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It’s all well and good to talk about the possibilities of investing in real estate using a self-directed IRA. But what if the balance in your IRA falls short of the market price for properties where you want to invest?Don’t worry. Just as homebuyers can get a mortgage, there are alternatives to all-cash purchases using a self-directed IRA.
Your IRA can borrow money to finance a purchase. If you choose this option, the IRS requires a non-recourse loan.
A non-recourse loan is a loan that the IRA holder is not personally liable for repaying. Reason being, you the IRA holder cannot personally guarantee the loan the IRA is acquiring to purchase an investment. The income from the IRA investment must also be enough to pay the loan payments for the non-recourse loan. Payments cannot come from the IRA holder directly since it’s the IRA that is considered the borrower. If loan payments are paid by the IRA holder directly that would be a violation and could cause the IRA to lose its tax deferred status.
Once you locate a lender/bank, the lender will lend to your IRA, not to you as an individual directly. Since you personally cannot guarantee the loan, the lender will have no recourse against you or the balance of your IRA funds in the event of a default. The lender will only be able to recover the property used as collateral for the loan.
Because these loans may be a higher risk for lenders, non-recourse loan-to-value ratios are typically different from more traditional loans. For these type of loans, loan to value ratios may go from 50 to 70% of the value of the property. This gives a better chance of the lender recouping their investment back in the event of a loan default. Interest rates for these type of loans may also be higher than other loans.
Non-Recourse Loans and Unrelated Debt Financed Income
When you use a non-recourse loan to purchase property in your self-directed IRA, the IRS considers this “acquisition indebtedness.” This acquisition indebtedness is taxable because, without the loan, the IRA would not have been able to buy the property. This subjects the IRA to Unrelated Debt Financed Income, or UDFI. Tax rates for this type of IRA income are subject to trust tax rates which are higher than individual income tax rates.
The amount of UDFI varies. For example, If your IRA borrows money to purchase a rental property, the percentage of debt compared to the value of the property will be applied to the income generated by the property (after the proportionate expenses associated with the debt are deducted, of course) to determine how much of the income is taxable.
If your IRA owes UDFI, your IRA will have to file an IRS Form 990-T to report the taxable income. Your IRA will have to acquire an Employer Identification Number (EIN) to file its own tax return (hopefully this was already done when the investment was created and funded). Taxes owed by the IRA must be paid by assets within the IRA and cannot be paid by you. Because of the complexity of UDFI, it is best to consult a tax professional to prepare IRS Form 990-T. Once complete, you can submit the Form 990-T to Entrust with your authorization to file and pay the UDFI tax.
Talk with your tax advisor or read IRS publication 598 to learn more about UDFI. You may also call and talk with a trained Entrust professional to learn more about non-recourse loans, UDFI and self-directed IRAs.