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How to Use Non-Recourse Loans to Buy Property in your IRA

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  |  By Chris Shanahan, CISP®

We’re entering the time of year that Zillow refers to as the “magic window” to list your home – mid-March to mid-April. It’s a time when homes sell about 15% faster and for 2% more than the average listing, according to the real estate site.

The arrival of this “magic window” spring selling season also means it’s the time of year when many of our clients are considering whether this is the year they will purchase property outright in their IRA.

Real estate investments can provide returns in two ways: capital gains and rental income. When you hold an investment property in an IRA, you can often defer taxes on any gains in value until you begin to take distributions from the account.

Not all investors have enough cash in their IRAs to purchase property outright so many IRA owners incorrectly assume they cannot directly buy real estate. But that is because many investors are not familiar with non-recourse loans (NRL).

Non-recourse loans allow an IRA holder to finance the purchase of investment property without the risk of sacrificing their entire IRA in case of a 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 a NRL, the bank can only recoup the underlying property, not the assets of the IRA itself. 

To pay down the loan, payments get made from the cash balance in your IRA. As your IRA custodian, PENSCO 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 two items to be aware of if you are considering using a non-recourse loan to directly purchase a property:

  1. Large down payment: Because a lender’s only recourse in the event of default is the underlying property, most lenders will require a substantial down payment. That can mean roughly 30% to 40% in many cases. 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.   

  2. Potential to create a taxable event in your IRA: Another item to be aware of with a debt-financed real estate transaction 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, because 60% of the total purchase was made with debt, it’s possible that 60% of the rental income in the first year could be subject to UDFI and taxed at the appropriate trust rate. 
    Keep in mind that everyone’s situation is unique so it’s best to consult with a tax and/or legal professional because there are many different circumstances where UDFI would not be incurred or need to be paid.

Real estate can offer the possibility of yielding significant long-term gains and it can be attractive to investors looking for alternative assets to hold in their retirement accounts. Understanding non-recourse loans can help you determine whether this is the year you decide to add the asset class to your IRA. 

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.

PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.