Self-Directed IRA: Non-Recourse Financing
Can I use a loan with my self-directed IRA to make an investment?
The unlimited investment capability of the self-directed IRA allows account funds to be invested into nontraditional assets such as real estate. Account owners who choose to purchase real estate can leverage the purchase with a non-recourse loan. A recourse loan cannot be used with an IRA to make investments; it would be considered a prohibited transaction.
Recourse Loans
A recourse loan is the most common type of loan offered by banks and other financial institutions. The recourse loan is guaranteed by the individual securing the loan. Investing with an IRA and a recourse loan is considered a prohibited transaction because the account owner would have to guarantee the loan to the account. This is prohibited by IRC Section 4975.
In most cases, this can be avoided by the use of a Checkbook IRA to pay the full amount of the real estate investment. If additional funding is needed for the purchase, the IRS allows the use of non-recourse financing in addition to the Checkbook IRA.
Non-Recourse Financing
A non-recourse loan is not guaranteed by the individual. Instead, the non-recourse loan is secured by and limited to the collateral which is, in this case, the real estate property itself. Because the loan does not involve the individual/ account owner, it is not considered a prohibited transaction by the IRS. In general, non-recourse loans are considered to be more risky to the lender and thus have less attractive terms than those of conventional recourse loans.
Understanding the rules of non-recourse financing
The rules for the use of non-recourse financing by a Checkbook IRA are outlined in IRC Section 514. It is important to note that the use of non-recourse loans with the IRA will trigger the UBIT tax. IRC Section 514 requires that debt-financed income, such as the income generated from the use of a non-recourse loan, be included as unrelated business taxable income (UBTI).
A portion of the income or gains generated by the debt-financed property will be subject to UBIT. The tax, which is generally 35%, is on the portion of income financed by the debt; it is proportional to the percentage financed by the loan. For example, if an investment property is purchased using 50% financing, then 50% of the income or gains would be subject to the UBIT.
Key Fact
The IRS allows this tax base to be reduced by a pro rata portion of deduction and depreciation of the property. The IRA is typically a tax-exempt entity to the IRS. Because the IRS treats the IRA as a taxpayer in this case, it gives the IRA the ability to allocate asset expense and depreciation to reduce the tax base.
The Solo 401k is not subject to the UBTI tax in the same way as an IRA. Because of an exclusion in the Unrelated Debt Financed Income rules, the Solo 401k is not subject to the UBTI tax when using non-recourse funding to invest in an asset.
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