**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-KSB**





**ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d)**


**OF
      THE SECURITIES EXCHANGE ACT OF 1934**





**For
      the fiscal year ended December 31, 2005**





**Commission
      File No. 333-106501**








**KH
      FUNDING COMPANY**


(Name
      of
      small business issuer in its charter)





**Maryland**
            **52-1886133**(State
                or other jurisdiction of
              incorporation
                or organization)
            (I.R.S.
                Employer
              Identification
                No.)





**10801
      Lockwood Drive, Suite 370**


**Silver
      Spring, Maryland 20901**


Address
      of principal executive offices, including zip code





**(301)
      592-8100**


Registrant's
      telephone number, including area code


Securities
                registered under Section 12(b) of the Act:
            **None**Securities
                registered under Section 12(g) of the Act:
            **None**(Title
                of class)




Check
      whether the issuer is not required to file reports pursuant to Section 13 or
      15(d) of the Exchange Act. Yes ¢®¡× No x




Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 12 months (or for such shorter period
      that the Registrant was required to file such reports), and (2) has been subject
      to such filing requirements for the past 90 days. Yes x No ¢®¡×




Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B contained in this form, and no disclosure will be contained,
      to
      the best of Registrant's knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-KSB or any
      amendment to this Form 10-KSB. Yes x No ¢®¡×




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). Yes ¢®¡× No x




Registrant's
      revenues for its most recent fiscal year were **$3,685,132** .




State
      the
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates computed by reference to the price at which the common equity
      was
      sold, or the average bid and asked price of such common equity, as of a
      specified date within the past 60 days. There is no market for the registrant's
      common equity.







**PART
      I**




**INTRODUCTORY
      STATEMENT**




The
      information contained in this report pertains to the registrant, KH Funding
      Company. References to the "Company," "KH Funding" or "we," "our" and "us"
      refer
      to KH Funding Company.




**FORWARD-LOOKING
      STATEMENTS**




Some
      of
      the statements contained in this annual report discuss future expectations,
      and
      other "forward-looking" information. Those statements are subject to known
      and
      unknown risks, uncertainties and other factors that could cause the actual
      results to differ materially from those contemplated by the statements. The
      "forward-looking" information is based on various factors and was derived using
      numerous assumptions. In some cases, you can identify these so-called
      "forward-looking statements" by words like "may," "will," "should," "expects,"
      "plans," "anticipates," "believes," "estimates," "predicts," "potential," or
      "continue" or the negative of those words and other comparable words. You should
      be aware that those statements only reflect our predictions. Actual events
      or
      results may differ substantially. Important factors that could cause our actual
      results to be materially different from the forward-looking statements are
      disclosed under the heading "Item 1. Description of Business—Risk
      Factors."




**ITEM
      1.**  **DESCRIPTION
      OF BUSINESS**




**General**




KH
      Funding Company (www.khfunding.com) conducts mortgage banking operations from
      its headquarters in Silver Spring, Maryland. Its primary business activities
      consist of originating, acquiring and servicing mortgage loans, and issuing
      interest-bearing debt securities ("Notes") to investors. We emphasize the direct
      origination of small commercial real estate mortgage loans and investment
      property residential mortgage loans. We also purchase first and second trust
      residential loans nationwide from other lenders and banks.




Our
      net
      income depends largely upon our net interest income, which is the difference
      between interest income from loans and investments, referred to as
      interest-earning assets, and interest expense on investor notes and other
      borrowed funds, referred to as interest-bearing liabilities. Our net interest
      income may be affected by general economic conditions, policies established
      by
      regulatory authorities, and competition.




**Operations**




We
      operate from a suite of offices located in Silver Spring, Maryland. We act
      as a
      mortgage banker or purchaser of mortgage and business loans and perform the
      record keeping, loan administration and servicing functions with regard to
      our
      assets and liabilities for the benefit of KH Funding's stockholders and note
      holders. We also administer our program of issuing and selling fixed and
      variable rate debt securities of varying maturities. Our mortgage banking and
      investor Note operations are similar to those of commercial banks, which
      administer their assets for the benefit of its stockholders and
      depositors.




Our
      assets of $50.90 million as of December 31, 2005 consist primarily of cash,
      mortgages, real property and investment securities. In the normal course of
      business we collect the income generated by the assets; receive funds from
      investors; handle the redemption of Notes; and maintain and track the receipts,
      disbursements and balances on escrow accounts established by the
      borrowers.




The
      following table sets forth certain information relating to KH Funding Company
      for the five years ended December 31, 2005. The average yield and cost of funds
      are derived by dividing interest income or interest expense by the average
      balance (exclusive of nonaccrual loans and of unamortized fees and costs) of
      notes receivable or notes payable, respectively, for the years shown. The
      interest categories are at contract rates and exclude the amortization of
      related fee income and expense.





**Year**
            
            **Average
                Yield******
              **Loan
                Portfolio**
            
            **Cost
                of Funds**
              **Investor
                Notes**
            
            **Net
                Interest**
              **Rate
                Spread**2001
            
            11.94%
            
            7.86%
            
            4.08%2002
            
            11.00%
            
            6.40%
            
            4.60%2003
            
            10.74%
            
            6.00%
            
            4.74%2004
            
            10.89%
            
            5.69%
            
            5.20%2005
            
            10.66%
            
            6.03%
            
            4.63%




Although
      2005 proved to be an environment of rising interest rates, our sale to investors
      of one-day demand Notes with checking account access has helped us to keep
      our
      cost of funds from rising at a faster rate because these Notes earn below the
      average rate of interest on our other investor Notes. Also helping to control
      our cost of funds was the turnover in the one and three-year investor Notes
      that
      matured in 2005. These Notes have largely been reinvested in one, three and
      five
      year Notes that pay less interest to the investor than the investor was earning
      on the maturing Note. The rates paid on our one-day and 30-day demand Notes
      are
      changed according to changes in the federal funds target rate. The decrease
      was
      due primarily to a slightly lower average interest rate on the new loans we
      added to our portfolio.




**Technology**




We
      maintain an off-site secondary location which has full back-up operability
      with
      up-to-date information. The software we use to track our loan portfolio is
      commercially in use by over 300 other subscribers. Our investment account
      software was made to our specifications to allow us to service our Note holders
      in an efficient and timely manner.




**Customer
      Service**




We
      provide monthly statements and timely, personal service to our investors, which
      have always cultivated a good "word-of-mouth" referral system. We have developed
      and made available to our investors on-line access to their accounts at
      www.khfunding.com. The web site allows investors to view their account
      information at anytime, such as account balances, maturity dates and recent
      transactions. Access to the web site allows investors to complete transfers
      from
      one account to another account, order wire transfers, and request
      withdrawals.




**Business
      Strategy**




Our
      business strategy is to grow and enhance our profitability by increasing our
      portfolio of mortgage and business loans. The additional funds necessary to
      carry through with this strategy will be obtained through the sale of investor
      Notes. In addition, we may seek to raise funds through private sale of our
      capital stock.




We
      intend
      to continue managing our assets and our strict collection procedures for any
      problem assets. We expect to realize more operating efficiencies and cost
      controls as we invest the proceeds from future offerings, as we do not expect
      significant additional personnel or facilities will be needed to handle the
      investing and administration of the increase in funds.




**Market
      Area and Credit Risk Concentration.**




Our
      lending activities are concentrated primarily in the Washington, D.C. and
      Baltimore, MD metropolitan areas. We also purchase residential mortgage loans
      from banks and other lenders in other states. As of December 31, 2005, our
      average loan size was $165,000. Our larger loans, above $250,000, are made
      with
      a strong emphasis on collateral-based underwriting as opposed to relying
      primarily on credit scoring.




**Competition**




KH
      Funding Company faces significant competition both in making loans and in
      attracting investor funds. Our competition for loans comes principally from
      commercial banks, mortgage companies, insurance companies and other financial
      service companies; often these are smaller local independent loan companies
      or
      individuals. Our competition for investor funds has historically come from
      competitors offering uninsured products, such as the mutual fund industry,
      securities and brokerage firms and insurance companies, as well as insured
      money
      market accounts and certificates of deposit at commercial banks.




We
      are
      finding that in originating loans, and acquiring loans, there has been
      increasing competition from large institutions. This trend is not material
      at
      this point as there is a sufficient amount of quality product available from
      smaller lenders and banks that can and do operate at our level. However, if
      this
      trend continues, it is possible that we may have difficulty originating or
      obtaining loans that meet our standards or that we will have difficulty
      competing with these larger originators, which often enjoy a lower cost of
      funds.




We
      believe that we will continue to be able to attract investors to our investment
      products. Our one, three and five-year term investments are priced at a rate
      that is normally more than 200 basis points (2%) above insured investments
      for a
      similar term at commercial banks. Our daily and 30-day liquidity products are
      competitively priced with other uninsured investments that have similar features
      such as checking account and withdrawal features. We provide holders of one-day
      demand Notes with checking accounts to access their funds through a third-party
      bank (this feature is not offered to South Carolina residents). The checking
      account privileges are exclusively for funds invested in investment Notes and
      allow the holders of one-day demand Notes to execute redemption or investment
      requests conveniently, quickly and with less expense than by wire transfer
      or
      the mail. The holder may write a check against the account, which reduces the
      Note balance. The holder may add to their investment by making deposits at
      the
      bank through which the checking accounts are provided.




**Lending
      Activities**




Our
      loan
      portfolio consists primarily of first and second trust real estate-backed loans
      that we have originated or acquired from other lenders. We also hold several
      business line-of-credit and fixed-term loans that we have directly originated.
      A
      small portion of our portfolio contains loans for consumer purposes such as
      auto
      and personal loans, and a few loans secured by the borrower's non-real estate
      assets such as stock.




We
      rely
      on community contacts as well as referrals from existing customers, attorneys
      and real estate professionals to generate business within our lending area.
      In
      addition, we have developed a list of brokers, banks and lenders nationwide
      that
      sell us loans.




We
      have
      developed underwriting policies to control the inherent risks in the origination
      and acquisition of loans. The policies address approval limits, loan-to-value
      ratios, appraisal requirements, debt service coverage ratios, loan concentration
      limits and other matters relevant to loan underwriting.




***First
      Trust Lending***




*Direct
      Origination* .
      We
      primarily originate first trust loans for investment (rented) residential real
      estate, and small commercial properties. We generally have a loan-to-value
      (LTV)
      of 80%, or less. Credit scores of the borrowers generally range in the mid
      600's. Credit scores are determined by complex computer programs which take
      into
      consideration many factors. There are three companies that are the primary
      providers of credit reports and credit scores for individuals. We generally
      obtain credit reports and/or credit scores from all three companies, and are
      a
      member of one, Equifax. Credit scores range from the 400s to the 800s. The
      lower
      the score, the lower the "quality" of credit or creditworthiness of the
      individual. Credit scores from 580 to mid-600's will generally indicate a "C/C+"
      borrower, mid-600s to 680 is an "B-/B/B+" borrower, high-600s to low-700s is
      an
      "A-" borrower and 720 or higher is an "A" borrower. Lenders adopt different
      guidelines for acceptability regarding credit scores. For us a credit score
      of
      580 to the 800s (the highest score possible) is within the range of
      acceptability in order to make or acquire a loan, however, we prefer the credit
      score to be in the mid-600s and above. The borrowers with a score below the
      mid-600s must provide us with a reason, or reasons, which mitigate the below
      mid-600s score.




*Acquired
      Loans* .
      The
      first trust loans we acquire nationwide are generally 90% LTV, or less, and
      they
      have been made to sub-prime borrowers. The majority of these loans are for
      lower-priced properties and the interest rates are usually 9.5% to
      11.5%.




***Second
      Trust Lending***




*Direct
      Origination* .
      The
      majority of our stand-alone, second trust loans, in which we do not have a
      first
      trust on the property, are on owner-occupied properties in which the borrowers
      are consolidating debts. The average LTV is up to 100%. The borrowers' credit
      scores generally start at 580 and average in the low 600's. The origination
      of
      these loans was discontinued in 2004.




*Acquired
      Loans* .
      We only
      acquire second trust loans if they have a total LTV of less than 100%. We
      formerly purchased loans with LTVs of up to 125%. However, we discontinued
      that
      practice in 2000. We also greatly curtailed purchasing stand-alone second trusts
      in 2000, as we would prefer to also own the first trust when a loan has a
      combined LTV of more than 90%. However, with a credit score in the low to mid
      600's, and up, we will still purchase stand-alone second trusts.




***Business
      Lending***




We
      directly originate loans to small businesses. We do not acquire small business
      loans. Most of the loans we make of this type are for a business generating
      less
      than $1,000,000 in gross revenue. If the business owns real estate, we will
      obtain a lien on the property(ies) owned by the business as part of our loan.
      If
      the business does not own real estate, we will usually place a lien on the
      primary residence of the owner(s) of the business. We prefer to extend credit
      facilities to a business only when the fair value of the equity in the real
      estate we have a lien on exceeds the loan amount. We are more
      collateral-sensitive when making business loans than we are "cash flow"
      sensitive. In other words, if we are considering a loan for a development stage
      or start-up business and we find the business plan or the results of operations
      for the business borrower to be reasonably acceptable, and the credit score
      of
      the borrower to be at the high end of our range of acceptability, then we will
      make the loan provided we are well secured with real estate collateral.
      Generally, the cash flow will not be present at the time the loan is closed,
      but
      will be expected to develop with the use of the loan proceeds. However, we
      do
      require that the borrower(s) have good credit and a reasonable ability to repay
      the loan. In the instances in which a business has accounts receivable as a
      primary source of repayment we will obtain a lien on the accounts
      receivable.




***Other
      Assets Lending***




Some
      of
      the loans in our portfolio are not secured by real estate or business assets.
      Automobiles and investor notes secure the majority of these loans. These types
      of loans are generally made to borrowers with whom we have a long-standing
      relationship.




***Unsecured
      Lending***




Less
      than
      one percent of our loan portfolio contains unsecured loans. The majority of
      these loans are for small amounts, under $5,000, made to borrowers with whom
      we
      have a long-standing relationship, or who have been referred to us by our
      trusted customers. A few of these loans are to borrowers with whom we originally
      held a collateralized loan, but the collateral has been foreclosed upon and
      the
      balances represent the deficiency.




The
      following table sets forth the composition of our loan portfolio by collateral
      type in dollar amounts for the periods indicated:





**Year
                Ended December 31,****Loans
                By Collateral Type**
            
            
            **2005**
            
            
            
            **2004**Residential
                Real Estate First Trust
            
            $
            6,801,401
            
            
            $
            4,251,283Business
                Assets and Commercial Real Estate First Trust
            
            
            5,159,408
            
            
            
            4,424,112Residential
                Investment Property First Trust
            
            
            24,557,183
            
            
            
            9,543,663Residential
                Real Estate Second Trust
            
            
            2,103,760
            
            
            
            1,116,984Other
                Assets (Auto, Stock)
            
            
            2,035,215
            
            
            
            1,013,265Other
                Loans
            
            
            441,843
            
            
            
            150,870Total
                loans receivable
            
            
            41,098,810
            
            
            
            20,378,129Unearned
                fees and other
            
            
            (50,078
            )
            
            
            (122,068
            )Less
                allowance for loan losses
            
            
            (369,791
            )
            
            
            (233,311
            )Total
                loans receivable, net
            
            $
            40,678,941
            
            
            $
            20,144,798




*Loan
      Approval Procedures and Authority* .
      The
      Chief Executive Officer may approve any loan up to and including $500,000.
      The
      Chief Executive Officer and another member of our Board of Directors must
      approve all loans over $500,000.




The
      Company has no internal appraisers and, as such, it relies on independent
      appraisers to determine the value of collateral underlying a loan. For
      commercial property mortgage loans, in addition to an independent appraisal,
      we
      generally require an environmental site assessment to be performed. We also
      require title and hazard insurance on the property for all first and second
      trust mortgage loans. In addition, we may require borrowers to make payments
      to
      a mortgage escrow account for the payment of property taxes.




**Non-Performing
      Assets**




Non-accrual
      loans include loans which are more than 90 days past due, and which have been
      identified by management as presenting uncertainty with respect to the
      collection of interest or principal. Once a loan is placed on non-accrual
      status, the Company ceases the recognition of interest earnings on these
      loans.




Loans
      are
      placed on non-accrual status either when reasonable doubt exists as to the
      full
      and timely collection of interest and principal, or when a loan becomes past
      due
      90 days or more and there are no extraordinary circumstances indicating payments
      on the loan will continue.




**Allowance
      for Loan Losses**




We
      maintain an allowance for loan losses. The allowance is increased by
      corresponding charges to provision for loan losses, and by recoveries of loans
      previously written-off. Write-off of a loan decreases the allowance. The
      adequacy of the allowance is periodically reviewed and adjusted by management
      based upon past experience, the value of the underlying collateral for specific
      loans, known or inherent risks in the loan portfolio, and current economic
      conditions.




The
      most
      common known risk in the loan portfolio is a non-performing or impaired loan
      (i.e., the loan is more than 90 days late and the possibility of collection
      is
      remote). If KH Funding has specific knowledge or some other reason to consider
      a
      loan impaired, management reviews the loan to determine if an impairment loss
      is
      required. Collections on the loan reduce the balance of the impaired
      asset.




If
      the
      non-accrual loan begins performing again, then it is reclassified as a
      performing asset and will accrue interest retroactively from the last date
      interest had been previously accrued.




If
      the
      impaired asset is only partially recovered, or if after all legal remedies
      have
      been exhausted no recovery, or no additional recovery, is available, then the
      un-recoverable portion is written off against the loan loss allowance and the
      balance of the loan loss allowance is decreased by the amount of the loan being
      written-off.




Our
      historical loan loss experience:





**Year****Ended December 31,**
            
            **Average**
              **Total
                Loans**
            
            **Write-Offs**
              **Net
                of Recoveries**
            
            **Percent**2001
            
            $
            11,590,130
            
            $
            104,964
            
            0.91%2002
            
            $
            14,823,498
            
            $
            139,069
            
            0.94%2003
            
            $
            15,900,842
            
            $
            111,278
            
            0.75%2004
            
            $
            17,676,284
            
            $
            244,389
            
            1.38%2005
            
            $
            32,473,227
            
            $
            114,568
            
            0.35%




At
      December 31, non-performing assets were as follows:





**2005**
            
            **2004**Loans
                on non-accrual status
            
            $
            836,390
            
            $
            583,351Real
                estate held for sale
            
            
            180,302
            
            
            0Total
                nonperforming assets
            
            $
            1,016,692
            
            $
            583,351Loans
                90 days past due and still accruing interest
            
            $
            1,625,356
            
            $
            2,109,236




All
      of
      the loans 90 days past-due which are still accruing interest are adequately
      collateralized and management does not anticipate the loss of principal or
      accrued interest receivable on these loans.




**Governmental
      Regulations**




In
      the
      future, our operations may become subject to federal and state laws and
      regulations relating to banking or lending operations. These regulations
      may:





require
            us to obtain and maintain additional licenses and
            qualifications;
        limit
            the interest rates, fees and other charges that we are allowed to
            collect;
        limit
            or prescribe other terms of our loan arrangements with borrowers;
            or
        subject
            us to potential claims, defenses and other
            obligations.


Although
      we believe that we are currently in compliance with statutes and regulations
      applicable to our business, there can be no assurance that we will be able
      to
      maintain compliance with existing or future governmental regulations. The
      failure to comply with any current or subsequently enacted statutes and
      regulations could result in the suspension or termination of our applicable
      laws
      and would have a materially adverse effect on us. Furthermore, the adoption
      of
      additional statutes and regulations, changes in the interpretation and
      enforcement of current statutes and regulations, or the expansion of our
      business into jurisdictions that have adopted more stringent regulatory
      requirements than those in which we currently conduct business could limit
      our
      activities in the future or significantly increase the cost of regulatory
      compliance.




In
      addition, certain environmental regulations may affect our operations. For
      example, our ability to foreclose on the real estate collateralizing our loans
      may be limited by environmental laws which pertain primarily to commercial
      properties that require a current or previous owner or operator of real property
      to investigate and clean up hazardous or toxic substances or chemical releases
      on the property. In addition, the owner or operator may be held liable to a
      governmental entity or to third parties for property damage, personal injury,
      investigation and cleanup costs relating to the contaminated property. While
      we
      would not knowingly make a loan collateralized by real property that was
      contaminated, it is possible that the environmental contamination would not
      be
      discovered until after we had made the loan.




**Insurance**




We
      maintain the following types of insurance for the benefit of KH
      Funding:


Bankers
            Bond: fidelity and theft coverage of $500,000;
        Mortgage
            Impairment: covers losses to properties when the borrowers policy has
            expired;
        Property
            Damage-Vacant Properties: covers losses to properties immediately after
            we
            take title, if they are vacant;
        Liability
            Coverage-Vacant Properties: covers liability losses to individuals at
            vacant
            properties after we take title;
        Key
            Man
            Life: $2.7 million payable to KH Funding in the event of the death of
            Robert
            L. Harris;
        Key
            Man
            Disability: $12,000 per month payable for one year to KH Funding in the
            event
            of the disability of Robert L. Harris;
        Umbrella
            Liability: $2 million in excess liability coverage above any primary
            liability
            coverage that we maintain;
        Landlord
            Policies for Individual Rental Properties: basic insurance for rented
            properties;
        Health
            Insurance: maintained for the benefit of the employees; and
        Business
            Owners Policy: comprehensive business and liability
            coverage.


**Personnel**




At
      December 31, 2005, we had five full-time and five part-time employees. We
      consider our relationships with our employees to be good.




**Risk
      Factors**




Our
      business, results of operations and financial condition are subject to a number
      of risks, including the risks set forth below. You should carefully consider
      these risks. Additional risks and uncertainties, including those that are not
      yet identified or that we currently think are insignificant, may also adversely
      affect our business, results of operations and financial condition.




*Our
      assessment of the quality of loans we acquire may be inaccurate which could
      adversely affect our profitability.*




Before
      we
      purchase or originate loans, we perform an evaluation of the loans in order
      to
      determine whether they are eligible for our portfolio. There is no guarantee
      that the initial analysis of these loans will reflect actual future results
      which, if unfavorable, could adversely affect our profitability. See "Item
      1.
      Description of Business—Lending Activities."




*If
      all of the remedies for recovering a defaulted loan that we own are inadequate,
      it could have a materially adverse effect on our financial
      results.*




We
      may
      fail to collect funds from originated and acquired loans. Our ability to fully
      recover amounts due under the originated and acquired loans may be adversely
      affected by, among other things:





the
            financial failure of the borrowers;
        the
            purchase of fraudulent loans;
        misrepresentations
            by a broker, bank or other lender;
        third-party
            disputes; and
        third-party
            claims with respect to security interests.


Any
      of
      these events could require us to seek enforcement of a borrower's guarantee,
      which could prove to be inadequate to fully collect the loans. Therefore, we
      cannot assure you that we will not experience losses on acquired or originated
      loans in the future. These potential future losses may be significant, may
      vary
      from current estimates or historical results and could exceed the amount of
      the
      balance budgeted to our loan losses. We do not maintain insurance covering
      such
      losses. In addition, the amount of provisions for loan losses may be less than
      actual future write-offs of the loans relating to these provisions. Any of
      these
      events could have a materially adverse effect on our business. See "Item 1.
      Description of Business—Allowance for Loan Losses."




*The
      company's results of operations depend significantly on economic conditions
      in
      the Baltimore-Washington metropolitan area.*




The
      Company's success depends primarily on the general economic conditions of the
      Baltimore-Washington metropolitan area. The local economic conditions in the
      areas have a significant impact on the demand for the Company's loans as well
      as
      the ability of the Company's customers to repay loans, the value of the
      collateral securing loans and the stability of the Company's funding sources.
      A
      significant decline in general economic conditions, caused by inflation,
      recession, acts of terrorism, outbreak of hostilities or other international
      or
      domestic occurrences, unemployment, changes in securities markets or other
      factors could impact these local economic conditions and, in turn, have a
      material adverse effect on the Company's financial condition and results of
      operations.




*Our
      lack of diversified operations and investments* *increases
      our exposure to risk of loss.*




Primarily
      our operations consist of, and our income is derived from, investing in mortgage
      loans that we purchase from brokers, banks and other lenders and making loans
      to
      small businesses and individuals. In addition, we invest excess cash in
      investment grade debt securities issued by financial companies that we hold
      for
      liquidity and investment purposes. Further, we hold as investments many of
      the
      properties on which we foreclose. Most of these properties are held as rental
      investments. This lack of diversification, of investing only in loans, and
      to a
      lesser degree in bonds and real estate, increases our exposure to the risk
      of
      loss if a substantial number of loans become uncollectible. This increases
      the
      risk that uncollectible loans could materially affect our financial
      results.




*Currently,
      we operate with limited capital levels and stockholders* *'
      equity, so in the event of the liquidation or dissolution of the Company holders
      of our Notes could lose all or a part of their investment.*




A
      company's capital represents the investment of its stockholders and is paid
      last, after all debt holders have been paid, in the event of a liquidation
      or
      dissolution of the company. Therefore, a greater amount of capital provides
      a
      greater amount of protection to debt holders in the event of a liquidation
      or
      dissolution. Our capital level provides only a modest amount of protection
      to
      the holders of our Notes. Therefore, in the event of an insolvency or
      liquidation, the holders of our Notes could lose all or part of their
      investment.




*Rapid
      changes, either upward or downward, in interest rates may adversely affect
      our
      financial condition or results of operations.*




Any
      future rise in interest rates may:


reduce
            customer demand for our products;
        widen
            investor spread requirements;
        change
            loan prepayment rates;
        increase
            our cost of funds;
        reduce
            the spread between the rate of interest we receive on loans and interest
            rates
            we must pay under our outstanding debt securities; and
        limit
            our access to borrowings in the capital markets. We
      are
      subject to risks associated with decreases in interest rates especially to
      the
      extent that we have issued fixed rate debt securities with scheduled maturities
      of over one year. At December 31, 2005, we had $11,304,479 debt securities
      with
      scheduled maturities greater than one year. If market interest rates decrease
      in
      the future, the rates paid on our long term debt securities could exceed the
      current market rate paid for similar instruments which could result in a
      reduction in our profitability and which could impair our ability to redeem
      the
      debt securities.




*If
      we
      are not able to sustain the levels of loan originations that we experienced
      in
      the past, our future operating results may be adversely affected and our ability
      to redeem the Notes may be impaired.*




It
      is
      necessary for us to continue adding loans to our investment portfolio because
      we
      need to re-invest proceeds of loan payoffs as they are received. We will also
      need to invest in more mortgages as we grow in size. Our ability to sustain
      the
      level of loan originations needed depends upon a variety of factors outside
      our
      control, including:





interest
            rates;
        economic
            conditions in our primary market area;
        decline
            in real estate values;
        competition;
            and
        regulatory
            restrictions.


In
      a
      rising interest rate environment, we would expect our ability to originate
      loans
      at interest rates that will maintain our current margins will be easier compared
      to a falling or stable interest rate environment. If we are unable to sustain
      our levels of growth, our profits may be reduced and our ability to repay the
      debt securities upon maturity impaired.




*The
      Company's allowance for loan losses may be insufficient.*




The
      Company maintains an allowance for loan losses, which is a reserve established
      through a provision for loan losses charged to expense, that represents
      management's best estimate of probable losses that have been incurred within
      the
      existing portfolio of loans. The allowance, in the judgment of management,
      is
      necessary to reserve for estimated loan losses and risks inherent in the loan
      portfolio. The level of the allowance reflects management's continuing
      evaluation of concentrations; specific credit risks; loan loss experience;
      current loan portfolio quality; present economic, political and regulatory
      conditions and unidentified losses inherent in the current loan portfolio.
      The
      determination of the appropriate level of the allowance for loan losses
      inherently involves a high degree of subjectivity and requires the Company
      to
      make significant estimates of current credit risks and future trends all of
      which may undergo material changes. Changes in economic conditions affecting
      borrowers, new information regarding existing loans, identification of
      additional problem loans and other factors, both within and outside of the
      Company's control, may require an increase in the allowance for possible loan
      losses. In addition, charge-offs in future periods may exceed the allowance
      for
      possible loan losses. Increases in the allowance for loan losses will result
      in
      a decrease in net income and capital, and may have a material adverse effect
      on
      the Company's financial condition and results of operations.




*We
      are dependent on our senior management team and, if we are not able to retain
      them, it could have a materially adverse effect on us.*




We
      are
      dependent upon the continued services and experience of our senior management
      team, including Robert L. Harris, our Chief Executive Officer and President,
      Louise B. Sehman, our Chief Financial Officer, Secretary and Treasurer, Martin
      Angeli, our Senior Vice President, James E. Parker, a Vice President, and Ronald
      L. Nicholson, a Vice President. We depend on the services of Messrs. Harris,
      Angeli and Parker and Ms. Sehman and other members of our senior management
      team
      to, among other things, continue our growth strategies and maintain and develop
      our client relationships. We have no employment agreements with any of our
      employees. The loss of the services of any of our senior management or any
      of
      our other key employees would disrupt our operations and would delay our planned
      growth while we worked to replace those employees. We maintain "key person"
      life
      insurance on Robert L. Harris only. As a result, if any of our other key
      employees were to die or become unable to provide services for us, our
      operations would be disrupted and we would have no means of recovering any
      resulting losses. In addition, if Mr. Harris were to die or become unable to
      provide services for us, there is no assurance that the insurance proceeds
      would
      be sufficient to recover any resulting losses.




*The
      Company is subject to environmental liability risk associated with lending
      activities.*




A
      significant portion of the Company's loan portfolio is secured by real property.
      During the ordinary course of business, the Company may foreclose on and take
      title to properties securing certain loans. In doing so, there is a risk that
      hazardous or toxic substances could be found on these properties. If hazardous
      or toxic substances are found, the Company may be liable for remediation costs,
      as well as for personal injury and property damage. Environmental laws may
      require the Company incur substantial expenses and may materially reduce the
      affected property's value or limit the Company's ability to use or sell the
      affected property. In addition, future laws or more stringent interpretations
      or
      enforcement policies with respect to existing laws may increase the Company's
      exposure to environmental liability. Although the Company has policies and
      procedures to perform an environmental review before initiating any foreclosure
      action on real property, these reviews may not be sufficient to detect all
      potential environmental hazards. The remediation costs and any other financial
      liabilities associated with an environmental hazard could have a material
      adverse effect on the Company's financial condition and results of
      operations.




*We
      have notes payable and notes receivable with certain of our officers, directors
      and principal stockholders. This might cause such persons to have a conflict
      of
      interest.*




As
      of
      December 31, 2005, some of our officers, directors and stockholders held notes
      payable from the Company totaling $5,935,165. Although such persons' equity
      ownership encourages them to act in the best interests of all stockholders,
      circumstances could arise where such persons, particularly those that are
      members of our Board of Directors, will be in a position of allocating available
      cash in a manner that may not be in the best interests of other stockholders.
      In
      addition, as of December 31, 2005, certain loans held by KH Funding to some
      of
      our officers, directors and stockholders totaled $4,274,751. Although we believe
      that each of these loans were on terms as favorable as could have been obtained
      from an unrelated party, the loans could create, or appear to create, potential
      conflicts of interest which may not necessarily be resolved in our favor. Our
      policies for underwriting mortgage loans and purchasing loans secured by real
      property are discussed under "Item 1. Description of Business—Lending
      Activities." This could have a material adverse effect on our business,
      operating results and financial condition. See "Item 14. Certain Relationships
      and Related Transactions."




*We
      do
      not have a compensation committee.*




Currently,
      we do not have a compensation committee and we do not know if or when such
      a
      committee will be formed. In the meantime, our Board of Directors governs
      decisions regarding compensation. Our Board of Directors is not entirely
      comprised of independent members. See "Management."




**ITEM
      2.**  **DESCRIPTION
      OF PROPERTY**




The
      real
      estate we own is generally acquired at foreclosure or through a deed-in-lieu
      of
      foreclosure. The more expensive properties on which we foreclose are sold as
      soon as possible. Generally, with the lower and medium priced single-family
      residential properties we acquire through foreclosure, we rent them out and
      continue ownership for a short period. Often these properties have a rental
      value that is high relative to fair market value. If so, we have an opportunity
      to maximize profits from an ultimate sale by finding a good tenant, making
      cosmetic and appliance upgrades, and then selling the property for, hopefully,
      a
      higher market value than may have been realized by a quick sale. In order to
      determine the fair market value of a foreclosed property we obtain an Opinion
      of
      Value from a licensed real estate professional.




We
      currently own residential real estate in several states, including:





one
            property held for sale in Waco, Texas;
        one
            property held for sale in Louisville, Mississippi;
        two
            properties held for sale in Schenectady, New York;
        one
            rental property in Gainesville, Georgia;
        one
            rental property in Grand Prairie, Texas;
        one
            rental property in Schenectady, New York;
        four
            rental properties in Montgomery, Alabama;
        one
            rental property in Waco, Texas;
        two
            rental properties in Leander, Texas; and
        two
            rental properties in South Bend, Indiana.


**ITEM
      3.**  **LEGAL
      PROCEEDINGS**




We
      are
      involved periodically in various claims and lawsuits that arise in connection
      with our financial services business. We believe that these routine legal
      proceedings, in the aggregate, are not material to our financial condition
      and
      results of operations.




ITEM
      4.  **SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS**


No
        matters were submitted to a vote of the shareholders during the fourth quarter
        of 2005.





- -




**PART
      II**




**ITEM
      5.**  **MARKET
      FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
      SECURITIES**




**Market,
      Holders and Dividends**




Our
      common stock is not listed on a public trading market. As of March 15, 2006
      we
      had 54 stockholders of record holding 2,568,951 shares. In each of the last
      two
      fiscal years we have paid an annual dividend on our common stock of $0.15 per
      share in 2004 and $0.0975 per share in 2005 and do anticipate paying additional
      dividends on our common stock in the foreseeable future.




**Equity
      Compensation Plan Information**




The
      following table sets forth information as of March 15, 2006 with respect to
      the
      compensation plans under which equity securities of the Company are authorized
      for issuance.





**Equity
                Compensation Plan Information****Plan
                category**
            
            **(a)
                Number of shares to be issued upon exercise of outstanding
                options**
            
            **(b)
                Weighted-average exercise price of outstanding
                options**
            
            **(c)
                Number of shares remaining available for future issuance under equity
                compensation plans (excluding shares reflected in column
                (a))**Equity
                compensation plans approved by security holders(1)
            
            -
            
            -
            
            1,000,000Equity
                compensation plans not approved by security holders(2)
            
            361,250
            
            $2.07
            
            n/aTotal
            
            361,250
            
            $2.07
            
            1,000,000




(1)  The
      2005
      Incentive Stock Option Plan was approved by stockholders in 2005.


(2)  From
      time
      to time, we have issued options or warrants to employees and non-employees
      (such
      as directors, consultants, advisors, vendors, customers, suppliers and lenders)
      in exchange for services or other consideration provided to us. These issuances
      have not been made pursuant to a formal policy or plan, but instead are issued
      with such terms and conditions as may be determined by our Board of Directors
      from time to time.




**Recent
      Sales of Unregistered Securities**




In
      2005,
      we issued 50,000 shares of common stock to one person upon exercise of options
      granted in 2000. We relied on the private placement exemption of Regulation
      D
      and Section 4(2) of the Securities Act of 1933, as amended.




**Repurchase
      of Securities**




We
      did
      not repurchase any of our Common Stock during 2005.




**ITEM
      6.**  **MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATION**




This
      discussion may contain statements that could be deemed forward-looking
      statements within the meaning of Section 21E of the Securities Exchange Act
      of
      1934 and the Private Securities Litigation Reform Act, which statements are
      inherently subject to risks and uncertainties. Forward-looking statements are
      statements that include projections, predictions, expectations or beliefs and
      future events or results or otherwise are not statements of historical fact.
      Such statements are often characterized by the use of qualifying words (and
      their derivatives) such as "expect," "believe," "estimate," "plan," "project,"
      "anticipate," or other statements concerning opinions or judgment of KH Funding
      and its management about future events. Factors that could influence the
      accuracy of such forward-looking statements include, but are not limited to,
      the
      financial success or changing strategies of KH Funding's customers, actions
      of
      government regulators, the level of market interest rates, and general economic
      conditions. See "Forward-Looking Statements."




**Overview**




KH
      Funding Company's primary business activities consist of originating, acquiring
      and servicing mortgage loans, and issuing interest-bearing debt securities
      to
      investors. KH Funding Company's business operations are conducted solely from
      its headquarters in Silver Spring, Maryland.




KH
      Funding currently has over 1,000 investors who have purchased its investment
      Notes dating back to 1990. The note purchasers have been attracted primarily
      through word-of-mouth referrals. The proceeds from the sale of Notes are used
      to
      make redemptions to existing note holders and for investment in real estate
      mortgage loans, business loans, investment grade debt securities and real
      property. We emphasize the direct origination of small commercial real estate
      mortgage loans and investment property residential mortgage loans. We purchase
      first and second trust residential loans nationwide from other lenders and
      banks.




Our
      net
      income depends largely upon our net interest income, which is the difference
      between interest income from loans and investments, referred to as
      interest-earning assets, and interest expense on investor Notes and other
      borrowed funds, referred to as interest-bearing liabilities. Our net interest
      income is significantly affected by general economic conditions, policies
      established by regulatory authorities and competition.




The
      Company has been expanding the distribution channels for sales of its investor
      Notes by engaging in strategic alliances with several major financial services
      firms throughout the country. We currently have signed selling agreements with
      three NASD Broker-Dealers with a network of over 250 registered representatives
      in the Midwest and West. These alliances give us the ability to sell our
      investor Notes through a network of financial consultants in defined geographic
      locations. To date, our distribution plan has been very successful, establishing
      close to 700 new investment accounts providing over $25,000,000 in funds to
      KH
      Funding. We plan to further increase our distribution network, and are currently
      in negotiations with several NASD member Broker-Dealers interested in
      distributing our Notes in parts of the United States where we are not currently
      represented.




**Summary
      Financial Data**




You
      should consider our summary financial information set forth below together
      with
      the more detailed financial statements included elsewhere in this
      report.





**Year
                Ended December 31,****2005**
            
            **2004**
            
            **2003**
            
            **2002**
            
            **2001****Statement
                of Operations Data:**Interest
                and Fees on Loans
            
            $
            3,323,449
            
            
            $
            2,006,449
            
            
            $
            1,826,202
            
            
            $
            1,757,153
            
            
            $
            1,463,789Other
                Income(1)
            
            
            311,683
            
            
            
            390,121
            
            
            
            232,299
            
            
            
            106,504
            
            
            
            105,800Total
                Revenue(2)
            
            
            3,635,132
            
            
            
            2,396,570
            
            
            
            2,058,501
            
            
            
            1,863,657
            
            
            
            1,569,589Provision
                for Loan Losses
            
            
            251,048
            
            
            
            266,700
            
            
            
            146,379
            
            
            
            144,165
            
            
            
            158,000Interest
                Expense
            
            
            2,412,360
            
            
            
            1,297,978
            
            
            
            1,273,677
            
            
            
            1,173,985
            
            
            
            1,007,521Non-Interest
                Expense
            
            
            1,016,039
            
            
            
            929,365
            
            
            
            634,279
            
            
            
            516,431
            
            
            
            440,364Total
                Expenses(3)
            
            
            3,428,399
            
            
            
            2,494,043
            
            
            
            1,907,956
            
            
            
            1,690,416
            
            
            
            1,447,885Net
                (Loss) Income
            
            
            (44,315
            )
            
            
            (97,473
            )
            
            
            4,166
            
            
            
            29,076
            
            
            
            (36,296
            )Per
                Common Share Data:Basic
                Earnings (Loss) Per Share(4)
            
            
            (0.02
            )
            
            
            (0.04
            )
            
            
            -0-
            
            
            
            0.02
            
            
            
            (0.02
            )Diluted
                Earnings (Loss) Per Share(5)
            
            
            (0.02
            )
            
            
            (0.04
            )
            
            
            -0-
            
            
            
            0.01
            
            
            
            (0.02
            )





(1)  Consists
      of all non-interest income plus interest on bank accounts, interest on
      investments-marketable securities and other interest.


(2)  The
      sum
      of interest and fees on loans plus other income as explained above in
      (1).


(3)  The
      sum
      of interest expense plus non-interest expense.


(4)  Using
      average of beginning and ending balance of number of shares and annual earnings,
      shown in cents per share.


(5)  Using
      average of beginning and ending balance of number of shares and number of
      outstanding options, and annual earnings-cents per share.





**Year
                Ended December 31,****2005**
            
            **2004**
            
            **2003**
            
            **2002**
            
            **2001****Balance
                Sheet Data:**Cash
                and Marketable Securities
            
            $
            7,177,851
            
            
            $
            3,325,093
            
            
            $
            4,169,911
            
            
            $
            2,371,931
            
            
            $
            357,957Loans
                less Allowance for Loan Losses
            
            
            40,678,941
            
            
            
            20,144,798
            
            
            
            15,590,526
            
            
            
            15,830,293
            
            
            
            13,036,199Real
                Estate Owned
            
            
            802,815
            
            
            
            709,973
            
            
            
            1,014,254
            
            
            
            1,011,424
            
            
            
            1,198,681Other
                Assets(1)
            
            
            2,403,133
            
            
            
            2,039,085
            
            
            
            2,280,217
            
            
            
            676,560
            
            
            
            423,112Total
                Assets
            
            
            50,770,545
            
            
            
            26,221,949
            
            
            
            23,090,908
            
            
            
            19,890,208
            
            
            
            15,015,949Notes
                Payable
            
            
            49,681,335
            
            
            
            24,817,403
            
            
            
            19,980,673
            
            
            
            17,482,519
            
            
            
            12,789,068Participation
                Loans
            
            
            -
            
            
            
            107,248
            
            
            
            105,636
            
            
            
            1,077,730
            
            
            
            1,024,115Other
                Liabilities(2)
            
            
            174,403
            
            
            
            101,446
            
            
            
            1,322,686
            
            
            
            358,902
            
            
            
            422,654Total
                Liabilities
            
            
            49,855,738
            
            
            
            25,026,097
            
            
            
            21,408,995
            
            
            
            18,919,151
            
            
            
            14,235,837Stockholders
                Equity
            
            
            914,807
            
            
            
            1,195,852
            
            
            
            1,681,913
            
            
            
            971,057
            
            
            
            780,112Other
                Financial Data:Return
                on Average Assets(3)
            
            
            (0.12
            )%
            
            
            (0.40
            )%
            
            
            0.02
            %
            
            
            0.17
            %
            
            
            (0.28
            )%Return
                on Average Equity(4)
            
            
            (4.20
            )%
            
            
            (6.77
            )%
            
            
            0.31
            %
            
            
            3.32
            %
            
            
            (3.90
            )%Stockholders'
                Equity to Total Assets
            
            
            1.81
            %
            
            
            4.56
            %
            
            
            7.28
            %
            
            
            5.1
            %
            
            
            5.2
            %**Loan
                Portfolio:**Principal
                Funded During Period
            
            $
            37,727,240
            
            
            $
            12,841,741
            
            
            $
            6,875,053
            
            
            $
            7,168,744
            
            
            $
            9,563,367Principal
                Received During Period
            
            $
            16,733,748
            
            
            $
            8,005,490
            
            
            $
            6,970,257
            
            
            $
            3,730,793
            
            
            $
            5,062,451Average
                Interest Rate For Period
            
            
            10.66
            %
            
            
            10.89
            %
            
            
            10.74
            %
            
            
            11.00
            %
            
            
            11.94
            %Loan
                Charge-offs as a Percent of Total Portfolio at End of
                Period(5)
            
            
            0.35
            %
            
            
            1.38
            %
            
            
            0.75
            %
            
            
            0.94
            %
            
            
            0.91
            %**Investor
                Notes Payable:**Sale
                of Notes During Period
            
            $
            120,110,831
            
            
            $
            49,008,102
            
            
            $
            26,630,166
            
            
            $
            22,926,619
            
            
            $
            14,418,456Redemption
                of Notes During Period
            
            $
            96,630,099
            
            
            $
            44,786,895
            
            
            $
            24,697,770
            
            
            $
            18,681,654
            
            
            $
            11,280,177Average
                Interest Expense Rate
            
            
            6.03
            %
            
            
            5.69
            %
            
            
            6.0
            %
            
            
            6.40
            %
            
            
            7.86
            %




(1)  Consists
      of the sum of the following: Accrued Interest, Prepaid Expenses, Other
      Receivables, Investments—Other, Property and Equipment-Net, and Other
      Assets.


(2)  Consists
      of the sum of the following: Borrowings, Accounts Payable and Accrued Expenses,
      and Escrows.


(3)  Using
      average of beginning and ending balances for assets, and earnings for period
      (annualized).


(4)  Using
      average of beginning and ending balances for equity, and earnings for period
      (annualized).


(5)  Annualized.




**Comparison
      of Financial Condition at December 31, 2005 and 2004**




*Assets* .
      Total
      assets increased $24.55 million, to $50.77 million at December 31, 2005, from
      $26.22 million at December 31, 2004. The size of the gross loan portfolio
      increased to $41.05 million from $20.38 million. Investments available for
      sale
      decreased from $658,248 to $598,609 due to a decrease in fair market
      value.




As
      of
      December 31, 2005 and 2004, non-accrual loans totaled $836,390 and $583,351,
      respectively. The increase of $253,039 is represented primarily by first trust
      loans on which the Company anticipates little or no loss.




Information
      related to non-performing assets and accruing past due loans are as
      follows:





**2005**
            
            **2004**Non-accrual
                loans
            
            $
            836,390
            
            
            $
            583,351Foreclosed
                real estate held for sale
            
            
            180,302
            
            
            
            -Total
                non-performing assets
            
            $
            1,016,692
            
            
            $
            583,351Ratio
                of non-performing assets to:Total
                loans and foreclosed assets
            
            
            2.49
            %
            
            
            2.90
            %Total
                assets
            
            
            2.01
            %
            
            
            2.22
            %Loans
                90 days or more past due and still accruing
            
            $
            1,625,356
            
            
            $
            2,109,236Ratio
                of loans 90 days or more past due and still accruing to:Total
                loans
            
            
            4.00
            %
            
            
            10.47
            %Total
                assets
            
            
            3.21
            %
            
            
            8.04
            %




As
      of
      December 31, 2005 and 2004, there were loans of $1,625,356 and $2,109,236,
      respectively, more than ninety days past due on the books of the Company that
      continue to earn interest. These loans are well collateralized and the borrowers
      are making regular payments.




*Liabilities* .
      Total
      liabilities increased $24.83 million or 99% to $49.86 million at December 31,
      2005, from $25.03 million at December 31, 2004. The increase was largely the
      result of increases in investor Notes due to our increased marketing efforts
      with our broker distribution program.




*Equity* .
      Total
      stockholders' equity decreased to $914, 807 or 24% in 2005 from $1,195,852
      in
      2004 due to the current year net loss, dividends paid to shareholders and a
      decrease in fair market value of our investments available for
      sale.




**Comparison
      of Operating Results for Years ended December 31, 2005 and
      2004**




The
      average yield earned on loans receivable decreased to 10.66% in 2005 from 10.89%
      in 2004. The decrease was due primarily to a slightly lower average interest
      rate on the new loans we added to our portfolio.




The
      average rate paid on investor Notes increased to 6.03% in 2005 from 5.69% in
      2004. The net result was a decrease in net interest rate spread, which was
      4.63%
      for 2005 as compared to 5.20% in 2004.




*Net
      Loss* .
      Net
      loss for the year ended December 31, 2005 was ($44,315) compared to net loss
      of
      ($97,473) for the year ended December 31, 2004. The lower loss was attributed
      to
      a larger loan portfolio earning 64% more interest income while operating
      expenses only increased 8%.




*Interest
      Income* .
      Total
      interest income was $3.53 million in 2005 compared to $2.27 million in 2004.
      The
      additional income resulted primarily from the growth in our loan portfolio.
      The
      interest income for all periods includes point and fee income, interest earned
      on bank investments and marketable securities.




*Interest
      Expense* .
      Interest expense was $2.41 million in 2005, an increase from the $1.30 million
      for 2004. The additional expense resulted from a large increase in investor
      accounts. The average rate paid on investor accounts increased to 6.03% in
      2005
      from 5.69% in 2004. The interest expense includes fees paid to
      broker-dealers.




*Provision
      for Loan Losses* .
      The
      provisions for loan losses was $251,048 in 2005 and $266,700 in 2004. We
      recovered one previously written-off loan of $6,500 in 2005 and $4,800 in 2004.
      At year-end our impaired loans were $836,390 in 2005 and $583,351 in 2004.
      Our
      allowance for loan losses was $369,791 at the end of 2005 and $233,311 at the
      end of 2004.




*Non-Interest
      Income* .
      We had
      non-interest income of $101,078 in 2005 and $121,637 in 2004. The decrease
      was
      principally the result of recognized impairment losses on investment
      securities.




*Non-Interest
      Expense* .
      Non-interest expense increased to $1,016,039 in 2005 from $929,365 in 2004.
      The
      increase was the result of increased salary expense, offering costs, and
      administrative expense.




*Income
      Taxes* .
      KH
      Funding Company is a Subchapter S corporation under the Internal Revenue Code
      and accordingly no items appear for income taxes.




**Liquidity
      and Capital Resources**




KH
      Funding Company's primary sources of capital are the proceeds from the sale
      of
      investor Notes, principal and interest payments on loans, sales of participation
      interests in loans and rental income. While maturities and scheduled
      amortization of loans and investments are predictable sources of funds, the
      sale
      of investor Notes and mortgage loan prepayments are greatly influenced by
      interest rate trends, economic conditions and competition. Our one-day demand
      Notes are a major cause of turnover in our cash positions.




The
      table
      below illustrates the sales of investor Notes versus redemptions for the years
      indicated:





**Year**
            
            **Notes
                Sold**
            
            **Notes
                Redeemed**
            
            **Percentage**2001
            
            $
            14,418,456
            
            $
            11,280,177
            
            78.23%2002
            
            $
            22,926,619
            
            $
            18,681,654
            
            81.47%2003
            
            $
            26,630,166
            
            $
            24,697,770
            
            92.74%2004
            
            $
            49,008,102
            
            $
            44,786,895
            
            91.39%2005
            
            $
            120,110,831
            
            $
            96,630,099
            
            80.37%




During
      the past few years, the combination of generally low interest rates on deposit
      products at commercial banks, the poor performance of the stock market, our
      public offerings of investor Notes, and increasing referrals from customers
      have
      positioned KH Funding to experience solid growth in the number of new investors
      attracted to its investment products. Based on its monitoring of historic trends
      and its current pricing strategy for investor Notes, management believes KH
      Funding Company should retain a large portion of its existing investors and
      experience a significant increase of funds from new investors in the
      future.




The
      maturities of notes payable at December 31, 2005 are as follows:





**Year****Ending
                December 31,**2006
                (includes one-day and 30-day demand notes)
            
            $
            38,504,2772007
            
            
            3,979,2562008
            
            
            3,137,9622009
            
            
            1,786,6242010
            
            
            2,345,0552011
            
            
            55,582Subtotal
            
            $
            49,808,756Unamortized
                brokerage costs
            
            
            (127,421
            )Total
                notes payable, net
            
            $
            49,681,335




*Redemption
      of Investor Notes* .
      Management believes that the risk of not being able to fund redemption requests
      only exists if the requests for redemption exceed the amount of readily
      available cash, i.e., if our liquidity is insufficient to fund redemptions.
      Upon
      the sale of a Note payable, the funds for redemption are immediately available.
      Of course, part of our investment strategy is to invest funds that are invested
      with us for a longer period into higher yielding, less liquid investments,
      such
      as mortgages; nevertheless, the funds are still available, just not immediately.
      Only holders of one-day demand Notes can ask for funds sooner than 30 days,
      and
      we make an effort to keep funds available for these requests. Only holders
      of
      30-day demand Notes can ask for funds sooner than 90 days, and if the funds
      will
      not be available within 30 days, we will sell some of our mortgage loans (notes
      receivable) to have the funds available to meet requests for funds from these
      Note holders. All other types of notes, that is the term notes of one, three
      and
      five years, are redeemable upon maturity, or prior to maturity on 90 days
      advance notice, subject to a penalty. If necessary, we will sell loans (notes
      receivable) in bulk to fund redemption requests from note holders.




The
      Company strives to maintain sufficient liquidity to meet all redemption
      requests. We normally hold 10% to 20% of our assets in cash and cash equivalents
      to fund redemptions of one-day demand Notes. This amount has historically been
      sufficient for us to meet our obligations. Also, if required, we are able to
      sell loans within 30 days to raise cash to meet redemption requests from 30-day
      account holders or within 90 days to meet early redemption requests from fixed
      term Note holders. The majority of our loan assets are classified as available
      for sale to meet liquidity demands, if necessary.




*Plan
      to Raise Additional Funds* .
      We
      intend to continue to expand our operations through future public offerings
      of
      debt by the Company and select, contracted broker-dealers., and through private
      sales of capital stock. We also intend to maintain a capital level of at least
      3% to 5% of total assets through the private sale of stock from time-to-time.
      However, there is no assurance that such transactions will occur or be
      successful.




In
      the
      first quarter of 2006, the Board of Directors approved the offering for sale
      of
      500,000 shares of stock at $3.00 per share. As of March 21, 2006, the Company
      has received subscriptions for 91,000 shares at $3.00 per share, or $273,000,
      and Robert L. Harris exercised an option to purchase 40,000 shares at $2.00
      per
      share. These transactions are expected to close by April 20, 2006.




We
      also
      expect that we will be able to attract more investors who are interested in
      our
      longer-term fixed rate notes. We are now offering trust services for IRA
      accounts through our Trust Services Department. We intend to expand these
      services and believe that IRA investors generally look for investments of a
      longer-term nature, which complements our preferred mode of
      investing.




*Use
      of Proceeds* .
      Net
      proceeds from Note offerings received by us in prior years has been used to
      fund
      new loans. However, rather than directly originating new loans, in the last
      five
      years we have purchased ever-larger portions of loans that have been added
      to
      our portfolio and are now purchasing approximately 80% of our new loans. We
      will
      continue to expand this wholesale component of our operations and have it be
      a
      major part of our loan acquisition strategy.




We
      anticipate that our operations will shift to acquiring larger percentages of
      loans at the wholesale level rather than interacting directly in the loan
      origination. This increased wholesale component will enable us to expand our
      operations and increase our net profit with a limited amount of additional
      expense because we anticipate that only a minimal expansion of our
      administrative functions will be needed to support an increased wholesale
      component.




We
      intend
      to purchase more liquid, marketable loans and to increase the volume of loans
      we
      purchase. To increase our investment and portfolio activity, we plan to identify
      and utilize additional brokers, lenders and banks as sources for our loan
      acquisitions.




**Known
      Trends, Events or Uncertainties**




Impact
      of
      Inflation and Interest Rates -The financial statements of KH Funding and notes
      thereto, presented elsewhere herein, have been prepared in accordance with
      accounting principles generally accepted in the United States of America, which
      require the measurement of financial position and operating results in terms
      of
      historical dollars without considering the change in the relative purchasing
      power of money over time and due to inflation. The impact of inflation is
      generally to increase the value of underlying collateral for the loans made
      by
      KH Funding to its borrowers. Unlike typical industrial companies, nearly all
      the
      assets and liabilities of KH Funding are monetary in nature. As a result,
      interest rates have a greater impact on KH Funding's performance than the
      effects of inflation generally.




**Critical
      Accounting Policies**




The
      Securities and Exchange Commission ("SEC") has issued guidelines on the
      disclosure of critical accounting policies. The SEC defines critical accounting
      policies as those that require application of management's most difficult,
      subjective or complex judgments, often as a result of the need to make estimates
      about the effect of matters that are inherently uncertain and may change in
      subsequent periods.




Our
      significant accounting policies are disclosed in the footnotes to the financial
      statements. Management believes the following significant accounting policies
      also are considered critical accounting policies:




*Loan
      Impairment* .
      A loan
      is considered impaired when, based on available information or current events,
      it is probable that we will be unable to collect scheduled payments of principal
      and interest when due according to the contractual terms of the loan agreement.
      Factors considered in determining impairment include payment status, collateral
      value, and the probability of collecting scheduled principal and interest
      payments when due. Loans that experience insignificant payment delays and
      payment shortfalls generally are not considered impaired. We measure impairment
      on a loan by loan basis using the present value of expected future cash flows
      discounted at the loan's effective interest rate, the loan's obtainable market
      value, or the fair value of the collateral if the loan is collateral-dependent.
      However, impairment is based on the fair value of the collateral if it is
      determined that foreclosure is probable.




*Allowance
      for Loan Losses* .
      We
      periodically evaluate the adequacy of the allowance for loan losses based on
      past loan loss experience, known and inherent risks in the portfolio, adverse
      situations that might affect the borrower's ability to repay, the estimated
      value of any underlying collateral, and current economic conditions. While
      we
      use information available in establishing the allowance for loan losses,
      evaluation assessments are inherently subjective and future adjustments to
      the
      allowance may be necessary if economic or other conditions differ substantially
      from the assumptions used in making the evaluation. The allowance for loan
      losses is a material estimate that is particularly susceptible to significant
      change in the near term.




**Recent
      Accounting Pronouncements**




In
      November 2005, the Financial Accounting Standards Board ("FASB") issued FASB
      Staff Position (FSP) 115-1, *The
      Meaning of Other-Than-Temporary Impairment and Its Application to Certain
      Investments* .
      This
      FSP provides additional guidance on when an investment in a debt or equity
      security should be considered impaired and when that impairment should be
      considered other-than-temporary and recognized as a loss in earnings.
      Specifically, the guidance clarifies that an investor should recognize an
      impairment loss no later than when the impairment is deemed
      other-than-temporary, even if a decision to sell has not been made. The FSP
      also
      requires certain disclosures about unrealized losses that have not been
      recognized as other-than-temporary impairments. Management applied the guidance
      in this FSP in 2005.




In
      May
      2005, the FASB issued Statement of Financial Accounting Standard ("SFAS") No.
      154, *Accounting
      Changes and Error Corrections* ,
      which
      changes the accounting for and reporting of a change in accounting principle.
      This statement applies to all voluntary changes in accounting principle and
      changes required by an accounting pronouncement in the unusual instance that
      the
      pronouncement does not include specific transition provisions. This statement
      requires retrospective application to prior period financial statements of
      changes in accounting principle, unless it is impractical to determine either
      the period-specific or cumulative effects of the change. SFAS 154 is effective
      for accounting changes made in fiscal years beginning after December 15, 2005.
      The adoption of this standard is not expected to have a material effect on
      financial condition, results of operations, or liquidity.




In
      December 2004, the FASB issued SFAS 153, *Exchanges
      of Nonmonetary Assets* ,
      an
      amendment of APB Opinion No. 29, *Accounting
      for Nonmonetary Transactions* .
      This
      statement amends the principle that exchanges of nonmonetary assets should
      be
      measured based on the fair value of the assets exchanged and more broadly
      provides for exceptions regarding exchanges of nonmonetary assets that do not
      have commercial substance. This statement is effective for nonmonetary asset
      exchanges occurring in fiscal periods beginning after June 15, 2005. The
      adoption of this standard is not expected to have a material impact on financial
      condition, results of operations or liquidity.




In
      December 2004, the FASB revised SFAS 123, *Accounting
      for Stock-Based Compensation* .
      SFAS
      123R establishes accounting requirements for share-based compensation to
      employees and carries forward prior guidance on accounting for awards to
      non-employees. In 2005, the FASB issued further guidance on the classification
      and measurement of freestanding financial instruments originally issued for
      employee service and the application of grant date as defined in SFAS 123R.
      The
      Company will be required to adopt this statement on January 1, 2006. The impact
      of SFAS 123R on the Company in 2006 and beyond will depend on various factors,
      among them being the Company's future compensation strategy. The adoption of
      this standard is not expected to have a material impact on financial condition,
      results of operations or liquidity.




In
      December 2003, the American Institute of Certified Public Accountants issued
      Statement of Position (SOP) 03-3, *Accounting
      for Certain Loans or Debt Securities Acquired in a Transfer* .
      SOP
      03-3 requires acquired loans, including debt securities, to be recorded at
      the
      amount of the purchaser's initial investment and prohibits carrying over
      valuation allowances from the seller for those individually evaluated loans
      that
      have evidence of deterioration in credit quality since origination, and it
      is
      probable all contractual cash flows on the loan will be unable to be collected.
      SOP 03-3 also requires the excess of all undiscounted cash flows expected to
      be
      collected at acquisition over the purchaser's initial investment to be
      recognized as interest income on a level-yield basis over the life of the loan.
      Subsequent increases in cash flows expected to be collected are recognized
      prospectively through an adjustment of the loan's yield over its remaining
      life,
      while subsequent decreases are recognized as impairment. Loans carried at fair
      value, mortgage loans held for sale, and loans to borrowers in good standing
      under revolving credit agreements are excluded from the scope of SOP 03-3.
      The
      Company adopted the provisions of SOP 03-3 effective January 1, 2005. The
      adoption of this standard did not have a material impact on financial condition,
      results of operation or liquidity.




**ITEM
      7.**  **FINANCIAL
      STATEMENTS**




**Index
      to Financial Statements**





**Report
                of Independent Registered Public Accounting Firm**
            20**Audited
                Financial Statements:**Balance
                Sheets as of December 31, 2005 and 2004
            21Statements
                of
                Operations for the years ended December 31, 2005 and 2004
            22Statements
                of
                Changes in Stockholders' Equity for the years ended December 31,
                2005 and
                2004
            23Statements
                of
                Cash Flows for the years ended December 31, 2005 and 2004
            24Notes
                to Financial Statements for the years ended December 31, 2005 and
                2004
            25-36





- -




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




Board
      of
      Directors and Stockholders


KH
      Funding Company


Silver
      Spring, Maryland




We
      have
      audited the accompanying balance sheets of KH Funding Company (the Company)
      as
      of December 31, 2005 and 2004, and the related statements of operations, changes
      in stockholders' equity and cash flows for the years then ended. These financial
      statements are the responsibility of the Company's management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.




We
      conducted our audits in accordance with standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.




In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the financial position of KH Funding Company as of December
      31, 2005 and 2004, and the results of its operations and cash flows for the
      years then ended in conformity with accounting principles generally accepted
      in
      the United States of America.




/s/
      Stegman & Company




Baltimore,
      Maryland


April
      7,
      2006





- -


**KH
      Funding Company**




Balance
      Sheets as of December 31,





**2005**
            
            **2004*****Assets***Cash
            $
            6,579,242
            
            
            $
            2,669,845Investments
                available for saleMarketable
                securities - at fair value
            
            598,609
            
            
            
            658,248Other
            
            50,872
            
            
            
            158,872Loans,
                less allowance for loan losses of (2005) $369,791 and (2004)
                $233,311
            
            40,678,941
            
            
            
            20,144,798Accrued
                interest receivable
            
            1,405,424
            
            
            
            853,448Other
                receivables
            
            126,269
            
            
            
            537,737Prepaid
                expenses
            
            374,762
            
            
            
            445,470Property
                and equipment-net
            
            137,623
            
            
            
            33,755Real
                estate ownedRental
                property
            
            622,513
            
            
            
            709,973Held
                for sale
            
            180,302
            
            
            
            -Other
                assets
            
            15,988
            
            
            
            9,803**Total
                Assets**
            $
            **50,770,545**
            
            
            $
            **26,221,949*****Liabilities
                and Stockholders' Equity*****Liabilities**Notes
                and accrued interest payable
            $
            49,681,335
            
            
            $
            24,817,403Other
                loans payable
            
            -
            
            
            
            66,200Participation
                loans
            
            -
            
            
            
            107,248Accounts
                payable and accrued payroll liabilities
            
            2,730
            
            
            
            1,900Escrows
                and security deposits
            
            171,673
            
            
            
            33,346**Total
                Liabilities**
            $
            **49,855,738**
            
            
            $
            **25,026,097****Stockholders'
                Equity**Common
                stock
              (5,000,000
                shares authorized; 2,555,556 shares (2005) and 2,505,556 shares (2004),
                issued and outstanding; $0.01 par value)
            $
            25,556
            
            
            $
            25,056Paid-in
                capital
            
            1,603,852
            
            
            
            1,750,443Accumulated
                deficit
            
            (429,688
            )
            
            
            (385,373
            )Subscription
                note receivable
            
            (185,450
            )
            
            
            (185,450
            )Accumulated
                other comprehensive loss
            
            (99,463
            )
            
            
            (8,824
            )**Total
                Stockholders' Equity**
            $
            **914,807**
            
            
            $
            **1,195,852****Total
                Liabilities and Stockholders' Equity**
            $
            **50,770,545**
            
            
            $
            **26,221,949**








*The
      accompanying notes are an integral part of these
      statements.*


- -


**KH
      Funding Company**




Statements
      of Operations for the years ended December 31,





**2005**
            
            **2004****Interest
                Income**Interest
                and fees on loans
            $3,323,449
            
            $2,006,449Interest
                on bank accounts
            113,380
            
            10,066Interest
                on investments-marketable securities
            31,000
            
            127,719Other
                interest
            66,225
            
            130,699Total
                interest income
            3,534,054
            
            2,274,933**Interest
                Expense**Interest
                and fees on borrowing
            2,400,423
            
            1,283,407Interest
                on participation loans
            11,937
            
            14,571Total
                interest expense
            2,412,360
            
            1,297,978Net
                interest income
            1,121,694
            
            976,955**Provision
                for Loan Losses**
            251,048
            
            266,700Net
                interest income after provision for loan loss
            870,646
            
            710,255**Non-interest
                Income**Rental
                income
            58,549
            
            71,351Gain
                on sale of real estate owned
            72,194
            
            53,868Gain
                on sale of securities
            -
            
            18,576Recognized
                loss on impairment of securities
            (50,000)
            
            (33,000)Other
            20,335
            
            10,842Total
                non-interest income
            101,078
            
            121,637**Non-interest
                Expense**Salaries
                and wages
            326,602
            
            301,984Professional
                fees
            131,135
            
            176,894Offering
                costs
            199,121
            
            132,376Administration
            94,923
            
            73,272Real
                estate maintenance
            50,385
            
            35,940Insurance
            62,395
            
            65,600Depreciation
            50,387
            
            46,250Rent
            53,327
            
            43,001Bank
                charges
            26,140
            
            23,374Other
            21,624
            
            30,674Total
                non-interest expense
            1,016,039
            
            929,365**Net
                Loss**
            **$****(44,315****)**
            
            **$****(97,473****)**Basic
                (loss) earnings per share
            $(0.02)
            
            $(0.04)Diluted
                (loss) earnings per share
            $(0.02)
            
            $(0.04)Cash
                dividends paid per common share
            $0.10
            
            $0.15





*The
      accompanying notes are an integral part of these
      statements.*


- -


**KH
      Funding Company**





Statements
      of Changes in Stockholders' Equity


For
      the
      years ended December 31, 2005 and 2004





**Common
                Stock**
              **Shares
                Amount**
            
            **Paid-in
                Capital**
            
            **Accumulated
                Deficit**
            
            **Subscription
                Note Receivable**
            
            **Accumulated
                Other Comprehensive (Loss) Income**
            
            **Total
                Stockholders' Equity****Balance
                at December 31, 2003**
            2,485,066
            
            
            $24,851
            
            $2,102,765
            
            $(287,900)
            
            $(185,450)
            
            $27,647
            
            $1,681,913**Additional
                Stock Issued**
            22,298
            
            
            223
            
            24,858
            
            
            
            
            
            
            
            25,081**Stock
                Redeemed**
            (1,808
            )
            
            (18)
            
            (4,083)
            
            
            
            
            
            
            
            (4,101)**Dividends
                Declared $.15 per share**
            
            
            
            
            
            (373,097)
            
            
            
            
            
            
            
            (373,097)**Comprehensive
                Income**Net
                loss for the year ended December 31, 2004
            
            
            
            
            
            
            
            (97,473)
            
            
            
            
            
            (97,473)Reclassification
                adjustment for gains included in net loss
            
            
            
            
            
            
            
            
            
            
            
            (18,576)
            
            (18,576)Change
                in fair value of investments
            
            
            
            
            
            
            
            
            
            
            
            (17,896)
            
            (17,896)**Total
                Comprehensive Income**
            
            
            
            
            
            
            
            
            
            
            
            
            
            (133,944)**Balance
                at December 31, 2004**
            2,505,556
            
            
            25,056
            
            1,750,443
            
            (385,373)
            
            (185,450)
            
            (8,824)
            
            1,195,852**Additional
                Stock Issued**
            50,000
            
            
            500
            
            99,500
            
            
            
            
            
            
            
            100,000**Dividends
                Declared $.10 per share**
            
            
            
            
            
            (246,091)
            
            
            
            
            
            
            
            (246,091)**Comprehensive
                Income**Net
                loss for the year ended December 31, 2005
            
            
            
            
            
            
            
            (44,315)
            
            
            
            
            
            (44,315)Change
                in fair value of investments
            
            
            
            
            
            
            
            
            
            
            
            (90,639)
            
            (90,639)**Total
                Comprehensive Income**
            
            
            
            
            
            
            
            
            
            
            
            
            
            (134,954)**Balance
                at December 31, 2005**
            2,555,556
            
            
            $25,556
            
            $1,603,852
            
            $(429,688)
            
            $(185,450)
            
            $(99,463)
            
            $914,807








*The
      accompanying notes are an integral part of these
      statements.*


- -


**KH
      Funding Company**





Statements
      of Cash Flows


For
      the
      years ended December 31,





**2005**
            
            **2004****Reconciliation
                of Net Income to Net Cash from Operating
                Activities**Net
                (loss) income
            $(44,315)
            
            $(97,473)Adjustments
                to reconcile net income to net cash from operating
                activitiesDepreciation
            50,387
            
            46,250Amortization
                of loan fees
            (61,873)
            
            (59,219)Provision
                for loan losses
            251,048
            
            266,700Gain
                on sale of securities
            -
            
            (18,576)Increase
                in accrued late charges
            8,148
            
            3,171Gain
                on sale of real estate owned
            (72,194)
            
            (53,868)Decrease
                (Increase) in prepaid expenses
            39,417
            
            (24,337)Recognized
                loss on impairment of investments
            50,000
            
            33,000Recovery
                of prior loan receivable write-off
            6,500
            
            4,800Increase
                in interest receivable
            (551,976)
            
            (298,798)Increase
                in interest payable (included in notes payable)
            1,317,000
            
            615,523Increase
                (Decrease) in accounts payable and accrued payroll
                liabilities
            830
            
            (662)Decrease
                (Increase) in prepaid offering costs
            32,616
            
            (62,012)Deferred
                loan origination costs
            (27,934)
            
            -**Net
                Cash provided by Operating Activities**
            997,654
            
            354,499**Cash
                Flows from Investing Activities**Principal
                repayments from borrowers
            16,733,748
            
            8,005,490Loans
                made to borrowers
            (37,727,240)
            
            (12,841,741)Purchase
                of marketable securities and other investments
            (31,000)
            
            (603,673)Proceeds
                from sale of marketable securities and other investments
            58,000
            
            2,484,950Payments
                for other receivables
            411,468
            
            (410,946)Purchase
                of fixed assets
            (129,716)
            
            (15,683)Proceeds
                from sale of real estate owned
            266,076
            
            371,846Payments
                to improve real estate owned
            (29,128)
            
            (8,840)Net
                Change in Other Assets
            (6,185)
            
            (1,142)**Net
                Cash Used in Investing Activities**
            (20,453,977)
            
            (3,019,739)**Cash
                Flow from Financing Activities**Proceeds
                from investor notes
            120,110,831
            
            49,008,102Principal
                payments on investor notes
            (96,630,099)
            
            (44,786,895)Proceeds
                from sales of common stock
            100,000
            
            1,025,081(Decrease)
                Increase on participation loans
            (107,248)
            
            1,611Payments
                on borrowings
            -
            
            (1,234,000)Payments
                of dividends
            (246,091)
            
            (373,097)Redemption
                of Common Stock
            -
            
            (4,101)Increase
                (Decrease) in escrow and security deposits
            138,327
            
            13,422**Net
                Cash Provided by Financing Activities**
            23,365,720
            
            3,650,123**Net
                Increase in Cash**
            3,909,397
            
            984,883**Cash
                Balance**,
                beginning of year
            2,669,845
            
            1,684,962**Cash
                Balance**,
                end of year
            $6,579,242
            
            $2,669,845**Supplemental
                cash flows information**Interest
                paid
            $1,095,360
            
            $619,992Transfer
                of loans to other real estate owned
            $283,460
            
            $66,528





*The
      accompanying notes are an integral part of these statements.*





- -




**NOTE
      A —**  **SUMMARY
      OF SIGNIFICANT POLICIES**




***Nature
      of Operation***




KH
      Funding Company (the Company) operated as a general partnership from its
      founding in December 1990 until July 1, 1994, at which date it incorporated.
      The
      Company is an authorized mortgage lender in the State of Maryland, and provides
      lending services in the Washington, DC and Baltimore, MD metropolitan areas,
      primarily to small businesses and individuals and also purchases mortgage loans
      nationwide. The lending services the Company provides include originating,
      buying and selling loans and in-house servicing of its loans.




***Use
      of Estimates in Preparing Financial Statements***




In
      preparing financial statements in conformity with accounting principles
      generally accepted in the United States of America, management is required
      to
      make estimates and assumptions that affect the reported amounts of assets and
      liabilities and the disclosure of contingent assets and liabilities at the
      date
      of the financial statements and revenue and expenses during the reporting
      period. Actual results could differ from those estimates.




***Reclassification***




Certain
      reclassifications have been made to the 2004 financial statements to conform
      with the 2005 presentation.




***Investment
      Available for Sale***




Most
      of
      the Company's investments are considered available for sale instruments and
      are
      recorded in compliance with Statement of Financial Accounting Standards (SFAS)
      No. 115, "Accounting for Certain Investments in Debt and Equity Securities."
      The
      cost of securities sold is determined by the specific identification method.
      Purchase premiums and discounts are recognized in interest income using the
      interest method over the term of the securities. Net unrealized holding gains
      and losses are reported as accumulated other comprehensive income, a separate
      component of stockholders' equity. Declines in the fair value of individual
      available-for-sale securities below their cost that are other than temporary
      result in a write-down of the individual security to its fair market value;
      write-downs are reflected in earnings as a realized loss on available-for-sale
      securities. Factors affecting the determination of whether an
      other-than-temporary impairment has occurred include a downgrading of the
      security by a rating agency, a significant deterioration in the financial
      condition of the issuer, or that management would not have the intent or ability
      to hold a security for a period of time sufficient to allow for any anticipated
      recovery in fair value.




***Loans
      Receivable and Allowance for Loan Losses***




Loans
      receivable are stated as unpaid principal balance net of any deferred fees
      and
      costs and payments in process, less the allowance for loan losses. Interest
      income from loans receivable is recognized using the interest method whereby
      interest income is recognized based upon the effective rate based upon
      outstanding principal. Loan origination fees received from borrowers are
      deferred and amortized in income over the established average life of related
      loan under a method which approximates the effective interest rate
      method.




The
      Company pays fees to third parties in connection with the acquisition of loans.
      These costs are amortized against interest income over the estimated average
      life of the loans under a method which approximates the effective interest
      rate
      method.




The
      Company incurs direct loan origination costs in its direct lending activities.
      These costs are capitalized and amortized against interest income over the
      estimated average life of the loans under a method which approximates the
      effective interest rate method.




The
      allowance for loan losses is increased for charges to income and decreased
      for
      charge-offs (net of recoveries). Management's periodic evaluation of the
      adequacy of the allowance is based on the Company's past loan loss experience,
      known or inherent risks in the portfolio, adverse situations which may affect
      the borrower's ability to repay, the estimated value of underlying collateral
      and current economic conditions. It is reasonably possible that the Company's
      allowance for loan losses could change in the near term.




Loans
      that are delinquent for more than three months are evaluated for collectibility
      and placed in non-accrual status when management determines that future earnings
      on that loan may be impaired. While in non-accrual status, collections on loans,
      if any, are recorded as collection of loan principal and no interest is
      recorded.




***Property
      and Equipment***




Property
      and equipment are stated at cost and depreciated over the estimated useful
      lives
      of three to 30 years, primarily using the straight-line method for financial
      statement purposes.




The
      unamortized costs of approximately $314,000 as of December 31, 2005 for the
      public debt offering are being amortized over the expected average life of
      the
      related debt proceeds of 36 months from the date incurred.




***Real
      Estate Owned***




Real
      estate owned represents property acquired by foreclosure, deed in lieu of
      foreclosure or purchase and is initially recorded at the lower of cost or fair
      market value at the date of acquisition. In order to determine the fair value,
      we obtain an opinion of value from a licensed real estate professional. Costs
      relating to the improvements of the property are capitalized. Holding costs
      are
      charged to expense as incurred. Subsequent to the foreclosure the property
      is
      advertised for rent or sale. Management makes the determination of whether
      to
      hold, rent or to sell the property on a case-by-case basis. Buildings for rental
      property are depreciated over 30.5 years.




***Notes
      Payable***




We
      offer
      several different types of notes payable to our customers. Some notes are sold
      directly to note holders and many are sold through brokers. The Company pays
      brokerage fees which it capitalizes and amortizes into interest expense over
      the
      life of related notes.




***Income
      Taxes***




The
      Company has elected under Subchapter S of the Internal Revenue Code to be
      treated as an S Corporation for tax purposes, and accordingly, items of income
      and loss are taxed to the shareholders. Therefore, no provision for income
      taxes
      is necessary.




***Earnings
      Per Share***




Basic
      earnings per share is derived by dividing net income available to common
      stockholders by the weighted-average number of common shares outstanding and
      does not include the effect of any potentially dilutive common stock
      equivalents. Diluted earnings per share is derived by dividing net income by
      the
      weighted-average number of shares outstanding, adjusted for the dilutive effect
      of outstanding stock options. For this calculation the effect of 361,250 and
      311,250 options have been excluded for 2005 and 2004, respectively, as their
      effect is antidilutive.





**Year
                Ended December 31,****2005**
            
            **2004**Basic:Net
                income (loss) (attributable to common stock)
            
            $
            (44,315
            )
            
            $
            (97,473
            )Average
                common shares outstanding
            
            
            2,505,693
            
            
            
            2,495,311Basic
                earnings per share
            
            $
            (0.02
            )
            
            $
            (0.04
            )Diluted:Net
                income (loss) (attributable to common stock)
            
            $
            (44,315
            )
            
            $
            (97,473
            )Average
                common shares outstanding
            
            
            2,505,693
            
            
            
            2,495,311Dilutive
                effect of stock options
            
            
            -
            
            
            
            -Average
                common shares outstanding - diluted
            
            
            2,505,693
            
            
            
            2,495,311Diluted
                earnings per share
            
            $
            (0.02
            )
            
            $
            $(0.04
            )




***Stock
      Based Compensation***




SFAS
      No.
      123, "Accounting for Stock-Based Compensation", as amended by SFAS No. 148,
      requires that stock-based compensation be accounted for on the fair-value method
      as described in SFAS No. 123, or on the intrinsic value-based method of
      Accounting Principles Board (APB) Opinion No. 25, whereby if options are priced
      at or above the fair value on the date of grant, no compensation expense is
      recognized by the Company as a result of the options. If the intrinsic
      value-based method is used, pro forma net income must be disclosed as if the
      fair value-based method had been applied. The Company continues to account
      for
      its employee stock options in accordance with APB Opinion No. 25.




Fair
      value of options are computed using the Minimum Value Method. A risk-free rate
      of 3.75% and 3.58% was used for 2005 and 2004, respectively, and a 5-year
      expected life of the options was used for both years. Zero volatility was used
      as the Company's shares are not publicly listed or traded. A dividend of $.08
      and $.15 per share per year paid quarterly is assumed for 2005 and 2004,
      respectively.




The
      following table summarizes information and presents the tabular information
      required under FAS 148. The Company is an S Corporation and there is no tax
      effect on the numbers presented in this table.





**Year
                Ended December 31,****2005**
            
            **2004**Net
                loss - as reported
            
            $
            (44,315
            )
            
            $
            (97,473
            )Deduct
                - total stock-based compensation determined under fair value-based
                method
                for all awards
            
            
            (55,046
            )
            
            
            (117,967
            )Pro
                forma net loss
            
            $
            (99,361
            )
            
            $
            (215,440
            )Loss
                per share:Basic
                - as reported
            
            $
            (0.02
            )
            
            $
            (0.04
            )Basic
                - pro forma
            
            $
            (0.04
            )
            
            $
            (0.09
            )Diluted
                - as reported
            
            $
            (0.02
            )
            
            $
            (0.04
            )Diluted
                - pro forma
            
            $
            (0.04
            )
            
            $
            (0.09
            )




***Comprehensive
      Income***




Comprehensive
      income includes all changes in stockholders' equity during a period, except
      those relating to investments by and distributions to stockholders. Our
      comprehensive income consists of net earnings and unrealized gains and losses
      on
      investments available-for-sale. Accumulated other comprehensive income is
      displayed as a separate component of stockholders' equity.




***Statement
      of Cash Flows***




For
      purposes of the statement of cash flows, the Company considers all highly liquid
      debt instruments with maturity of three months or less to be cash
      equivalents.




**NOTE
      B —**  **INVESTMENT
      SECURITIES - AVAILABLE FOR SALE**




Investment
      securities available for sale consists of the following at December
      31:


**2005****Amortized
                  Cost**
              
              **Gross
                  Unrealized Gains**
              
              **Gross
                  Unrealized Losses**
              
              **Estimated
                  Fair Value**Corporate
                  Bonds
              $623,351
              
              $-
              
              $(99,463)
              
              $523,888Other
              74,721
              
              -
              
              -
              
              74,721Totals
              $698,072
              
              $-
              
              $(99,463)
              
              $598,609


**2004****Amortized
                  Cost**
              
              **Gross
                  Unrealized Gains**
              
              **Gross
                  Unrealized Losses**
              
              **Estimated
                  Fair Value**Corporate
                  Bonds
              $632,211
              
              $-
              
              $(8,824)
              
              $623,387Other
              34,861
              
              -
              
              -
              
              34,861Totals
              $667,072
              
              $-
              
              $(8,824)
              
              $658,248




All
      of
      the corporate bonds outstanding at December 31, 2005 mature in between one
      and
      five years.




Securities
      with unrealized losses, segregated by length of impairment at December 31,
      2005
      were as follows:




****
              **Less
                  than**
                **12
                  Months**
                **Estimated**
                **Fair
                  Value**
              ****
              **More
                  than 12 Months Unrealized Losses**
              ****
              **Total
                  Estimated**
                **Fair
                  Value**
              ****
              **Unrealized**
                **Losses**
              ****
              **Estimated**
                **Fair
                  Value**
              ****
              **Unrealized**
                **Losses**Corporate
                  Bonds
              
              $-
              
              $-
              
              $523,888
              
              $99,463
              
              $523,888
              
              $99,463Other
              
              -
              
              -
              
              -
              
              -
              
              -
              
              -Totals
              
              $-
              
              $-
              
              $523,888
              
              $99,463
              
              $523,888
              
              $99,463




Declines
      in the fair value of available-for-sale securities below their cost are not
      deemed to be other than temporary. In estimating other-than-temporary impairment
      losses, management considers, among other things, (i) the length of time and
      the
      extent to which the fair value has been less than cost, (ii) the financial
      condition and near-term prospects of the issuer, and (iii) the intent and
      ability of the Company to retain its investment in the issuer for a period
      of
      time sufficient to allow for any anticipated recovery in fair
      value.




Information
      related to the sale of marketable securities during the years ended December
      31,
      2005 and 2004 is as follows:





**2005**
            
            **2004**Gross
                Proceeds
            
            $
            -
            
            
            $
            2,484,950Gross
                Gains
            
            $
            -
            
            
            $
            21,795Gross
                Losses
            
            $
            -
            
            
            $
            (3,219
            )




**NOTE
      C —**  **OTHER
      INVESTMENTS**




The
      Company has invested excess funds in several development stage companies.
      Because the Company maintains a minority position in these investments and
      cannot exert control the investments are accounted for under the cost method
      of
      accounting whereby only cash transactions effect the carrying value. There
      is no
      readily determinable market value for these investments. Management periodically
      reviews their status to determine if there has been any impairment to their
      value.




During
      2005, the Company determined that one of these investments was worthless and
      recognized an impairment loss of $50,000. There was a partial-redemption in
      the
      other investment, the only one remaining at December 31, 2005, in the amount
      of
      $58,000.




In
      2004,
      one of the company's investments was considered worthless. This investment
      was
      written-off, creating an impairment loss of $33,000. The carrying value of
      Other
      Investments was $50,872 and $158,872 at December 31, 2005 and 2004,
      respectively.




**NOTE
      D —**  **LOANS
      RECEIVABLE**




Loans
      receivable consist of 244 collateralized loans and 9 uncollateralized loans
      for
      2005 and 204 collateralized loans and 7 uncollateralized loans for 2004. The
      loans receivable originate from various individuals and businesses ranging
      in
      balance from $501 to $2,600,000 for 2005 and $501 to $993,999 for 2004, bearing
      interest rates ranging from 1.5 percent to 24 percent in 2005 and from 3 percent
      to 24 percent in 2004, with a weighted-average yield of 10.66 percent and 10.89
      percent, respectively. Uncollateralized loans constitute approximately 0.8
      percent and 0.7 percent of the gross loan value at December 31, 2005 and 2004,
      respectively.




Loan
      origination fees received from borrowers are deferred and amortized into
      interest income over the estimated average life of the loans under a method
      which approximates the effective interest rate method. The unamortized loan
      origination fees, which are included as a reduction to loans receivable balance,
      were $154,530 and $120,207 at December 31, 2005 and 2004,
      respectively.




The
      Company pays fees to third parties in connection with the acquisition of loans.
      These costs are amortized against interest income over the estimated average
      life of the loans under a method which approximates the effective interest
      rate
      method. The costs which were unamortized were $164,774 and $6,413 at December
      31, 2005 and 2004, respectively.




The
      Company incurs direct loan origination costs in its lending activities. These
      costs are capitalized and amortized against interest income over the estimated
      average life of the loans under a method which approximates the effective
      interest rate method. Unamortized direct loan origination costs were $27,934
      at
      December 31, 2005. No such unamortized costs existed at December 31,
      2004.




- -
 
 **KH
            Funding Company**
  Notes
            to
            Financial Statements
 *For
            the Years Ended December 31, 2005 and 2004*


***Loans
      Receivable by Collateral Type***




The
      Company's loans receivable portfolio consists of the following by type of loans
      at December 31:





**2005**
            
            **2004****Primary
                Collateral Type**
            
            **Amount**
            
            **Amount**Residential
                Real Estate First Trust
            
            $
            6,801,400
            
            
            $
            4,251,283Business
                Assets and Commercial Real Estate First Trust
            
            
            5,159,408
            
            
            
            4,424,112Residential
                Investment Property First Trust
            
            
            24,557,184
            
            
            
            9,543,663Residential
                Real Estate Second Trust
            
            
            2,103,760
            
            
            
            1,116,984Other
                Assets (Auto, Stock)
            
            
            2,035,215
            
            
            
            1,013,265Other
                Loans
            
            
            441,843
            
            
            
            150,870Total
                loans receivable, gross
            
            
            41,098,810
            
            
            
            20,500,177Unearned
                fees and other
            
            
            (50,078
            )
            
            
            (122,068
            )Less
                allowance for loan losses
            
            
            (369,791
            )
            
            
            (233,311
            )Total
                loans receivable, net
            
            $
            40,678,941
            
            
            $
            20,144,798




Maturities
      as of December 31, 2005, are as follows:





**Year
                Ending December 31,**2006
            
            $
            23,653,6332007
            
            
            2,794,0522008
            
            
            1,152,7632009
            
            
            931,3252010
            
            
            4,271,4622011
                and thereafter
            
            
            8,295,575Total
                loans receivable, gross
            
            $
            41,098,810




The
      fair
      value of the gross loans receivable is estimated to be $40,998,847 and
      $20,457,162 at December 31, 2005 and 2004, respectively. These estimates are
      based on discounted cash flows using the year end average interest for loans,
      assuming a mid-year pay-off of such loan in the year due.




Analysis
      of the allowance for loan loss is as follows:





**Year****Ending
                December 31,**
            
            **2005**
            
            **2004**Beginning
                balance
            
            $
            233,311
            
            
            $
            211,000Provision
                for loan losses
            
            
            251,048
            
            
            
            266,700Loans
                charged off
            
            
            (121,068
            )
            
            
            (249,189
            )Recovery
                of loans previously charged off
            
            
            6,500
            
            
            
            4,800Ending
                balance
            
            $
            369,791
            
            
            $
            233,311




Loans
      in
      non-accrual status totaled $836,390 and $583,351 at December 31, 2005 and 2004,
      respectively.




As
      of
      December 31, 2005 and 2004, the Company had loans of $1,625,356 and $2,109,236,
      respectively, which were more than ninety days late and for which the Company
      continues to accrue interest. The Company has collateral for these loans and
      management believes that both the principal and the related accrued interest
      is
      collectible.




**Analysis
      of****Loan
      Loss Reserves**





**12/31/05**
            
            **12/31/04**Total
                recorded investment in impaired loans at the end of the
                period
            
            $
            836,390
            
            
            $
            583,351Amount
                of that recorded investment for which there is a related allowance
                for
                credit losses
            
            $
            836,390
            
            
            $
            516,126Amount
                of related allowance for credit losses associated with such
                investment
            
            $
            228,493
            
            
            $
            175,117Amount
                of that recorded investment for which there is no related allowance
                for
                credit losses
            
            $
            -
            
            
            $
            67,225**12/31/05**
            
            **12/31/04**The
                average recorded investment in impaired loans during the
                period
            
            $
            709,871
            
            
            $
            512,412The
                related amount of interest income recognized within that period when
                the
                loans were impaired
            
            $
            -
            
            
            $
            -The
                amount of income recognized using a cash basis during the time within
                that
                period that the loan was impaired
            
            $
            -
            
            
            $
            -




At
      December 31, 2005 the Company had outstanding loan balances to one borrower
      and
      its affiliated entities of $2,978,000 which represented 7.35% of loans
      outstanding at that date. Management believes that this concentration is
      adequately collateralized with first deeds of trust on related real
      estate.




**NOTE
      E —**  **PROPERTY
      AND EQUIPMENT**




Property
      and equipment consists of the following as of December 31:





**2005**
            
            **2004**Furniture
                and equipment
            
            $
            82,302
            
            
            $
            53,025Automobiles
            
            
            27,074
            
            
            
            27,074Computer
                software
            
            
            80,642
            
            
            
            73,266Leasehold
                improvements
            
            
            18,813
            
            
            
            -0
            -208,831
            
            
            
            153,365Less:
                Accumulated depreciation
            
            
            71,208
            
            
            
            119,610Property
                and equipment - net
            
            $
            137,623
            
            
            $
            33,755




Depreciation
      expense related to property and equipment for the years ended December 31,
      2005
      and 2004, totaled $25,848 and $21,050, respectively.




**NOTE
      F —**  **REAL
      ESTATE OWNED**




Real
      estate
      owned currently consists of rental and held for sale real estate.





**2005**
            
            **2004**Rental
                property:Buildings
            
            $
            625,301
            
            
            $
            668,087Less:
                Accumulated Depreciation
            
            
            70,538
            
            
            
            61,864554,763
            
            
            $
            606,223Land-rental
                property
            
            
            67,750
            
            
            
            103,750Total
                rental
            
            $
            622,513
            
            
            $
            709,973Held
                for Sale:Buildings
            
            $
            155,302
            
            
            $
            -0
            -Land-held
                for sale
            
            
            25,000
            
            
            
            -0
            -Total
                held for sale
            
            $
            180,302
            
            
            $
            -0
            -




Depreciation
      expense related to rental property for the years ended December 31, 2005 and
      2004, totaled $24,539 and $25,201, respectively.




**NOTE
      G —**  **NOTES
      PAYABLE, INTEREST EXPENSE AND TYPES OF NOTES**




Information
      related to notes payable at December 31, 2005 and 2004 is as
      follows:





**2005**
            
            **2004**Number
                of notes payable
            
            
            1,310
            
            
            
            518Highest
                balance
            
            $
            3,589,022
            
            
            $
            1,355,265Lowest
                balance
            
            $
            2
            
            
            $
            102Lowest
                interest rate
            
            
            4.00
            %
            
            
            4.00
            %Highest
                interest rate
            
            
            9.25
            %
            
            
            9.85
            %Weighted
                average interest rate
            
            
            6.05
            %
            
            
            5.69
            %Number
                of accounts greater than $100,000
            
            
            104
            
            
            
            52Value
                of accounts over $100,000
            
            $
            27,960,681
            
            
            $
            16,153,262




The
      carrying values of the notes payable approximate their fair value.





**Year
                Ending December 31,**2006
            
            $
            38,504,2772007
            
            
            3,979,2562008
            
            
            3,137,9622009
            
            
            1,786,6242010
            
            
            2,345,0552011
            
            
            55,582Subtotal
            
            $
            49,808,756Unamortized
                brokerage costs
            
            
            127,421Total
                Notes and accrued interest payable
            
            $
            49,681,335




The
      maturity date is considered to be the date on which the note first becomes
      a
      demand note. Included in the due in 2006 category is $10,108,628 on one-day
      demand accounts, which the creditor can immediately withdraw and $14,060,673
      that requires a 30-day notice before withdrawal can be made.





- -
 
 **KH
            Funding Company**
  Notes
            to
            Financial Statements
 *For
            the Years Ended December 31, 2005 and 2004*




The
      Company has three classes of notes payable, Series II, III and IV notes. Series
      II notes were sold in private offerings by the Company from inception through
      November 2, 2003. On November 3, 2003 the Company registered a Public Offering
      with the Securities and Exchange Commission. Subsequent to the November 3,
      2003
      offering the Company registered secondary Public Offerings with the Securities
      and Exchange Commission on August 2, 2004 and July 15, 2005. The Series III
      and
      IV notes were sold under the public offerings. The Series III notes are senior
      to all other debt of the company and are secured with a priority lien on the
      assets of the Company. The Series IV notes join the Series II notes in right
      of
      payment and both are subordinate to senior debt of the Company.




As
      of
      December 31, 2005, notes payable outstanding by class of securities is as
      follows:





Series
                II
            Privately
                issued subordinated debt
            
            $
            4,468,645Series
                III
            Publicly
                issued senior debt
            
            
            39,425,659Series
                IV
            Publicly
                issued subordinated debt
            
            
            5,914,452Subtotal
            
            
            
            49,808,756Unamortized
                brokerage costs
            
            
            
            (127,421
            )Total
                Notes and accrued interest payable
            
            
            $
            49,681,335




The
      Company's notes are sold directly to note holders and also through brokers.
      For
      those notes sold through brokers the Company pays brokerage fees which it
      capitalizes and amortizes into interest expense over the life of the related
      notes. The unamortized brokerage costs were $127,421 and $50,051 at December
      31,
      2005 and 2004, respectively.




For
      the
      year ended December 31, 2005 and 2004, interest expense totaled $2,290,136
      and
      $1,224,076, respectively, and interest paid totaled $916,466 and $619,992,
      respectively.




**NOTE
      H —**  **RELATED
      PARTY TRANSACTIONS**




The
      following related party transactions exist as of the dates shown
      below:





Included
            in loans receivable at December 31, 2005 and 2004, are eleven notes and
            eight
            notes totaling $4,274,751 and $1,833,611, respectively, from officers
            and
            shareholders.
        Included
            in the notes payable at December 31, 2005 and 2004, are 59 and 52 notes
            totaling $5,935,165 and $5,389,637, respectively, which are held by officers
            and shareholders.
        There
            is a loan of $185,450, shown in the equity section of the Balance Sheet
            as a
            contra-equity, made to the Company's CEO for the purchase of 100,000
            shares of
            stock in the Company. The interest rate on this loan is seven percent.
            The
            stock has a book value of about $38,000 as of December 31, 2005. At December
            31, 2005, there was no accrued interest receivable on this
            loan.


All
      of
      the above transactions were consummated on substantially the same terms,
      including interest rates and collateral, as those prevailing for comparable
      transactions with other customers.




**NOTE
      I —**  **WARRANTS,
      OPTIONS AND OTHER STOCK ISSUED**




***Stock
      Option Plans***




The
      Company has granted stock options to employees, shareholders and board members.
      All options granted vest on the day they are granted. All options granted to
      date are non-statutory options. The Company has the following stock options
      outstanding:




*Other
      Stock Options* .
      During
      fiscal year 1999 the Company granted options to purchase 201,250 shares of
      common stock at $2.00 per share. These options expired in 2004. During fiscal
      year 2000, the Company granted options to purchase 50,000 shares of common
      stock
      at $2.00 per share in connection with the issuance of a note payable. These
      options were exercised in 2005. During fiscal year 2004, 20,000 options at
      $1.00
      per share were exercised. During 2004, the Company granted options to purchase
      161,250 shares of common stock at $2.00 per share. During 2005, the Company
      granted options to purchase 100,000 shares of common stock at $2.25 per share.
      The following depicts option activity for the years ended December 31, 2005
      and
      2004:





**Number
                of**
              **Shares**
            
            **Weighted-Average**
              **Exercise
                Price**
            **Range**Options
                outstanding at end of year-2003
            
            
            371,250
            
            
            $
            1.96
            
            
            $
            1.00-2.00Options
                granted-2004
            
            
            161,250
            
            
            
            2.00
            
            
            
            2.00Options
                expired-2004
            
            
            (201,250
            )
            
            
            2.00
            
            
            
            2.00Options
                exercised-2004
            
            
            (20,000
            )
            
            
            1.00
            
            
            
            1.00Options
                outstanding at end of year-2004
            
            
            311,250
            
            
            
            2.00
            
            
            
            2.00Options
                granted-2005
            
            
            100,000
            
            
            
            2.25
            
            
            
            2.25Options
                expired-2005
            
            
            -
            
            
            
            -
            
            
            
            -Options
                exercised-2005
            
            
            (50,000
            )
            
            
            2.00
            
            
            
            2.00Options
                outstanding at end of year-2005
            
            
            361,250
            
            
            $
            2.07
            
            
            $
            2.00-2.25





At
      December 31, 2005 all of the Company's outstanding options were exercisable.
      The
      weighted average exercise price of these options is $2.07 and the weighted
      average remaining contractual life in years is 3.27. All of the options
      outstanding were granted outside of any Stock Option Plan of the
      Company.




**NOTE
      J —**  **COMMITMENTS
      AND CONTINGENCIES**




***Lease
      Commitment***




In
      October 2005, the Company expanded office facilities to approximately twice
      the
      original size. A new 10-year lease was signed at that time which will expire
      October 31, 2015. The following is a schedule by years of approximate future
      minimum payments under the lease as of December 31, 2005:





**Year
                Ending December 31,**2006
            
            $
            94,6962007
            
            
            98,4882008
            
            
            102,4262009
            
            
            106,5222010
            
            
            110,784Thereafter
            
            
            600,810Total
            
            $
            1,113,726




Rent
      expense under operating leases totaled $53,327 and $43,001 for the years ended
      December 31, 2005 and 2004, respectively.




**NOTE
      K —**  **LOAN
      PARTICIPATION**




At
      December 31, 2005, there were no active participation loans. The December 31,
      2004 participation loan balance of $207,009 was paid-off in total during
      2005.




**NOTE
      L —**  **TRUST
      ACTIVITIES**




The
      Company became a trustee of IRA accounts in February 2003. The IRA accounts
      are
      self-directed. A portion of the assets under the trust have been invested in
      notes payable of the Company. As a trustee, the Company is subject to Section
      1.408-2(e) of the Internal Revenue Code and is subject to reviews by IRS
      examiners. No such review occurred in 2004. We underwent a review in 2005 and
      are not aware of any issues resulting from such review.





**Year****Ending
                December 31,**
            
            **2005**
            
            **2004**Total
                Assets under Trust
            
            $
            5,417,337
            
            
            $
            2,242,256Portion
                of Assets Invested in KH Funding Notes Payable
            
            $
            5,342,337
            
            
            $
            2,024,117Portion
                of Assets Invested in Outside Investments
            
            $
            75,000
            
            
            $
            218,139




**NOTE
      M —**  **RECENT
      ACCOUNTING PRONOUNCEMENTS**




In
      November 2005, the Financial Accounting Standards Board ("FASB") issued FASB
      Staff Position (FSP) 115-1, *The
      Meaning of Other-Than-Temporary Impairment and Its Application to Certain
      Investments* .
      This
      FSP provides additional guidance on when an investment in a debt or equity
      security should be considered impaired and when that impairment should be
      considered other-than-temporary and recognized as a loss in earnings.
      Specifically, the guidance clarifies that an investor should recognize an
      impairment loss no later than when the impairment is deemed
      other-than-temporary, even if a decision to sell has not been made. The FSP
      also
      requires certain disclosures about unrealized losses that have not been
      recognized as other-than-temporary impairments. Management applied the guidance
      in this FSP in 2005.




In
      May
      2005, the FASB issued Statement of Financial Accounting Standard ("SFAS") No.
      154, *Accounting
      Changes and Error Corrections* ,
      which
      changes the accounting for and reporting of a change in accounting principle.
      This statement applies to all voluntary changes in accounting principles and
      changes required by an accounting pronouncement in the unusual instance that
      the
      pronouncement does not include specific transition provisions. This statement
      requires retrospective application to prior period financial statements of
      changes in accounting principle, unless it is impractical to determine either
      the period-specific or cumulative effects of the change. SFAS 154 is effective
      for accounting changes made in fiscal years beginning after December 15, 2005.
      The adoption of this standard is not expected to have a material effect on
      financial condition, results of operations, or liquidity.




In
      December 2004, the FASB issued SFAS 153, *Exchanges
      of Nonmonetary Assets* ,
      an
      amendment of APB Opinion No. 29, *Accounting
      for Nonmonetary Transactions* .
      This
      statement amend the principle that exchanges of nonmonetary assets should be
      measured based on the fair value of the assets exchanged and more broadly
      provides for exceptions regarding exchanges of nonmonetary assets that do not
      have commercial substance. This statement is effective for nonmonetary asset
      exchanges occurring in fiscal periods beginning after June 15, 2005. The
      adoption of this standard is not expected to have a material impact on financial
      condition, results of operations or liquidity.




In
      December 2004, the FASB revised SFAS 123, *Accounting
      for Stock-Based Compensation* .
      SFAS
      123R establishes accounting requirements for share-based compensation to
      employees and carries forward prior guidance on accounting for awards to
      non-employees. In 2005, the FASB issued further guidance on the classification
      and measurement of freestanding financial instruments originally issued for
      employee service and the application of grant date as defined in SFAS 123R.
      The
      Company will be required to adopt this statement on January 1, 2006. The impact
      of SFAS 123R on the Company in 2006 and beyond will depend on various factors,
      among them being the Company's future compensation strategy. As of December
      31,
      2005, all of the Company's options are vested, having been earned by
      employees.




In
      December 2003, the American Institute of Certified Public Accountants issued
      Statement of Position (SOP) 03-3, *Accounting
      for Certain Loans or Debt Securities Acquired in a Transfer* .
      SOP
      03-3 requires acquired loans, including debt securities, to be recorded at
      the
      amount of the purchaser's initial investment and prohibits carrying over
      valuation allowances from the seller for those individually evaluated loans
      that
      have evidence of deterioration in credit quality since origination, and it
      is
      probable all contractual cash flows on the loan will be unable to be collected.
      SOP 03-3 also requires the excess of all undiscounted cash flows expected to
      be
      collected at acquisition over the purchaser's initial investment to be
      recognized as interest income on a level-yield basis over the life of the loan.
      Subsequent increases in cash flows expected to be collected are recognized
      prospectively through an adjustment of the loan's yield over its remaining
      life,
      while subsequent decreases are recognized as impairment. Loans carried at fair
      value, mortgage loans held for sale, and loans to borrowers in good standing
      under revolving credit agreements are excluded from the scope of SOP 03-3.
      The
      Company adopted the provisions of SOP 03-3 effective January 1, 2005. The
      adoption of this standard did not have a material impact on financial condition,
      results of operation or liquidity.




**ITEM
      8.**  **CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**




None.




**ITEM
      8A.**  **CONTROLS
      AND PROCEDURES**






*Evaluation
      of Disclosure Controls and Procedures* .
      The
      Company's management is responsible for establishing and maintaining a system
      of
      disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)
      under the Exchange Act) that is designed to ensure that information required
      to
      be disclosed by the Company in the reports that the Company files or submits
      under the Exchange Act is recorded, processed, summarized and reported, within
      the time periods specified in the Commission's rules and forms. Disclosure
      controls and procedures include, without limitation, controls and procedures
      designed to ensure that information required to be disclosed by an issuer in
      the
      reports that it files or submits under the Securities Exchange Act of 1934
      (the
      "Exchange Act") is accumulated and communicated to the issuer's management,
      including its principal executive officer or officers and principal financial
      officer or officers, or persons performing similar functions, as appropriate
      to
      allow timely decisions regarding required disclosure.




Management
      identified a material weakness in our internal control over financial reporting
      related to the accounting for other real estate owned as to valuation and
      operating expenses. This control deficiency resulted in an audit adjustment
      of
      $59,690 to the 2005 financial statements prior to their public release.
      Management believes that the financial statements included in this report fairly
      present in all material respects our financial condition, results of operations
      and cash flows for the periods presented. Additionally, management has initiated
      a plan to improve its controls and procedures over financial reporting which
      includes an internal review process as well as a complete review of accounting
      for other real estate.




Our
      Chief
      Executive Officer and Chief Financial Officer have evaluated the effectiveness
      of the design and operation of our disclosure controls and procedures in
      accordance with Rule 15d-15 of the Exchange Act. Based on their evaluation,
      the
      Chief Executive Officer and Chief Financial Officer concluded that, as of the
      end of the period covered by this report, our disclosure controls and procedures
      were effective to provide reasonable assurance that information required to
      be
      disclosed in the Company's reports filed or submitted under the Exchange Act
      is
      recorded, processed, summarized and reported in a timely manner the information
      required to be disclosed in reports we file under the Exchange Act.




*Changes
      in Internal Controls* .
      No
      change in our internal control over financial reporting occurred during our
      fourth quarter of 2005 that has materially affected, or is reasonably likely
      to
      materially affect, our internal control over financial reporting.




*Limitations
      on the Effectiveness of Controls* .
      KH
      Funding's management, including the Chief Executive Officer and Chief Financial
      Officer, does not expect that its disclosure or internal controls will prevent
      all errors or fraud. A control system, no matter how well conceived and
      operated, can provide only reasonable, not absolute, assurance that the
      objectives of the control system are met. Further, the design of a control
      system must reflect the fact that there are resource constraints, and the
      benefits of controls must be considered relative to their costs. Because of
      the
      inherent limitations in a cost-effective control system, misstatements due
      to
      error or fraud may occur and not be detected.




**ITEM
      8B.**  **OTHER
      INFORMATION**




None.





- -
 
 **KH
            Funding Company**
  Notes
            to
            Financial Statements
 *For
            the Years Ended December 31, 2005 and 2004*




**PART
      III**




**ITEM
      9.**  **DIRECTORS,
      EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION
      16(A)
      OF THE EXCHANGE ACT**




*Directors
      and Executive Officers* .
      The
      following is the name, age and position of each of our current directors and
      executive officers as of December 31, 2005:





**Name**
            
            **Age**
            
            **Position(s)**Robert
                L. Harris
            
            56
            
            Chief
                Executive Officer, President and DirectorLouise
                B. Sehman
            
            71
            
            Chief
                Financial Officer, Secretary and TreasurerJames
                E. Parker
            
            57
            
            Vice
                President - Investors RelationsRonald
                L. Nicholson
            
            51
            
            Vice
                President - Accounts and Loan AdministrationMartin
                Angeli
            
            42
            
            Senior
                Vice President - SalesJin
                S. Kim
            
            57
            
            DirectorJack
                H. Breskow*
            
            76
            
            DirectorDr.
                Mervyn Feldman*
            
            71
            
            DirectorSolomon
                Kaspi
            
            38
            
            DirectorAlvin
                Shapiro*
            
            74
            
            DirectorJeremiah
                P. Connor*
            
            66
            
            Director





*  Asterisks
      denote individuals who we believe are "independent directors" as that term
      is
      defined by the listing standards of the American Stock Exchange.




Robert
      L.
      Harris, age 56, was a founder of KH Funding Company in 1990 when he also began
      his service as Managing General Partner and then President. He has been the
      President, Chief Executive Officer and a director of KH Funding since its
      incorporation in 1994. Prior to founding KH Funding, Mr. Harris owned and
      operated businesses and managed commercial and corporate real estate for various
      firms in Maryland. He attended the Citadel Military College and Montgomery
      College.




Louise
      B.
      Sehman, age 71, joined KH Funding Company in 1992. She currently serves as
      the
      Chief Financial Officer, Secretary and Treasurer of KH Funding. Ms. Sehman
      was a
      payroll supervisor for a convenience store chain before joining us. She attended
      the University of Maryland. Ms. Sehman retired as Chief Financial Officer and
      Treasurer effective March 31, 2006.




James
      E.
      Parker, age 57, joined KH Funding Company in 1997. He currently serves as the
      Vice President of Investor Relations and Trust Services. Mr. Parker was an
      assistant controller of a lumber and supply company before joining us. He earned
      a Bachelor of Science from the University of Maryland. Mr. Parker became Chief
      Financial Officer effective upon the retirement of Ms. Sehman.




Ronald
      L.
      Nicholson, age 51, joined KH Funding Company in 1996. He currently serves as
      the
      Vice President of Accounts and Loan Administration.




Martin
      Angeli, age 42, joined KH Funding Company in 2003. He currently serves as the
      Senior Vice President of National Sales and Broker Dealer relationships. Mr.
      Angeli has been licensed since 1989 and has extensive experience as an NASD
      registered representative. He has previously held positions as Vice President
      at
      State Bond & Mortgage, Senior Vice President at Smith Barney and Vice
      President at Oppenheimer & Co. and Merrill Lynch. He attended Simon Bolivar
      and Metropolitan University in Caracas, Venezuela where he earned a Bachelor
      in
      Business Administration.




Jin
      S.
      Kim, age 57, has served as a director of KH Funding Company since its
      incorporation in 1994. Ms. Kim was also a founder of KH Funding. Ms. Kim
      has owned and managed investment real estate since 1981. She is licensed as
      a
      real estate appraiser in Maryland. Ms. Kim resigned as a director on March
      24,
      2006.




Jack
      H.
      Breskow, age 76, has served as a director of KH Funding Company since its
      incorporation in 1994. Mr. Breskow is an executive officer of Jack H. Breskow
      and Associates, Ltd., which provides business, estate and financial planning
      services to its clients. He is a Certified Life Underwriter and Accredited
      Estate Planner.




Dr.
      Mervyn Feldman, age 71, has served as a director of KH Funding Company since
      1998. Dr. Feldman maintains an active medical practice specializing in podiatry.
      He attended Wilson Teachers College and the Pennsylvania College of Podiatric
      Medicine.




Solomon
      Kaspi, age 39, has served as a director of KH Funding Company since 2004. Mr.
      Kaspi is a mortgage and finance professional, and has been since 1990. Mr.
      Kaspi
      graduated from the University of Maryland. Mr. Kaspi resigned as a director
      on
      March 24, 2006.




Alvin
      Shapiro, age 74, has served as a director of KH Funding Company since 2004.
      Mr.
      Shapiro is president of an actuarial firm which specializes in small business
      pension plans. Mr. Shapiro is a stockbroker, has his Series 6 license and has
      insurance industry designations of CLU and CHFC. Mr. Shapiro has a MBA from
      John
      Hopkins University and a Bachelors of Science in Finance from American
      College.




Jeremiah
      P. Connor, age 66, has served as a director of KH Funding Company since 2004.
      Mr. Connor is currently a partner of Connor & Assoc. CPA's, P.C. Mr. Connor
      is a Certified Public Accountant with over 35 years of accounting experience.
      Mr. Connor is a distinguished member of state and national CPA organizations.
      He
      graduated with a Bachelor of Commercial Science from Benjamin Franklin
      University.




We
      do not
      have employment agreements with any of our employees. We do not maintain
      director and officer insurance.




*Board
      of Directors* .
      At
      December 31, 2005, we had seven members of our Board of Directors, who are
      elected to annual terms and until their successors are elected and qualified.
      Executive officers are appointed by the Board of Directors on an annual basis
      and serve until their successors have been duly elected and qualified. There
      are
      no family relationships among any of our directors, officers or key employees.




*Committee
      of the Board* .
      The
      Board of Directors has established one standing committee to assist it in
      carrying out its responsibilities, namely the Audit Committee. It is the Board's
      plan to appoint both a Nominations Committee and a Compensation Committee in
      the
      near future. As of the Record Date the composition and other information
      regarding the Board's committee was as follows:




*Audit
      Committee* .


Number
                of Members:
            ThreeMembers:
            Jeremiah
                Connor - Chairman, Alvin Shapiro and Robert L. Harris
              
              We
                believe that Messrs. Connor and Shapiro are each an "independent
                director"
                as that term is defined by the listing standards of The American
                Stock
                Exchange. In addition, Messrs. Connor and Shapiro are each an "audit
                committee financial expert" as that term is defined in Item 401 of
                Regulation S-B and by the listing standards of The American Stock
                Exchange.Number
                of Meetings in 2004:
            FourFunctions:
            Recommends
                to the Board the independent accountants each year and approves the
                compensation and terms of their engagement
              Examines
                the scope and extent of the audit conducted by the independent public
                accountants and to advise the Board with respect thereto
              Reviews
                the recommendations of the independent public accountants with respect
                to
                accounting methods and internal controls, and to advise the Board
                with
              respect
                thereto
              Reviews
                the annual audit report of our independent accountants and reports
                of
                examinations by our regulatory agencies
              Performs
                such other functions and responsibilities as may be assigned by the
                BoardCharter
            The
                Audit Committee operates pursuant to a charter that was adopted by
                the
                Board in March 2004.




*Audit
      Committee Financial Expert* .
      Rules
      adopted by the Securities and Exchange Commission (the "SEC") require that
      we
      disclose whether our Board of Directors has determined that our Audit Committee
      includes a member who qualifies as an "audit committee financial expert" as
      that
      term is defined in the SEC's rules. To qualify as an audit committee financial
      expert under the SEC's rules, a person must have a relatively high level of
      accounting and financial knowledge or expertise which he or she has acquired
      through specialized education or training or through experience in certain
      types
      of positions. The Board of Directors has determined that Messrs. Connor and
      Shapiro are each an "audit committee financial expert" as that term is defined
      in Item 401 of Regulation S-B and by the listing standards of the American
      Stock
      Exchange. Both Messrs. Connor and Shapiro satisfy the independence requirements
      of the American Stock Exchange.




*Code
      of Ethics* .
      Our
      Board of Directors has adopted a Code of Ethics that applies to our directors
      and to all our executive officers, including without limitation our principal
      executive officer and principal financial officer. A copy of our Code of Ethics
      is posted on our website, www.khfunding.com. In addition, a copy will be
      provided without charge to any person upon request. Requests for copies of
      our
      Code of Ethics should be sent by mail to Corporate Secretary at KH Funding,
      10801 Lockwood Drive, Suite 370, Silver Spring, Maryland 20901, or by telephone
      to (301) 592-8100.




**ITEM
      10.**  **EXECUTIVE
      COMPENSATION**




***Summary
      Compensation***




The
      following table sets forth the compensation earned during the fiscal years
      ended
      December 31, 2005, 2004 and 2003 by our Chief Executive Officer and each of
      our
      other executive officers whose combined salary and bonus exceeded $100,000
      during those years. We may refer to these officers as our named executive
      officers elsewhere herein. Other than the Chief Executive Officer, no named
      executive officer earned a total annual salary and bonus in excess of $100,000
      during the last three completed fiscal years, therefore, the following table
      sets forth the certain compensation paid by us, including salary, bonus and
      certain other compensation to our Chief Executive Officer for fiscal years
      ended
      December 31, 2005, 2004 and 2003.


**Long-Term****Compensation****Annual****Compensation**
              **Awards**
              **Payouts****Name
                  and**
                **Principal
                  Position**
              **Year**
              **Salary($)**
              **Bonus($)**
              **Other
                  Annual Compensation($)**
              **Restricted
                  Stock($)**
              **Securities
                  Underlying Options/ SARs($)**
              **LTIP
                  Pay-outs ($)**
              **All
                  Other Compensation**Robert
                  L. Harris,
                CEO/President
              2005
              $
                  118,454
              $1,191
              $-
              $-
              $-
              $-
              $-2004
              118,000
              -
              -
              -
              150,000
              -
              -2003
              125,020
              3,692
              -
              -
              -
              -
              -





***Option
      Grants in Last Fiscal Year***




The
      following table contains information concerning the grant of stock options
      approved by our Board of Directors to the named executive officers in the
      Summary Compensation table above during the fiscal year ended December 31,
      2005.





**Name**
            **Number
                of Securities Underlying Options Granted (#)**
            **%
                of Total Options**
              **Granted
                to Employees in Fiscal Year**
            **Exercise
                or**
              **Base
                Price**
              **($/Sh)**
            **Expiration**
              **Date**Robert
                L. Harris
            -0-
            -
            -
            -




***Aggregated
      Option Exercises in Last Fiscal Year and FY-End Option
      Values***




The
      following table sets forth information with respect to the named executive
      officers in the Summary Compensation table above concerning the exercisability
      of options during the fiscal year ended December 31, 2005 and exercisable and
      unexercisable stock options held as of the end of fiscal year December 31,
      2005.
      None of our named executive officers exercised options in the last fiscal year.
      The table below outlines the value, as of December 31, 2005, of options granted
      to our Chief Executive Officer to date that remain exercisable.





**Number
                of Securities Underlying**
              **Unexercised
                Options at FY-End (#)**
            **Value
                of Unexercised In-the-Money**
              **Options
                at FY-End ($)****Name**
            **Shares
                Acquired on Exercise**
            **Value**
              **Realized
                ($)**
            **Exercisable/**
              **Unexercisable**
            **Exercisable/**
              **Unexercisable**Robert
                L. Harris
            -
            -
            250,000/0
            $500,000/0




***Director
      Compensation***




Directors
      received a maximum of either (i) $200 or (ii) an outright grant of 100 shares
      of
      the Company's Common Stock, for each Board meeting attended. No additional
      fees
      are paid for attendance at any Committee meetings.




**ITEM
      11.**  **SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, DIRECTORS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS**




The
      following table sets forth information with respect to the beneficial ownership
      of our Common Stock as of March 15, 2006 for:





each
            person who we know owns beneficially more than 5% of our Common Stock,
        each
            executive officer,
        each
            of
            our directors, and
        all
            of
            our executive officers and directors as a group.


The
      number of shares beneficially owned by each stockholder is determined under
      rules promulgated by the SEC. The information does not necessarily indicate
      beneficial ownership for any other purpose. Under these rules, the number of
      shares of Common Stock deemed outstanding includes shares issuable upon exercise
      of options held by the respective person or group which may be exercised within
      60 days after March 15, 2006. Further, such beneficial ownership includes
      securities owned by or for the spouse, children or certain other relatives
      of
      such person as well as other securities as to which the person has or shares
      voting or investment power. The same shares may be beneficially owned by more
      than one person. Beneficial ownership may be disclaimed as to certain of the
      securities.




Our
      Common Stock is privately held and there is no public trading market for our
      Common Stock. All addresses for the executive officers and directors are KH
      Funding's address at 10801 Lockwood Drive, Suite 370, Silver Spring, Maryland
      20901.





**Name
                and Position**
            **Number
                of Shares(1)**
            
            **Percent
                of Class**Robert
                L. Harris, President, CEO and Director
            715,000
            (1)
            
            25.5
            %Jack
                H. Breskow, Director
            39,700
            (2)
            
            1.4
            %Jeremiah
                P. Connor, Director
            0
            
            
            0.0
            %Dr.
                Mervyn Feldman, Director
            97,478
            (3)
            
            3.5
            %Solomon
                Kaspi, Director
            500,500
            
            
            17.8
            %Jin
                S. Kim, Director
            516,700
            
            
            18.4
            %Alvin
                Shapiro, Director
            600
            
            
            0.0
            %All
                Directors and Executive Officers as a Group (7 persons)
            1,869,978
            (4)
            
            66.6
            %




(1)  Includes
      (i) 465,000 shares of Common Stock held directly (100,000 shares of which secure
      a loan receivable of $185,450 owed to KH Funding) and (ii) options to purchase
      250,000 shares of Common Stock, which are exercisable currently or within 60
      days of the table date.


(2)  Includes
      37,500 shares of Common Stock held by his wife, Eufrosene Breskow.


(3)  Includes
      95,778 shares of Common Stock held with his wife, Harriet Feldman, as tenants
      by
      the entirety.


(4)  Includes
      options to purchase 250,000 shares of Common Stock, which are exercisable
      currently or within 60 days of the table date.




**ITEM
      12.**  **CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS**




The
      following are brief descriptions of transactions between us and any of our
      directors, executive officers or stockholders known to us to own beneficially
      more than 5% of our shares, or any member of the immediate family of any of
      those persons, or other entities in which such persons beneficially own more
      than 5%.




KH
      Funding had related party notes held by us and recorded as notes receivable
      on
      our balance sheet totaling $4,274,751 and $1,833,611 as of December 31, 2005
      and
      2004, respectively, and made by the following officers and stockholders: Robert
      L. Harris, Jin S. Kim, Ainslee H. Sadler, Richard J. Harris and Dr. Mervyn
      Feldman.




KH
      Funding had related party notes made by us and recorded as notes payable on
      our
      balance sheet totaling $5,935,165 and $5,389,637 as of December 31, 2005 and
      2004, respectively, that were held by officers, directors and stockholders
      of
      which $1,516,848 were held by officers, directors, and 5% or more stockholders
      identified as: Robert L. Harris, Jin S. Kim, Louise B. Sehman, Jack H. Breskow,
      Dr. Mervyn Feldman, Solomon Kaspi, James Parker and Nick Nicholson.




There
      is
      a loan of $185,450, shown on the Balance Sheet as a contra-equity, made to
      KH
      Funding's CEO for the purchase of 100,000 shares of stock in KH Funding. The
      interest rate on this loan is seven percent. The stock has a book value of
      about
      $38,000 as of December 31, 2005. At December 31, 2005, there was no accrued
      interest receivable on this loan.




We
      believe that each transaction with a related party was on terms as favorable
      as
      could have been obtained from an unrelated party. And, all future transactions
      between us and any of our directors, executive officers or stockholders known
      to
      us to own beneficially more than 5% of our shares, or any member of the
      immediate family of any of those persons, or other entities in which such
      persons beneficially own more than 5%, will be entered into on terms as least
      as
      favorable as could be obtained from unaffiliated independent third parties.
      Such
      determination shall be made by our independent directors.




**ITEM
      13.**  **EXHIBITS**




The
      following exhibits are filed with or incorporated by reference into this
      report.




3.1
            Articles
                of Incorporation of KH Funding Company (Incorporated by reference
                from
                Exhibits to our Registration Statement on Form SB-2, Registration
                File No.
                333-106501)




3.2
            Articles
                of Amendment of KH Funding Company (Incorporated by reference from
                Exhibits to our Registration Statement on Form SB-2, Registration
                File No.
                333-106501)




3.3
            Bylaws
                of KH Funding Company (Incorporated by reference from Exhibits to
                our
                Registration Statement on Form SB-2, Registration File No.
                333-106501)




10.1
            1998
                Stock Incentive Plan (Incorporated by reference from Exhibits to
                our
                Registration Statement on Form SB-2, Registration File No.
                333-106501)




10.2
            Selling
                Agreement by and between KH Funding Company and Capital Financial
                Services
                Inc. (Incorporated by reference from Exhibits to our Registration
                Statement on Form SB-2, Registration File No.
                333-117038)




10.3
            2005
                Equity Incentive Plan (Incorporated by reference from Exhibit 10.3
                to our
                Registration Statement on Form SB-2, Registration File No.
                333-1241155)




10.4
            Selling
                Agreement by and between KH Funding Company and Spencer Edwards,
                Inc.




10.5
            Selling
                Agreement by and between KH Funding Company and CapWest Securities,
                Inc.




23
            Consent
                of Stegman & Co.




31.1
            Certification
                by the Chief Executive Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002




31.2
            Certification
                by the Chief Financial Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002




32.1
            Certification
                by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002




32.2
            Certification
                by the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002




**ITEM
      14.**  **PRINCIPAL
      ACCOUNTANT FEES AND SERVICES**




As
      our
      independent accountants for 2004 and 2005, Stegman & Company provided
      various audit and other services for which we were billed for fees as further
      described below. Except as described below, under its current procedures the
      Audit Committee specifically pre-approves all audit services and other services
      provided by our accountants. In the case of tax services and other permissible
      non-audit services, the Committee has delegated authority to its Chairman to
      approve services. Any approval of additional services by the Chairman is
      communicated to the full Committee at its next regularly scheduled meeting.
      The
      Committee also may authorize management to obtain tax services from our
      accountants from time to time during the year up to a specified aggregate amount
      of fees. Requests for advice in addition to that amount would require further
      approval.




Our
      Audit
      Committee has considered whether Stegman & Company's provision of non-audit
      services is compatible with maintaining its independence. The Committee believes
      that those services do not affect Stegman & Company's
      independence.




***Audit
      Fees***




For
      2004
      and 2005, Stegman & Company audited our consolidated financial statements
      included in our Annual Reports on Form 10-KSB, and it reviewed the condensed
      interim financial statements included in our Quarterly Reports on Form 10-QSB.
      The aggregate amount of fees for those services was $34,270 and $59,344,
      respectively. For the first, second and third quarters of 2004, Grant Thornton
      LLP performed our audits and their fees totaled $115,148.




***Audit-Related
      Fees***




For
      each
      2004 and 2005, Stegman & Company performed no audit-related tasks for
      us.




***Tax
      Fees***




In
      2004,
      we paid Grant Thornton LLP $8,000 for tax compliance services and preparation
      of
      corporate returns.




***All
      Other Fees***




In
      2005,
      there were no additional fees from Stegman & Company.





- -




**SIGNATURES**




In
      accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934,
      we
      have caused this Report to be signed on our behalf by the undersigned, thereunto
      duly authorized.




Dated:
                April 17, 2006
            **KH
                FUNDING COMPANY**By:
            /s/
                Robert L. HarrisRobert
                L. Harris,President
                and Chief Executive Officer







In
      accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934,
      this
      Report has been signed by the following persons on our and in the capacities
      as
      of April 17, 2006.





**Name**
            
            **Title**/s/
                Robert L. Harris
            
            President,
                Chief Executive Officer and DirectorRobert
                L. Harris/s/
                Louise B. Sehman
            
            Chief
                Financial Officer, Secretary and TreasurerLouise
                B. Sehman/s/
                Jack Breskow
            
            DirectorJack
                Breskow/s/
                Jeremiah A. Connor
            
            DirectorJeremiah
                A. Connor/s/
                Dr. Mervyn Feldman
            
            DirectorDr.
                Mervyn Feldman/s/
                Solomon Kaspi
            
            DirectorSolomon
                Kaspi/s/
                Jin S. Kim
            
            DirectorJin
                S. Kim/s/
                Alvin Shapiro
            
            DirectorAlvin
                Shapiro








- -




**EXHIBIT
      INDEX**




3.1
            Articles
                of Incorporation of KH Funding Company (Incorporated by reference
                from
                Exhibits to our Registration Statement on Form SB-2, Registration
                File No.
                333-106501)




3.2
            Articles
                of Amendment of KH Funding Company (Incorporated by reference from
                Exhibits to our Registration Statement on Form SB-2, Registration
                File No.
                333-106501)




3.3
            Bylaws
                of KH Funding Company (Incorporated by reference from Exhibits to
                our
                Registration Statement on Form SB-2, Registration File No.
                333-106501)




10.1
            1998
                Stock Incentive Plan (Incorporated by reference from Exhibits to
                our
                Registration Statement on Form SB-2, Registration File No.
                333-106501)




10.2
            Selling
                Agreement by and between KH Funding Company and Capital Financial
                Services
                Inc. (Incorporated by reference from Exhibits to our Registration
                Statement on Form SB-2, Registration File No.
                333-117038)




10.3
            2005
                Equity Incentive Plan (Incorporated by reference from Exhibit 10.3
                to our
                Registration Statement on Form SB-2, Registration File No.
                333-1241155)




10.4
            Selling
                Agreement by and between KH Funding Company and Spencer Edwards,
                Inc.




10.5
            Selling
                Agreement by and between KH Funding Company and CapWest Securities,
                Inc.




23
            Consent
                of Stegman & Co.




31.1
            Certification
                by the Chief Executive Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002




31.2
            Certification
                by the Chief Financial Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002




32.1
            Certification
                by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002




32.2
            Certification
                by the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002





- -


Exhibit
      23




**CONSENT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**










The
      Board
      of Directors


KH
      Funding Company


Silver
      Spring, Maryland







We
      hereby
      consent to the inclusion of our report dated April 7, 2006 relating to the
      balance sheets of KH Funding Company (the "Company") as of December 31, 2005
      and
      2004 and the related statements of operations, changes in stockholders' equity
      and cash flows for the years then ended in the Company's Form 10-KSB for the
      year ended December 31, 2005 to be filed with the Securities and Exchange
      Commission.





/s/
      Stegman & Company







Baltimore,
      Maryland


April
      14,
      2006





- -


Exhibit
      31.1




**CERTIFICATION
      PURSUANT TO SECTION 302**




**OF
      THE SARBANES-OXLEY ACT OF 2002**




I,
      Robert
      L. Harris, certify that:




1.  I
      have
      reviewed this Annual Report on Form 10-KSB of KH Funding Company;




2.  Based
      on
      my knowledge, this report does not contain any untrue statement of a material
      fact or omit to state a material fact necessary to make the statements made,
      in
      light of the circumstances under which such statements were made, not misleading
      with respect to the period covered by this report;




3.  Based
      on
      my knowledge, the financial statements, and other financial information included
      in this report, fairly present in all material respects the financial condition,
      results of operations and cash flows of the small business issuer as of, and
      for, the periods presented in this report;




4.  The
      small
      business issuer's other certifying officer(s) and I are responsible for
      establishing and maintaining disclosure controls and procedures (as defined
      in
      Exchange Act Rules 13a-15(e) and 15d-15(e)) for the small business issuer and
      have:




(a)
      Designed such disclosure controls and procedures, or caused such disclosure
      controls and procedures to be designed under our supervision, to ensure that
      material information relating to the small business issuer, including its
      consolidated subsidiary, is made known to us by others within those entities,
      particularly during the period in which this report is being
      prepared;




(b)
      OMITTED;




(c)
      Evaluated the effectiveness of the small business issuer's disclosure controls
      and procedures and presented in this report our conclusions about the
      effectiveness of the disclosure controls and procedures, as of the end of the
      period covered by this report based on such evaluation; and




(d)
      Disclosed in this report any change in the small business issuer's internal
      control over financial reporting that occurred during the small business
      issuer's most recent fiscal quarter (the small business issuer's fourth fiscal
      quarter in the case of an annual report) that has materially affected, or is
      reasonably likely to materially affect, the small business issuer's internal
      control over financial reporting; and




5.  The
      small
      business issuer's other certifying officer(s) and I have disclosed, based on
      our
      most recent evaluation of internal control over financial reporting, to the
      small business issuer's auditors and the audit committee of the small business
      issuer's board of directors (or persons performing the equivalent
      functions):




(a)
      All
      significant deficiencies and material weaknesses in the design or operation
      of
      internal control over financial reporting which are reasonably likely to
      adversely affect the small business issuer's ability to record, process,
      summarize and report financial information; and




(b)
      Any
      fraud, whether or not material, that involves management or other employees
      who
      have a significant role in the small business issuer's internal control over
      financial reporting.





Dated:
                April 17, 2006
            /s/
                Robert L. HarrisRobert
                L. HarrisPresident
                and Chief Executive Officer





- -


Exhibit
      31.2




**CERTIFICATION
      PURSUANT TO SECTION 302**




**OF
      THE SARBANES-OXLEY ACT OF 2002**




I,
      Louise
      B. Sehman, certify that:




1.  I
      have
      reviewed this Annual Report on Form 10-KSB of KH Funding Company;




2.  Based
      on
      my knowledge, this report does not contain any untrue statement of a material
      fact or omit to state a material fact necessary to make the statements made,
      in
      light of the circumstances under which such statements were made, not misleading
      with respect to the period covered by this report;




3.  Based
      on
      my knowledge, the financial statements, and other financial information included
      in this report, fairly present in all material respects the financial condition,
      results of operations and cash flows of the small business issuer as of, and
      for, the periods presented in this report;




4.  The
      small
      business issuer's other certifying officer(s) and I are responsible for
      establishing and maintaining disclosure controls and procedures (as defined
      in
      Exchange Act Rules 13a-15(e) and 15d-15(e)) for the small business issuer and
      have:




(a)
      Designed such disclosure controls and procedures, or caused such disclosure
      controls and procedures to be designed under our supervision, to ensure that
      material information relating to the small business issuer, including its
      consolidated subsidiary, is made known to us by others within those entities,
      particularly during the period in which this report is being
      prepared;




(b)
      OMITTED;




(c)
      Evaluated the effectiveness of the small business issuer's disclosure controls
      and procedures and presented in this report our conclusions about the
      effectiveness of the disclosure controls and procedures, as of the end of the
      period covered by this report based on such evaluation; and




(d)
      Disclosed in this report any change in the small business issuer's internal
      control over financial reporting that occurred during the small business
      issuer's most recent fiscal quarter (the small business issuer's fourth fiscal
      quarter in the case of an annual report) that has materially affected, or is
      reasonably likely to materially affect, the small business issuer's internal
      control over financial reporting; and




5.  The
      small
      business issuer's other certifying officer(s) and I have disclosed, based on
      our
      most recent evaluation of internal control over financial reporting, to the
      small business issuer's auditors and the audit committee of the small business
      issuer's board of directors (or persons performing the equivalent
      functions):




(a)
      All
      significant deficiencies and material weaknesses in the design or operation
      of
      internal control over financial reporting which are reasonably likely to
      adversely affect the small business issuer's ability to record, process,
      summarize and report financial information; and




(b)
      Any
      fraud, whether or not material, that involves management or other employees
      who
      have a significant role in the small business issuer's internal control over
      financial reporting.





Dated
                April 17, 2006
            /s/
                Louise B. SehmanLouise
                B. SehmanChief
                Financial Officer, Secretary and
                Treasurer





- -


Exhibit
      32.1




**CERTIFICATION
      PURSUANT TO 18 U.S.C. SECTION 1350 ADOPTED**




**PURSUANT
      TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002**







Certification
      of CEO




The
      undersigned hereby certifies that, to his knowledge (i) the foregoing Annual
      Report on Form 10-KSB filed by KH Funding Company (the "Issuer") for the year
      ended December 31, 2004, fully complies with the requirements of Section 13(a)
      or 15(d), as applicable, of the Securities Exchange Act of 1934, and (ii) the
      information contained in that Report fairly presents, in all material respects,
      the financial condition and results of operations of the Issuer on the dates
      and
      for the period presented therein.





Dated:
                April 17, 2006
            /s/
                Robert L. HarrisRobert
                L. HarrisPresident
                and Chief Executive Officer





- -


Exhibit
      32.2




**CERTIFICATION
      PURSUANT TO 18 U.S.C. SECTION 1350 ADOPTED**




**PURSUANT
      TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002**







Certification
      of CFO




The
      undersigned hereby certifies that, to his knowledge (i) the foregoing Annual
      Report on Form 10-KSB filed by KH Funding Company (the "Issuer") for the year
      ended December 31, 2004, fully complies with the requirements of Section 13(a)
      or 15(d), as applicable, of the Securities Exchange Act of 1934, and (ii) the
      information contained in that Report fairly presents, in all material respects,
      the financial condition and results of operations of the Issuer on the dates
      and
      for the period presented therein.





Dated:
                April 17, 2006
            /s/
                Louise B. SehmanLouise
                B. SehmanChief
                Financial Officer, Secretary and
                Treasurer