Taking on Debt in a Self-Directed IRA
Most people do not realize that an IRA can actually borrow money and take on debt. IRS regulations require that the debt be “Non-Recourse”. What does that mean you might ask? Non-Recourse debt means that there is no personal guarantee or collateral. Traditional financing has a personal guarantee that allows the lender to “go after” other assets in the case of foreclosure. Non-Recourse debt has no personal guarantee so the only recourse is the property itself.
Because of the higher risk to the lender, most banks will not loan on a non-recourse basis. There are some banks that will. Typically, they require a high down payment to protect themselves. 35-40% down (or more) is not uncommon. Also, the borrower, in this case the IRA, is responsible for making the payments. So the bank is going to want to know how that is going to occur. That is why in most cases, the purchased property must cash flow very quickly. If the bank is going to loan out on a rehab property that will be uninhabitable for the next 6 months, they are going to make sure the IRA has enough cash left over to cover the mortgage until cash flow begins. Lender requirements vary from bank to bank and situation to situation.
Another “issue” with non-recourse debt is Unrelated Business Income Tax (UBIT) and/or Unrelated Debt Financed Income (UDFI). The IRS imposes a tax on the portion of the investment income that is attributable to the loan. In other words, they don’t like the idea that non-IRA money can float into the transaction which can help the IRA grow tax-free faster than it could on its own. So, some of your investment income could be taxable. This is not to say that the investment cannot still have a good return. It is just something to keep in mind before you get involved with IRA related debt.
UBIT Associated with Debt in a Self Directed IRA
One strategy to avoid this tax would be to do this transaction in an Individual 401(k) instead of an IRA. However, not everyone is eligible for this type of plan. You really need to be self-employed with no employees (other than a spouse) to qualify. Debt within a qualified retirement plan (such as an individual 401(k) plan) is not subject to the same UBIT/UDFI taxes mentioned previously.
When all is said and done, these strategies can help certain clients in certain situations. Most IRA transactions remain 100% cash deals. However, if a client is interested in leveraging, it is nice to know there are some options. Midland Trust is not a financial advisor or accountant, so it is best to clarify any transaction with potential tax consequences with your CPA or Financial Planner.
For questions regarding debt in a self-directed IRA, contact Midland today.