Using self-directed IRA funds to purchase income-generating real estate is a profitable strategy an ever-growing number of investors are employing. These accounts (a.k.a. real estate IRAs) can buy rental property as an investment, just as they would buy stock market securities. This means real estate IRA holders can use their retirement funds to purchase real estate without incurring early distribution taxes or penalties and they can realize the rental payments as tax-deferred income within their IRA.
The challenge, however, is this: How do you purchase real estate that costs more than the money you’ve accumulated in your retirement account? Because the Internal Revenue Code prohibits account holders from extending credit (a personal guarantee) to their own accounts, personal loans can’t be mixed with IRA funds. So unless you have an IRA flush with funds, it would seem that your purchase options are slim to none.
Leveraging borrowed funds
There is a way out of this dilemma. Real estate IRA accounts can make use of borrowed money as long as the credit history, income and/or assets of the account holder are not used to acquire or guarantee repayment of the loan.
There is only one leverage option that meets these criteria: non-recourse loans.
A non-recourse loan is (in this case) a loan made to an IRA (not a person), and it’s based solely on the value of the property acquired with that debt, not the credit of the individual who is the beneficiary of the real estate IRA about to purchase the property.
While a non-recourse loan is a boon to those needing the extra cash, there is a bit of a tradeoff. Understandably, banks are averse to risk and, since there is no personal collateral guaranteeing non-recourse loans, banks must protect themselves. They have no recourse against the IRA or IRA holder with this kind of loan (hence, the name), so the loan typically comes with higher than normal interest rates, and banks typically require that the IRA provide a high down payment on the real estate—anywhere from 30 percent to 50 percent. The high down payment is in case of default: If the IRA-purchased real estate has to be foreclosed on, the bank wants to makes sure it has enough equity to cover costs of foreclosing and sale…while still retaining a profit.
As a rule, banks will also require that a small reserve (up to 20 percent) remain in the real estate IRA account at the time of closing. It’s expected that this money will be used to cover loan payments, maintenance, insurance dues and taxes.
Additionally, the account holder must show that the rental property will provide a positive cash flow based on current vacancy and rental rates. Do be aware that a portion of that rental income, equal to the ratio of debt, is subject to a UDFI (unrelated debt-financed income) tax calculation. UDFI is produced when an IRA or other tax-advantaged entity produces income from an asset that is financed in part or whole through debt.
For example, if the real estate IRA borrows 70 percent of the purchase price, then 70 percent of the income generated by the property is subject to a tax calculation (because the borrowed portion is not tax-deferred money). However, the remaining 30 percent of the income remains tax-deferred, since it belongs to the IRA. Normal tax deductions on the investment (i.e., property taxes , depreciation , etc.) also apply at the same ratio as the ratio of debt (in this case, 70 percent of the property taxes) further reducing the potential tax burden. So it’s a bad news/good news situation: Although non-recourse loans invite potential tax payments, those payments signify a profit!
Non-recourse loans and real estate IRAs
Using a non-recourse loan in conjunction with your real estate IRA monies can create a powerful wealth-building tool. But it’s a tool that needs to be carefully engaged and properly utilized. It’s extremely important that, in setting up your IRA real estate purchase in conjunction with a non-recourse loan, you work with an experienced and reputable real estate IRA provider, real estate lender and tax professional.
There are a limited number of banks that will provide non-recourse loans, and it’s worth your while to seek them out. Be prepared for the possibility of some confusion, however, since many banks that have provided non-recourse loans in the past have usually done so for multi-unit or commercial purchases, not single-family homes bought by an IRA as an account investment.
With the right counsel and professional direction, you can fearlessly open the door to many more investment opportunities for your real estate IRA. And real estate you once thought was out of reach can be yours.