Self-Directed IRA: Non Recourse Loan

Financing is possible within a self directed IRA

With a Self-directed IRA, plan participants can choose to invest their retirement funds into non-traditional investment options, including real estate. Investors, however, often want to leverage their real estate investment. So is it possible to do so with a real estate purchase that will be held in an IRA account? The truth is, a Self-directed IRA can leverage its investment but only with a non-recourse loan. It is the only financing option that doesn’t trigger a prohibited transaction.

A recourse loan is the most common type of financing option, usually issued by a bank or a financial institution. With a recourse loan, the individual who apply for the loan will also be the guarantor for the loan. If a recourse loan is used to finance investments within a self-directed IRA, it will be seen as a prohibited transaction. The reason is that the recourse loan would require the plan owner to act as the guarantor, and by doing so, he or she will violate the IRC Section 4975.

Usually, to avoid creating a prohibited transaction, the account holder of a Checkbook IRA would have to purchase the entire property with no financing. In case additional financing is needed, the IRS only allows non-recourse loans for a Checkbook IRA account.

With a non-recourse loan, the individual does not act as the guarantor. The non-recourse loan is secured only by the collateral, which is the real estate property in this situation. This way, the plan holder can stay uninvolved in the process and avoid creating a prohibited transaction.

Non-recourse loans, however, are considered more risky by lenders because they can only go after the collateral. Therefore, non-recourse loans will have less favorable terms for the borrowers.

IRC section 514 outlines all the regulations regarding non-recourse financing and self-directed IRA. The use of non-recourse loans with the IRA, although is not seen as a prohibited transaction, will still be charged with UBTI tax. Income from leveraged investment, or from the use non-recourse loan, is required by IRC Section 514 to be included in unrelated business taxable income (UBTI). The tax is usually calculated as 35% of the financed portion of the total income.

For example, if your checkbook IRA funds half of the property’s purchase price, and take out a non-recourse loan for the other half, then UBTI tax will be calculated based on 50% of the property’s value.

A pro rata portion of deduction and depreciation of the property can reduce this tax base, as permitted by the IRS. Usually, the IRA is seen as a tax-exempt by the IRS. Since in this case, the IRA becomes a taxpayer, it is allowed by the IRS to allocate asset expense and depreciation to lower the tax base.