Some of you may have considered a non-recourse loan for your real estate investment, either because you are short on cash or you want to use loaned monies as leverage for your investment, or possibly both. While it’s true that a non-recourse loan is an option for real estate investment, there are other options available that would not result in your IRA being subjected to UDFI tax.
What is a Non-Recourse Loan?
A non-recourse loan is a loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the collateral.
What is UDFI?
A subset of UBIT (Unrelated Business Income Tax), is the Unrelated Debt-Financed Income (UDFI) tax. Under IRC § 514, the IRS will assess a tax on any income that is derived from the use of “acquisition indebtedness” in passive self-directed IRA investments. For example, if your self-directed IRA uses $30,000 of its own funds and also borrows $70,000 (using a non-recourse note) to purchase a $100,000 rental property that generates $10,000 annual rent, the IRS would assess UDFI tax on about $7,000 of the profit (since 70 percent of the investment came from leverage). The tax rates for UDFI range from 15-38 percent (consult your CPA or other tax professional for more details).
*NOTE: Solo/Individual 401k accounts & other Qualified Plans are exempt from UDFI
Another option to a non-recourse loan is an investment partner. Below is a list of investment partners to consider:
- Self-directed IRA holder(s)
- Qualified plans (i.e., 401K, 457, 403B, etc.) and IRA holder(s)
- Private investor(s)
The above listed could partner with you in a TIC (Tenants In Common) relationship in which your interest rate could be lower and the terms could be more flexible than a lender without being subject to UFDI. You would still be employing the concept of using OPM (Other People’s Money), but without the added tax that would cut into your profit.
Keep in mind, relative to the percentage of ownership of the property among all parties, the profits and expenses must be split accordingly. For example, if you decide to partner with your spouse’s or other investors IRA and/or private funds to make a real estate purchase and the ownership between both parties are 50/50, all expenses, rents and profits must be split in accordance to these ownership percentages.
There are investors in your community and local investment clubs losing money in the stock markets, whose employers are no longer matching in their 401K’s, and/or not making a great return. They are looking for alternative investment options, and they are looking for partners of a similar mind.
Disclaimer: The above listed information is NOT intended to be tax or legal advice as The Entrust Group professionals do not provide legal and/or tax advice. The variables are designed to educate investors and for you to factor in these variables when making your investment.