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How to Debt-Finance a Real Estate purchase for your IRA

House on stack of cash

  |  By Chris Shanahan, CISP®

Investing IRA funds in real estate can be a great way to diversify your retirement portfolio, and for some of our clients, it’s a way to invest their nest eggs into what they know and what they love.  But not all investors have enough cash in their IRAs to purchase property outright.  Does that mean a dead end for their real estate IRA strategy?

Not quite - with the help of a non-recourse loan (NRL), investors can finance the purchase of investment property without the risk of sacrificing their entire IRA in the case of default.  After making a down payment for the investment property, you can borrow the rest of the balance using a non-recourse loan from a participating bank.  With an NRL, the bank can only recoup the underlying property, not the assets of the IRA itself. 

So how does the NRL get paid down?  By payments made from your IRA cash balance, of course.  At your direction, your IRA custodian will pay down the principal and interest according to the terms of the loan, decreasing the amount of the liability in your IRA account as the principal decreases.  The loan amount is updated in your account every time a payment is made.

There are a few considerations to be aware of.  For one thing, most lenders will require a substantial down payment (30%-40% in many cases), since their only recourse is the underlying property.  For example, a $100,000 property might require a $40,000 down payment from the IRA, with a participating bank fronting the remaining $60,000.  Your IRA account would reflect the full value of the property as one line item, then another corresponding liability position for the portion that was debt-financed.   

Another thing to consider with these debt-financed real estate transactions is the possibility of Unrelated Debt Financed Income (UDFI), a sub-section of Unrelated Business Taxable Income (UBTI).  UDFI would apply in the case of rental income being generated by a property that was partially financed by debt.  Using the example from above, since 60% of the total purchase was made with debt, 60% of the rental income will be subject to UDFI and taxed at the appropriate trust rate. 

Now let’s say you sell the property two years later for $200,000.  Great return on investment right?  Well, similarly to how rental income must be separated into what was purchased by your IRA’s cash and what was debt-financed, the proceeds from the sale must be split the same way.  In the example that we have been using, 40% of the profits would flow through the IRA tax-deferred, while the remaining 60% would be subject to UDFI.

Since there are many different circumstances where UDFI would not be incurred or need to be paid, and because PENSCO cannot give tax or legal advice, we highly recommend that you consult a tax and/or legal professional for your unique situation.

Want to learn more about debt-financing a real estate purchase in your IRA?  Contact PENSCO today – we’ll help you figure out what’s possible.

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.