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A self directed IRA or Solo 401(k) opens the door to a powerful wealth building strategy – the use of leverage.  When purchasing a property, your plan can choose to obtain a mortgage rather than pay all cash.  The use of other people’s money in this fashion allows you to gain a higher dollar-for-dollar return on your retirement plan’s investment.

Debt Must be Non-Recourse

IRS rules prohibit any provision of benefit from you or a disqualified party to the plan.  This precludes you from placing a personal guarantee on any debt instrument such as a mortgage.  As such, an IRA or 401k must obtain a non-recourse mortgage.  In this type of loan, you are not utilizing your credit to qualify and are not pledging your personal assets as security for the loan in the event of default.  Rather, the plan is the borrower and the property can be the only security for the loan.  Essentially, the property is qualifying for the loan.

This type of non-recourse loan is not widely available in the marketplace, but there are a handful of institutions that offer such loans on a nationwide basis.  There are also some local or regional banks and private investment groups that will lend to IRA and 401k borrowers on a non-recourse basis.

The two leading national lenders are:

You may also choose to borrow from a private party, obtain seller financing, or enter into lease-purchase or contract-for-deed transactions.

Lending Guidelines

This type of loan is higher risk to the lender, and their underwriting policies are going to me more conservative as a result.  Typical guidelines you might find are as follows:

  • Down payment of at least 30%.  Condos as high as 50%
  • 10% – 15% cash reserves in the plan at the time of the loan
  • Terms range from 5/1 arms to 25 year fixed rate loans
  • Rates will generally be 1% – 1.5% higher than a typical investor loan with a personal guarantee.  A range of 4.75% – 6.25% is common, depending on the loan terms.
  • Clean, cash flow properties work well.  Options are limited for properties requiring extensive repairs or raw land.

Such loans typically take 4-6 weeks to process, so you will want to have your self directed plan in place and work closely with a lender before entering into a contract to purchase property.

Tax Implications for IRA Borrowers

When an IRA (or other tax exempt entity) utilizes debt financing to acquire property, a trust tax known as Unrelated Debt Financed Income (UDFI) comes into play.

The general principal is that the tax exempt entity’s investment is fully sheltered from taxation, but the portion of the income generated through the use of borrowed, non-exempt funds is taxable.

In most cases, the financial impact of the tax is limited.  A $100,000 rental property that is 50% debt financed and produces 10% returns would incur a tax bill of less than $200 for the year, for example.

If you do intend to use mortgage financing in an IRA, you will want to work with your tax professional to evaluate the impact both in terms of tax cost as well as the administrative costs of recordkeeping and tax filings.

UDFI taxation applies to IRA’s, but does not apply to Solo 401(k) plans.

Do you have a real estate investment in mind? Use our calculator to compare the expected return on investment for an all cash real estate purchase versus a leveraged purchase through a non-recourse loan.

In Summary

While leveraging an IRA investment does create the administrative overhead and expense of the UDFI filing, the bottom line to your IRA can still be very favorable.  Through leveraging, you will typically generate more income and increase the cash-on-cash return relative to your IRA’s capital participation in the transaction.  While you forfeit some of this increased return through taxation, your IRA still gets to keep the large majority of this leveraged income.

Resources:

ira mortgage calculatorUDFI Calculator – Real Estate: All Cash Purchase vs Leveraged Property Purchase in an IRA

IRS Publication 598 – Tax on Unrelated Business Income of Exempt Organizations

Internal Revenue Code section 514 – Unrelated Debt-Financed Income

IRS forms 990-T:

990-T Instructions

990-T Form

 

A WORD OF CAUTION: Do not wait until you have found a property to purchase before setting up a Self Directed IRA plan. You will be greatly disappointed to discover that you’re likely to lose the property due to timing.