What if you found the perfect rental property to hold in your IRA, but you didn’t want to sell your stock position just yet? What if you cannot make another contribution until next year? You may be aware you could get a partner, but what if you would rather have all the potential gains accrue to your own self-directed IRA?
Your local Bank of America branch is not likely going to want to write a loan for your IRA or even understand how an IRA can be the borrower, but before you walk away from a prime piece of property you should understand that your IRA options may be better than you think.
First, from the perspective of the Internal Revenue Service, there is no issue or ruling that prevents utilizing leverage (getting a loan) to purchase income-producing real estate in an IRA. The problem may be who you get the loan from, and if there is a personal guarantee of repayment.
For example, if you were purchasing a vacation home for yourself, a local community bank may be happy to write the loan, so long as you had a good credit score, the income to pay back the loan, be willing to give a first mortgage to the bank, and your personal signature to guarantee that you will make the payments.
A loan to your IRA, because of IRS rules, is a bit different. First, because you are the owner of the IRA, you are not allowed to personally guarantee that you will make the payments. This is due to the rules in section 4975 of the IRS code. It also prevents your spouse and other “disqualified” people to co-sign or otherwise pledge assets to entice the lender to make the loan to your IRA.
Now, without that personal guarantee, most financial institutions will take a pass on issuing these types of loans. Thankfully, there are still a few banks that will issue these loans, and moreover many private lenders are familiar with the rules around lending to IRAs and are comfortable with the process. Should the seller of the real estate own a significant portion of equity in the property, they could also privately lend to the IRA buyer in order to secure the sale.
Lenders to IRAs are particularly interested in the value of the purchased property and the rental income that it will produce – since their only protection from non-payment is foreclosure and they cannot come after the IRA holder personally. Because of the increased risk, the lenders may require 30% or more down-payment from the IRA, and interest rates may be a bit higher as well. These types of loans are called “non-recourse” since the lender cannot attach any other asset other than the purchased real estate.
Let’s look at an example:
Purchase price for a vacation rental in Belize hotel investment: $200,000
IRA down-payment amount: $60,000
Remainder needed via loan: $140,000
Annual projected rental income: $24,000
Annual rental management fees: $2,400
Annual maintenance costs: $1,800
Annual insurance and taxes: $3,500
Annual mortgage payments: $10,560
Total costs for Belize rental: $18,260
Profit before Unrelated Debt-Financed Income (UDFI) Tax: $5,740
Estimated UDFI Tax paid by IRA (depreciation of $5,818, no tax): $0
Net Cash Flow $5,740
First year return after UDFI Tax $5,740 profit / $60,000 IRA down payment = 9.6%
Keep in mind, this example does not include the benefit of rent increases, property appreciation, and increased equity each year based on loan pay down.
As with any financial transaction within your IRA, you should always seek the counsel of your tax advisor. In certain situations, there may be taxes owed by your IRA should it receive a profit from the leveraged portion of the property purchased by the IRA. This tax, derived from Unrelated Debt-Financed Income of your IRA, is paid directly from your IRA and not by you personally. It does not apply to the first $1000 of gain, and may be reduced each year as the loan balance is reduced.
If you have specific questions about how IRA leverage can work for your IRA investment, both domestically and abroad, you can contact us to the right. As a specialist in self-directed IRAs and one of the country’s leading administrators, we can also provide a listing of financial institutions that are willing to make loans to IRAs, so you can determine the costs of the loan and the underlying terms.