When it comes to using IRA and non-recourse financing to make an IRA or Roth IRA investment, it is crucial that one keeps in mind several important tax rules. 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. In other words, most investors using retirement funds will use cash to make the investment.
However, the IRS does allow one to use their IRA funds to make an investments with financing. The reason for this is that the Internal Revenue Code Section 4975 prohibits the IRA holder (you) or any disqualified person from personally guaranteeing a loan made to the IRA. Pursuant to Internal Revenue Code Section 4975(c)(1)(B), a disqualified person (i.e. the IRA holder or any other disqualified person) cannot lend money or use any other extension of credit with respect to an IRA. 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 an IRA or a self directed IRA such as real estate a recourse loan cannot be used. This leaves the IRA investor with only one financing option – a non-recourse loan.
A non-recourse IRA 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, non-recourse loans are 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 a 35% tax. 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 35%.
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 ration, and the IRA investment generates $1,000 of income annually, 30% of the income or $700 would be subject to the UBTI tax. Note – the $700 tax base could be reduced by any pro rata portion of deduction/depreciation associated the debt-financed property.
The rational 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 .