Updated 1/25/2019
Put the Power of Leverage to Work in your IRA
Are you looking to maximize your retirement plan's investments? One strategy you should consider is leveraging through a self-directed IRA or Solo 401(k). By obtaining a mortgage instead of paying cash for an investment property, you can achieve a higher return on investment. This strategy, known as leverage, can significantly boost your wealth-building potential.
While the use of leverage is quite uncommon in conventional asset environments, it is well-suited for real estate investments. Real estate as an asset class thrives on debt financing, making it a widely used strategy with favorable results.
Debt Must be Non-Recourse
It's important to note that IRS rules prohibit any benefit from you or any disqualified party to your plan. As a result, you are not allowed to provide personal guarantees on debt instruments, such as mortgages, within your IRA or 401(k). This is where non-recourse mortgages come into play. With a non-recourse loan, you do not utilize your credit to qualify and your personal assets are not pledged as security in case of default. The property itself serves as the sole security for the loan, making it the borrower's primary qualification.
While non-recourse loans are not widely available, there are a few institutions that offer them nationwide. Additionally, some local or regional banks and private investment groups provide non-recourse loans to IRA and 401(k) borrowers. You also have the option to explore private party loans, seller financing, lease-purchase, or contract-for-deed transactions.
Lending Guidelines
Given the higher risk associated with non-recourse loans, lenders have more conservative underwriting policies. Here are some typical guidelines you might encounter:
- Minimum down payment of 30% (may be as high as 50% for condos)
- 10-15% cash reserves in the plan at the time of the loan
- Loan terms ranging from 5/1 adjustable-rate mortgages to 25-year fixed-rate loans
- Interest rates generally 1% - 1.5% higher than typical investor loans with personal guarantees
- Clean, cash flow properties are preferred, while options may be limited for properties requiring extensive repairs or raw land
The loan process typically takes 4-6 weeks, so it's crucial to have your self-directed plan in place and work closely with a lender before entering into a property purchase contract.
Tax Implications for IRA Borrowers
When an IRA or other tax-exempt entity utilizes debt financing to acquire property, Unrelated Debt Financed Income (UDFI) taxes come into play. The general principle is that while the investment itself remains tax-exempt, the portion of income generated through borrowed, non-exempt funds becomes taxable.
In most cases, the financial impact of these taxes is relatively limited. For example, a $100,000 rental property that is 50% debt-financed and generates a 10% return would incur a tax bill of less than $200 for the year. However, it is essential to work with a tax professional to evaluate the impact of these taxes, as well as the administrative costs of record-keeping and tax filings.
The Solo 401(k) Exemption to UDFI for Real Estate Investments
While UDFI taxation applies to IRAs with all forms of debt financing, a Solo 401(k) benefits from an exemption when using debt financing for real property acquisitions.
In Summary
Although leveraging an IRA investment introduces administrative overhead and UDFI filing expenses, the overall impact on your IRA can still be highly favorable. By leveraging, you typically increase the cash-on-cash return relative to your IRA's capital participation in the transaction. While taxation does reduce some of this increased return, the majority of the leveraged income still belongs to your IRA.
Resources
- UDFI Calculator: All Cash Purchase vs Leveraged Property Purchase in an IRA
- IRS Publication 598: Tax on Unrelated Business Income of Exempt Organizations
- Internal Revenue Code Section 514: Unrelated Debt-Financed Income
- IRS Forms 990-T: 990-T Instructions & 990-T Form
A WORD OF CAUTION: Do not wait until you have found a property to purchase before setting up a Self-Directed IRA plan. Timing is critical, and failure to set up the plan beforehand may result in losing the property.