A Self-Directed IRA is a unique retirement solution that can be used to unlock a vast universe of investment opportunities unavailable to most retirement investors. By using one, you can use retirement funds to make traditional investments, but you are also allowed to invest in more non-traditional investments, including real estate – tax-free and without custodian consent. Cash is the traditional asset used to purchase investments for retirement, whether the investment ultimately comes in the form of stocks, precious metals, or real estate. Most investors using retirement funds to make an investment will not borrow any funds to make the investment.
- The internal Revenue Code prohibited the use of a loan that is personally guaranteed
- Retirement plans can only use non-recourse financing for an investment
- If you are self-employed, you can utilize the Solo 401(k) loan feature to borrow money from the plan
IRS Tax Code and Using an IRA as Collateral
The primary reason retirement account investors don’t typically borrow cash (also called debt or leverage) to invest in real estate is Internal Revenue Code Section 4975, which prohibits the IRA holder from personally guaranteeing a Self-Directed IRA Loan. Pursuant to the Internal Revenue Code, a disqualified person (i.e., the IRA holder) cannot lend money or use any other extension of credit with respect to an IRA. In other words, only non-recourse financing is allowed.
As a result, the owner of a Self-Directed IRA cannot use a standard loan or mortgage loan as part of an IRA transaction because that would trigger a prohibited transaction pursuant to Code Section 4975. A loan becomes a ‘recourse loan’ when the bank can seek recourse or payback from the individual guaranteeing the loan. Recourse loans are generally the most common loan offered by banks and financial institutions across the country. As such, with a Self-Directed IRA, a recourse loan cannot be used as a part of your investment strategy. This leaves the Self-Directed IRA investor with only one financing option – a non-recourse loan.
What is a Non-Recourse Loan?
Put simply, a non-recourse loan is a loan that is not guaranteed by anyone. In essence, the lender is securing the loan only with the underlying asset that the loan will be used to pay for. Therefore, if the borrower is unable to repay the loan, the lender’s only recourse is against the underlying asset (i.e., the real estate) and not the individual. This is where the term non-recourse comes from. Of course, the issue arises that non-recourse loans are far more difficult to secure than a traditional recourse loan or mortgage. While reputable non-recourse lenders exist, the rate on a non-recourse loan is typically less attractive than a traditional recourse loan.
The IRS allows IRA and 401(k) plans to use non-recourse financing, and only non-recourse financing. Additional rules discussing the use of non-recourse financing by an IRA can be found in Internal Revenue Code Section 514, which confirms the real issue with this kind of situation. The Code requires debt-financed income to be included in unrelated business taxable income (UBTI or UBIT), which generally triggers a maximum tax of 37% tax.
Even if non-recourse debt financing is used, the portion of the income generated by the debt-financed asset will be subject to the UBTI tax. Thus, for example, if a Self-Directed IRA investor invests $70,000 cash and borrows $30,000 on a non-recourse basis, and the IRA investment generates $1,000 of income annually. Here, 30% of the income (or $300) would be subject to UBTI tax, even if that $300 tax base could be reduced by any deduction/depreciation associated the debt-financed property. The rationale behind the IRS code is often muddled, but here, the IRS is treating the IRA, typically treated as tax-exempt pursuant to IRC 408, as a taxpayer by imposing a tax on the debt-financed portion. In other words, the IRS allows the investor to proportionally allocate any asset expenses or depreciation in order to reduce the tax base. This is accomplished through IRS Form 990-T.
Interestingly, the UBTI/UBIT taxes in this scenario can be avoided by investing in real estate through a Solo 401(k) Plan while using non-recourse financing. This reality comes from an exception to the Unrelated Debt Financed Income (UDFI) rules found in IRC 514(c)(9). This is only one reason why the Solo 401(k) Plan is such an attractive investment vehicle.
Avoiding the UBTI Tax for a Self-Directed IRA Investor
Most Self-Directed IRA investors will never have to deal with the UBTI tax because it is only triggered under specific situations. In general, the UBTI tax is triggered in three ways:
- By using margin to buy stocks or securities;
- By using a non-recourse loan to acquire real estate, even if there is an exemption for some 401(k) plans. The golden rule here is that the loan cannot be guaranteed by the IRA owner pursuant to the IRS prohibited transaction rules; or
- By investing in an active trade or business operated through an LLC or pass-through entity, such as a partnership.
The most common way to avoid the application of the UBTI tax is via the use of a subchapter C-Corporation blocker.
The Subchapter C-Corporation Blocker
Using a C Corporation is the most common way to block the imposition of the UBTI tax. Here’s how it works. A C Corporation is taxed as a separate entity, distinct from its shareholders, making it subject to a corporate entity tax. A pass-through entity, like an LLC, is a flow-through entity, and as such, there is no entity lever tax and all LLC income and gains flow through to the members. Put simply, with an LLC, the members pay tax on the LLC’s income. On the other hand, if a Self-Directed IRA (through a C Corporation) makes an investment, income would be subject to corporate income tax, currently at 21% in 2022 and 2023 on the net corporate income. However, that income would not be subject to the UBTI tax.
Structuring the Investment as Debt
If a Self-Directed IRA can structure an investment though a flow-through entity as a loan instead of an equity, the IRA would not be subject to UBTI tax because interest on a loan is exempt from UBTI tax.
The Solo 401(k) Option
IRC 514(c)(9) contains an important exemption to the UBTI tax for 401(k) plans who use a non-recourse loan to acquire real estate. Unfortunately, the exemption does not apply to other IRAs and only applies to the acquisition of real estate. To benefit from the Solo 401(k) plan, an investor must meet just two eligibility requirements:
- The presence of self-employment activity.
- The absence of full-time employees.
If you pass these two eligibility requirements, you and your spouse are technically considered “owner-employees” rather than “employees” under the IRS code. In addition, the following types of employees may be excluded from coverage under these rules:
- Employees under 21 years of age.
- Employees that work fewer than 1,000 hours annually or can show a history of at least three consecutive years of 500 hours of annual service.
- Union employees
- Nonresident alien employees
What type of Business can set up a Solo 401(k)?
Any U.S. based legal business. At a basic level, a business is defined under the IRS code as an activity in which a profit motive is present and economic activity is involved. The business can be a side gig, such as driving for Uber as a 1099 or even selling shoes on eBay. If you are self-employed, then using a Schedule C to report income or expenses will work. However, if you report rental income on a Schedule E as your sole source of income, you will not be deemed to be in business since a Schedule E is for passive real estate or interest income.
Using a loan with a Self-Directed IRA often comes with some substantial disadvantageous tax consequences. The most important thing for any self-directed IRA seeking to use a loan for investment purposes is that the loan must be non-recourse. In addition, a Self-Directed IRA investor using a non-recourse loan to acquire real estate should be mindful of the potential application of the UBTI tax rules and consider the potential work around provided above.