-recourse loan for 60 percent of the purchase price, then, initially, 60 percent of the income received by the IRA would be subject to the UDFI tax. To offset this tax, the IRA may also get to deduct a certain percentage of expenses, as well. It is important to note that the IRA, not you personally, is the entity responsible for paying any UDFI tax liability.
IRC 514 explains UDFI in great detail, but it is critical that you consult with your accountant or other tax professional, as well, to ensure your IRA remains in compliance with IRS guidelines.