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Nonrecourse Financing – How Does it Work?

nonrecourse financing

When one uses a Self-Directed IRA or Solo 401(k) plan, one must be aware of the rules set forth by the IRS. An important rule, especially for real estate investors, is nonrecourse financing. Oftentimes, an investor will need to borrow money to purchase a property. Doing so is certainly within the rules. However, you must pay attention to the tax consequences, along with the prohibited transaction rules when doing so.

Key Points
  • Real Estate remains the number one alternative investment for retirement savers
  • Nonrecourse financing may be used to purchase a property
  • Beware of the UBTI/UDFI rules when using an IRA
  • Solo 401(k) plans are exempt from UBTI

What is Nonrecourse Financing?

As defined by Investopedia:

Non-recourse debt is a type of loan secured by collateral, which is usually property. If the borrower defaults, the issuer can seize the collateral but cannot seek out the borrower for any further compensation, even if the collateral does not cover the full value of the defaulted amount. This is one instance where the borrower does not have personal liability for the loan.

Retirement account investors may only use nonrecourse financing to borrow funds for an investment. The account cannot personally guarantee the loan. Therefore, if you borrow money to purchase a real estate property and default on the loan, the lender may only go after the property itself, and no other assets. Obviously, this is very favorable for the borrower and therefore interest rates on the loan are much higher than a recourse loan.

Many real estate investors who need capital will borrow funds to make up the difference in a purchase price. The better your track record and the more funds in the plan, the easier it is to get a loan. Your personal credit score does not factor into the loan application. Capital is the biggest factor when deciding on an investment. Therefore, borrowing money is a popular strategy among investors. However, when using a retirement account, you must keep in mind that all expenses should come from that account. Thus, when taking out a nonrecourse loan, make sure you have enough funds in your plan to cover all expenses. For example, if you are renovating an income property, don’t invest your entire IRA in the price of the property. Leave enough in the plan to cover all your expected costs.

Utilizing the Nonrecourse Loan

When you are looking to borrow for your real estate investment, your IRA is the one doing the borrowing. You are not liable for the loan, and you cannot guarantee it. There is no recourse against you or other assets if you default on the loan. Generally, it may be a good idea to have a separate retirement plan that deals with one nonrecourse loan for a property. But, that’s not a requirement. It just depends how well you can keep up with the loan and other assets in the plan.

The Self-Directed IRA

The most common way for retirement investors to purchase real estate is via a Self-Directed IRA. So long as your custodian allows for alternative investments, such as real estate, you are free to invest as you wish. Depending on the type of IRA you have, you might have total freedom (checkbook control) or need permission before making an investment (custodian control).

Once you find a property you wish to invest in, you first need to check your finances. As we mentioned earlier, all expenses should be paid out from your retirement plan.

Let’s say you borrow $25,000 to purchase a $100,000 property. 25% of the property is considered debt-financed. This leads to a special tax under the Unrelated Debt Financed Income (UDFI) rules. UDFI is part of the Unrelated Business Taxable Income (UBTI) regime. Essentially, you pay a tax based on the percentage of the property the loan pays for. If it’s a rental property, 25% of the income generated in the above example will be subject to the tax. If you sell the house, again, the same percentage is taxed on the purchase price.

You must weigh the tax, which is as high as 37%, when making an investment. The whole point of using retirement funds to invest is the tax advantages of the plan. The IRS Form 990-T must be filled out when using nonrecourse financing on an IRA property.

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    Solo 401(k)

    Just like an IRA, you can self-direct a Solo 401(k). The Solo 401(k) is the best retirement plan for the self-employed. Again, if your plan administrator allows for it, you can invest in anything you want. 401(k) plans offer distinct advantages to IRAs. These include higher contribution limits, loan option and UBTI exemption.

    Obviously, that last point is most important here. When using a nonrecourse loan to purchase a real estate property, a 401(k) plan is not subject to the UBTI tax. This is especially attractive for real estate investors who are self-employed. You still must use nonrecourse financing, but the 37% tax will not apply. It’s important to note that the exemption only applies to real estate, and not other types of investments.

    Conclusion

    Real estate continues to be the most popular alternative investment for retirement savers. It’s important to keep in mind the ramifications of using nonrecourse leverage when investing. Generally, the income/earnings generated by the investment will outweigh the UBTI tax. However, one should speak with a financial planner and tax specialist before making any type of investment with retirement funds.

    If you have any questions on nonrecourse financing, how it works and the tax consequences, please contact us @ 800.472.0646.

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