Over the last few years, with the prices of real estate assets increasing, a growing number of Self-Directed IRA investors have had to turn to leverage to secure a flip or real estate investment. According to the CoreLogic price index, home prices nationwide, including distressed sales, increased year-over-year by around 10% in October 2022. Further, according to the National Association of Realtors, December 2022 brought 4.02 million in sales, a median sales price of $366,900, and 2.9 months of inventory. The median sales price is up 2.3% year-over-year, and inventory was up 1.7 months from December 2021.
This article will examine the IRS rules surrounding the use of a rehab loan in connection with a Self-Directed IRA investment. In addition, it will explore the application of the Unrelated Business Taxable Income (UBTI) tax as well as a potential work-around for real estate investors.
Buying Real Estate with an IRA
When IRAs were created in 1974 by ERISA, the Act did not distinguish between an IRA that invested in stocks and a Self-Directed IRA that invests in alternative assets, such as real estate. When Congress enacted the IRA rules, they understood the importance of investment diversification.
Instead of deciding what you can invest in, they laid out what you cannot invest in. These prohibited transactions are outlines in the Internal Revenue Code (IRC) Sections 408 and 4975. Other than life insurance, collectibles, and transactions that involve or benefit the IRA holder or a “disqualified person,” one can use his or her IRA to make almost any type of investment. A disqualified person is generally defined as the IRA holder, any of his or her lineal descendants or ascendants, and any entities controlled by such persons.
In sum, so long as the real estate investment does not involve or benefit a disqualified person you can do it with your Self-Directed IRA. The most popular real estate investments include residential and commercial properties, rentals, fix-and-flips, liens and notes.
Related: Purchasing Real Estate with a Roth IRA
Can I use a Rehab Loan to Buy Real Estate with my Self-Directed IRA?
A Self-Directed IRA can use leverage or debt to acquire real estate with only one caveat. The rehab loan must be a nonrecourse loan. Why? IRC Section 4975(c)(1)(b) does not allow an IRA owner or any disqualified person to personally guarantee an obligation of their IRA.
Basically, a nonrecourse loan is a loan that is not guaranteed by anyone. In principle, the lender is securing the loan by the underlying asset or property that the loan will be used for, such as the real estate property. Thus, if the borrower is unable to repay the loan, the lender’s only remedy is against the underlying asset, not the individual – hence the term non-recourse. In general, a nonrecourse loan is somewhat more difficult to secure than a traditional loan or mortgage. There are a number of reputable non-recourse lenders, however, the rate on the loan is typically less attractive than a traditional loan.
Related: Investing in Real Estate with a Self-Directed IRA
Why use a Rehab Loan to Buy Real Estate?
The consensus among real estate investors is that one should attempt to use as much leverage as possible for investment real estate. For example, let’s suppose your IRA put down 10% on a $400,000 house. The initial investment would then be $40,000. Two years later, should that house increase in value to $550,000 you could sell and receive far more than your initial $40,000. Based on these facts, your principle investment of $40,000 gets returned, plus an extra $110,000. In that case, your Self-Directed IRA would have risked far less than a cash-buying investor would have in this situation, yet still made a substantial profit. In addition, by using leverage, you will have more funds available to make additional investments and potentially generate more returns.
Using leverage with a Self-Directed IRA sound like a no-brainer on the surface. Unfortunately, the IRS has imposed a set of tax rules when a retirement account uses leverage to acquire an asset.
The UBTI Rules
In general, the majority of income and gains associated with an IRA will flow back to the plan without tax. This is known as tax deferral. However, in a number of instances, the UBTI tax could be triggered when a retirement account invests in certain types of transactions, and turn a potential tax-free investment into a very tax-inefficient one.
The UBTI tax is triggered in three circumstances:
- Retirement account uses margin to buy stock
- Retirement account invests in an active business through a pass-through entity
- An IRA uses a nonrecourse loan to purchase real estate
In the case of an IRA that uses leverage to acquire real estate, if the net income associated with the investment, net of expenses, such as loan payments and depreciation, exceeds $1,000 in a year, the UBTI tax would apply and impose a maximum tax rate of 37% on the debt-financed portion of the investment. The UBTI tax rates follow the trust tax rates and reach the maximum rate at a very low income threshold (approximately $15,000).
UBTI & Real Estate Flips with Leverage
We now know that if you want to borrow money for a real estate transaction involving your IRA, the rehab loan must be nonrecourse. We also know that when leverage is used, the UBTI tax may be assessed. Next, we will illustrate some real-world examples to show how this may affect your bottom line.
Example 1: Hilary uses $100,000 in her Self-Directed IRA and borrows $100,000 from a nonrecourse lender to do a flip. Six months later, she sells the property for $160,000. Because Jen used 50% debt in comparison to the equity used, one-half of the gains ($30,000), would be subject to the UBTI, net of any expenses. The UBTI tax is reported on IRS Form 990-T, which is due April 15th (IRA Financial will file the form for no fee for our clients).
Example 2: Valerie uses $200,000 in her Self-Directed IRA and borrows $100,000 from a nonrecourse lender to buy a rental property. The rental property generates $20,000 of net income, after expenses. Because she used 33% debt in comparison to the equity used, one-third of the net income ($6,666), would be subject to the UBTI tax.
Example 3: John uses $100,000 in his Self-Directed IRA and borrows $100,000 from a nonrecourse lender to buy a rental property. The rental property loses money during the year because of various improvement costs. Because the IRA did not earn more than $1,000 of net income associated with the investment, the IRA is not subject to the UBTI tax.
One other thing to keep in mind if you are self-employed. There is an exemption for UBTI in the IRC for 401(k) plans. If you are eligible for a Solo 401(k) and use leverage on a real estate investment, you are not subject to the UBTI tax. Something to keep in mind when considering a real estate investment using retirement funds.
To answer the subject of this article, yes you can combine a rehab loan with your Self-Directed IRA to secure a flip. There are two things to consider: the loan must be nonrecourse, and the UBTI tax will apply. Before using leverage on your IRA real estate investment, you must first determine if the tax hit will be worth it. The more equity (IRA funds) you can use, the less of a tax bite you’ll see when you sell the property. Plus, nonrecourse lenders generally require a higher cash down payment than traditional lenders.
The tax advantages of investing with a Self-Directed IRA usually work to your advantage. However, in this case, you may not be so lucky. It’s suggested you work with a financial advisor to assess the transaction before diving in. Of course, if you have any questions about how everything works, you can contact us at anytime.