Use of a Non-Recourse Loan with a Self-directed IRA
The self-directed IRA, along with the Checkbook IRA and Solo 401k, can invest in both traditional and non-traditional assets. Participants in these self-directed retirement accounts often invest in a wide range of real estate opportunities, from rental properties to foreclosures to raw land.
The full amount of the purchase can come from the participant’s self-directed IRA or Solo 401k account. However, if additional funding is needed, it must be in the form of a non-recourse loan. Only a non-recourse loan can be used in conjunction with the Checkbook IRA and Solo 401k.
Non-recourse loans only with a self-directed IRA
A recourse loan cannot be made to a self-directed IRA account.
This type of loan is guaranteed by the individual obtaining the loan. In the case of a loan default, the lender can pursue recourse from the individual. According to IRC Section 4975, this would be considered a prohibited transaction because the recourse loan involves a disqualified person, the account owner. The account owner cannot guarantee the loan to the retirement account.
A non-recourse loan does not involve the individual obtaining the loan; it is not guaranteed by the individual. Instead, a non-recourse loan uses the purchased property as recourse. It is a loan secured by collateral only; the individual borrower is not liable in the case of default. Because the individual does not guarantee the loan, it is not considered a prohibited transaction by the IRS. The non-recourse loan can be used with a self-directed retirement plan to finance a real estate investment. This is not considered a violation of the plan’s tax-exempt status.
Self-directed IRA and UBTI
Note that the use of a non-recourse loan with a self-directed IRA incurs the UBTI tax. When the self-directed IRA purchases real estate that is leveraged with mortgage financing, the income it produces is considered Unrelated Debt Financed Income (UDFI). UDFI is a type of Unrelated Business Taxable Income (UBTI) which is subject to tax.
UBTI tax rates are typically 35%. The income and gains produced by the portion that is financed by the non-recourse loan is subject to UBTI tax. In other words, if 50% of a property is financed by a non recourse loan, then 50% of the income will be subject to the UBTI tax.
The use of a non-recourse loan with a Solo 401k does not trigger the UBTI tax. The Solo 401k is exempt from the rules of UDFI as outlined in IRC Section 514.