The ability to use self-directed IRAs for a wider variety of alternative investments is one of its biggest benefits. Since self-directed IRAs are legal entities, they can borrow money, and they can get a mortgage. However, it’s very important to know that the loan must be a non-recourse loan.
A non-recourse loan is a secured loan that is backed by a pledge of collateral, typically the property that it is being used to purchase. In the event of a default, the lender can only seize the collateral. Because the lender is limited in recovery options, the interest rate may be higher than it would have been for a recourse loan. The down payment required may be higher as well and comes from cash already in the IRA. Some cash, typically 10% of the loan, may be required to remain in the IRA as an emergency fund. Lenders also look at the property’s ability to pay its own monthly expenses, making it less likely to end up in default.
It’s also important to know that the loan cannot involve a disqualified person. This includes the account holder’s spouse, ancestors, lineal descendants or the spouses of any lineal descendants.
The number of companies nationally that offer non-recourse loans in small, but all type of loans are offered: 15, 20, 30 year fixed and ARMs. There are several requirements, including:
- The loan must be at least $50,000
- There is a 65% to 70% loan to value requirement
- The loan rate is 65 to 75 basis points over conventional financing
To best illustrate how the process works, here is a case study about James Henry who wanted to get a mortgage with his self-directed IRA.
James wanted to buy a piece of property for $100,000 but only had $60,000 in his IRA. He decided that he would invest $40,000 and get a non-recourse loan for $60,000.
Once James secured the loan, he proceeded to close on the property. The loan was made to IRA Innovations LLC FBO James Henry IRA. James signed all the documents as Read and Approved, and IRA Innovations signed on behalf of the IRA. Every month, James’ IRA made loan payments to the bank.
A few months after James purchased the property, someone offered to buy the house for $125,000. James accepted the offer, and made a $25,000 profit from his investment.
After closing, the $25,000 profit had to be broken out by what money created the profit for tax purposes. In the case of James’ investment it looked like this:
- $10,000 of the profit came from James’ money from his IRA
- $15,000 of the profit came from the borrowed money
The IRS has a tax that is called Unrelated Debt Financed Income (UDFI). In this case, $15,000 profits x 35% = $5,250 had to be paid by the IRA for UDFI tax. This means that the real real profit was $19,750.
Keep in mind that UDFI does not apply if the property is debt free for over one year.
IRA Innovations provides self-directed retirement account administration and education. As the experts when it comes to “alternative” investments including private equity, they can provide the necessary tools and information to get started with a real estate IRA.