The Self-Directed IRA is a retirement solution that will unlock a world of investment opportunities. The Self-Directed IRA is a retirement investment vehicle that allows one to use their retirement funds to make traditional as well as non-traditional investments, such as real estate, tax-free and without custodian consent. In most instances, investors using retirement funds to make an investment will use cash to make the investment. Whether the investment is in the form of stocks, precious metals, or real estate, most investors using retirement funds to make the investment will not borrow any funds to make the investment. One significant reason why retirement account investors will generally not borrow money (also called debt or leverage) as part of an investment of real estate acquisition is the Internal Revenue Code Section 4975 prohibits the IRA holder (you) from personally guaranteeing a Self-Directed IRA Loan. Pursuant to Internal Revenue Code Section 4975(c)(1)(B), a disqualified person (i.e. the IRA holder) cannot lend money or use any other extension of credit with respect to an IRA. Only non-recourse financing is allowed.
In other words, the IRA holder cannot personally guarantee a loan made to his or her IRA. As a result, in the case of a Self-Directed IRA, one could not use a standard loan or mortgage loan as part of an IRA transaction since that would trigger a prohibited transaction pursuant to Code Section 4975. This type of loan is often referred to as a recourse loan since the bank can seek recourse or payback from the individual guaranteeing the loan. These loans are generally the most common types of loans offered by banks and financial institutions. Thus, in the case of a Self-Directed IRA, a recourse loan cannot be used. This leaves the Self-Directed IRA investor with only one financing option – a non-recourse loan. A non-recourse loan is a loan that is not guaranteed by anyone. In essence, the lender is securing the loan by the underlying asset or property that the loan will be used 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) not the individual – hence the term non-recourse. In general, a non-recourse loan is far more difficult to secure than a traditional recourse loan or mortgage. There are a number of reputable non-recourse lenders, however, the rate on a non-recourse loan are typically less attractive than a traditional recourse loan.
The IRS allows IRA and 401(k) plans to use non-recourse financing only. The rules covering the use of non-recourse financing by an IRA can be found in Internal Revenue Code Section 514. Code Section 514 requires debt-financed income to be included in unrelated business taxable income (UBTI or UBIT), which generally triggers close to a 40% tax for 2018. In general, if non-recourse debt financing is used, the portion of the income or gains generated by the debt-financed asset will be subject to the UBTI tax, which is generally 40% for 2018. Thus for example, if an individual invests 70% IRA funds and borrows 30% on a non-recourse basis, 30% of the income or gains generated by the debt financed investment would be subject to the UBTI tax. For example, if a Self-Directed IRA investor invests $70,000 and borrows $30,000 on a non-recourse basis (the IRA holder is not personally liable for the loan) – 70/30 equity to debt finance ratio, and the IRA investment generates $1,000 of income annually, 30% of the income or $300 would be subject to the UBTI tax. Note – the $300 tax base could be reduced by any pro rata portion of deduction/depreciation associated the debt-financed property. The rationale behind this is that since the IRS is treating the IRA, which is typically treated as tax-exempt pursuant to IRC 408, as a taxpayer by imposing a tax on the debt-financed portion, the IRS will allow the investor to allocate proportionally any asset expenses or depreciation in order to reduce the tax base. The IRS Form 990-T is the form where the UBTI must be disclosed to the IRS.
Interestingly, by investing in real estate through a Solo 401(k) Plan, if one uses non-recourse financing, the Solo 401(k) plan will escape the UBTI/UBIT tax due to an exception to the Unrelated Debt Financed Income (UDFI) rules found under IRC 514(c)(9). This is one reason why the Solo 401(k) Plan is such an attractive investment vehicle.