IRA Non-Recourse Loans

A self-directed IRA can buy real estate with borrowed money, but only with a non-recourse loan. The lender's only security is the property itself. Neither you nor anyone else who is a disqualified person can sign or guarantee the loan. Here is how it works with an IRA LLC, what it costs in tax, and where investors go wrong.

What makes a loan non-recourse

If the IRA LLC defaults, the lender can take the property and nothing else. It cannot pursue you personally, your other assets, or the rest of your IRA. Lenders price for that risk, so expect a larger down payment (often 30 to 50 percent), a higher interest rate than a conventional mortgage, and cash reserves held in the IRA.

Why a personal guarantee is not allowed

Internal Revenue Code Section 4975 prohibits any direct or indirect lending of money or extension of credit between your IRA and a disqualified person. A personal guarantee counts as an extension of credit. In Peek v. Commissioner (2013), the Tax Court held that IRA owners who personally guaranteed a loan to a company their IRAs owned had engaged in a prohibited transaction, and their IRAs were treated as distributed. The loan must be in the name of the IRA LLC, signed by the LLC as borrower, with no guarantee from you, your spouse, your parents, your children or any other disqualified person.

How the purchase works with an IRA LLC

1. Your IRA funds the LLC, and the LLC holds the cash for the down payment, closing costs and reserves.
2. The LLC applies with a lender that offers non-recourse loans to IRAs or IRA-owned LLCs.
3. The property is titled in the LLC's name, and the LLC signs the loan documents as borrower.
4. All rent goes into the LLC's bank account, and all expenses and loan payments are paid from it. You never pay an expense personally or put rent in your own account.
5. The LLC tracks the debt balance and the property's basis each year for the tax calculation below.

The UDFI tax on leveraged income

IRAs are normally exempt from tax on rent and on gains from selling property. Debt changes that. Under IRC Section 514, income from property bought with borrowed money is unrelated debt-financed income (UDFI), which is taxed as unrelated business taxable income (UBTI). Only the portion tied to the debt is taxed: roughly the average loan balance divided by the property's average adjusted basis for the year. As the loan is paid down, the taxable share shrinks. If the property is sold while debt remains, or within 12 months after the debt is paid off, part of the gain is also taxable. When the IRA's gross UBTI is $1,000 or more for the year, the IRA must file IRS Form 990-T and pay the tax from IRA funds. The LLC's records make that filing simple for your tax preparer.

Example

An IRA LLC buys a $300,000 rental with $150,000 cash from the IRA and a $150,000 non-recourse loan. In year one the debt is about half the basis, so about half of the net rental income is UDFI. The other half stays tax-deferred (or tax-free in a Roth IRA). Each year the loan is paid down, a smaller share is taxable. Note: figures are simplified for illustration.

Solo 401(k) vs. IRA for leveraged real estate

A Solo 401(k) is treated differently. IRC Section 514(c)(9) exempts qualified retirement plans, including a Solo 401(k), from the UDFI tax on most real estate debt. The exemption does not apply to IRAs. If you are self-employed with no full-time employees and plan to use leverage, a Solo 401(k) may be the better vehicle.

Is leverage worth it in an IRA?

Leverage lets your IRA control a larger property and can raise returns. In return, the IRA pays a higher rate, taxes part of the leveraged income, and must hold enough reserves to cover vacancies and repairs, because you cannot add personal money to cover a shortfall. Many investors compare a cash purchase, a non-recourse loan, and a Solo 401(k) before deciding.