Using your pension to invest is hot. The problem is, like most other popular investing trends, there are pitfalls for the inexperienced.

Take UDFI (unrelated debt-financed income) and UDFI Tax, for example. Not everyone has enough cash in their plan to buy a property or business outright. Not everyone wants to sink all of their pension money into a single project, either. UDFI happens when your pension fund borrows money to make up the difference.

For example, say you wanted to purchase a bakery using money from your Roth IRA, but only had half of the purchase price in your pension account. If your Roth IRA borrowed the other 50 percent, then only 50 percent of the profit flowing back into your IRA would be tax-free. The other half would be considered UDFI and taxed at ordinary tax rates. If you sold the bakery the same apportionment factor would be applied to any gain. The government doesn't think you should get to earn tax-free income when you use someone else's money.

So does the possibility of paying UDFI Tax mean you should avoid leverage in your pension plan? Or, a better question: is it possible to avoid UDFI and still get the maximum results with leverage?

Yes! Here are four possible ways to avoid or minimize the UDFI impact:

1. Match your projects to your pension. If your investment is long-term and you're taking advantage of all of the expenses that you can for real estate, you’ll be showing very little, if any, taxable gain during the time you’re holding the property. When you get around to selling that piece of real estate the UDFI Tax issue will be small. On the other hand, if you're thinking about investing pension money in a cash-rich, expense-poor business, you may want to reconsider using your pension. Or, find another investment partner or partners to take up the slack so you can all buy the business together outright and avoid UDFI entirely.

2. Time your asset sales. UDFI Tax doesn't come up until you sell an asset and it's only calculated on the income earned by that asset in the previous year. So, by positioning yourself to pay the asset off entirely one year before selling it, there won't be any UDFI -- or UDFI Tax.

3. Use a better kind of pension plan. Here's a powerful tax tip: 401(k) plans (including the new Solo Roth 401(k) plan) are exempt from UDFI and UDFT. Most traditional 401(k) plans can't do this, because they aren't truly self-directed. In other words, you get to choose your investments -- but only from a list provided to you by your pension administrator or custodian. A true self-directed 401(k) can invest in just about anything.

4. Find a UDFI-friendly investment. It's hard to argue with the success and powerful results of real estate investing. How many other investments can you think of that have paid off so dramatically over the past few years? But, if you don't know much about real estate investing, are you sure you want to learn using your nest egg?

That's why I'm excited about the idea of using pension money to invest in REITs, or Real Estate Investment Trusts. A REIT is a meeting of qualified minds with investor money. It's like an investment partnership in the sense that you pay into it and experienced leaders invest your funds. But unlike a partnership there are no cash-calls in a REIT. You only risk what you invest.

Shares in a REIT are usually tradable in the same way you would any other type of corporate stock - something you can't always do in an LLC or partnership situation -- or at least not easily.

Best of all, there's no UDFI Tax, no matter what kind of pension fund you might use to invest in a REIT.

The secret, of course, is finding a good REIT to invest in. You need to check out the credentials of the people running it very carefully. If they don't have a good track record, you may want to pass, no matter how good the deal looks on paper. Make sure you also look at how the REIT pays out. Some go for immediate cash flow; others for long-term capital gain. Which fits your pension needs best?

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Published: June 20, 2007

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Diane Kennedy, the nation's pre-eminent tax strategist, is owner of Diane Kennedy & Associates, a leading tax strategy and accounting firm and founder of TaxLoopholes. She is the author of The Wall Street Journal and Business Week bestsellers, Loopholes of the Rich and Real Estate Loopholes, and co-author of The Insider's Guide to Real Estate Investing Loopholes, The Insider's Guide to Making Money in Real Estate, and TaxLoopholes for eBay Sellers. Register for free Tax Strategy updates and e-Newsletters delivered via email from TaxLoopholes.com. You will be updated on current tax law changes as well as proactive tax strategies the wealthy use plus news regarding Diane Kennedy.