Yes, you can use debt financing to purchase real estate in a self directed IRA. However, to do so legally, you must use the IRA-purchased property, not the IRA itself, as security for the loan. This type of permitted borrowing is called non-recourse lending. A non-recourse loan is not like the loan on your personal residence. In fact, it is very different. Here, unlike your home loan, if the loan isn’t paid back as promised, the lender may take the IRA-owned property used to secure the debt, but may not take recourse against any of your other assets. Because of its unique nature, not very many banks or lending institution offer these types of loans, but they do exist, and your self-directed IRA custodian may be able to point you in the right direction.
Like other loans, non-recourse loans do have a monthly payment and some type of amortization schedule which will need to be followed. Therefore, your IRA property will need to be able to make the loan payments from its cash flow, its annual IRA contributions (within the 2016 limits – $5,500 or $6,500 if 50 or over), or some combination of the two. Simply put, you need to have more money coming into your IRA than is going out. This also means you need to have sufficient liquidity in your IRA for other real estate related expenses like property taxes, insurance, and other repairs and maintenance. Remember, the IRA itself must pay all expenses.
Let’s look at a simple example:
Loan Information: Present Value of Loan $100,000
Term (amortization period) 30 year Fixed
Annual Interest Rate 7%
Monthly Payment $665.30
Annual Payment $7,983.62
Taxes: Annual Property Tax $1,500
Insurance: Annual Insurance Premium $400
Repairs/Maint: Annual Repairs $150
Total Annual Cost of Property:
Payment $ 7,983.62
Taxes $ 1,500
Insurance $ 400
Repairs $ 150
Total $ 10,033.62
The amount of $10,033.62 is the amount of money going out each year, and so your property would need to have more than this amount coming in each year. So, for a person under the age of 50, you could subtract the $5,500 annual IRA contribution from the $10,033.62 annual expenses and you would need ($10,033.62 – $5,500 = $4,533.62) $4,533.62 of cash flow from the property.
In addition to annual operating expense, in accordance with Section 511 of the Internal Revenue Code, if your IRA property has debt, or if a mortgage was incurred with its acquisition, you must pay annual taxes on any income produced. This special tax is called Unrelated Business Taxable Income (UBTI). Please note that this tax does not apply to every property purchased with an IRA but only to those that have related debt. Here is an example of how it works. Please be advised that I am not a CPA and that the following calculations are for illustrative purposes only. I advise you seek tax advice from your own CPA when it applies to your individual situation.
First, your income is taxed only after deductions are made for expenses and for other items that are deductible. Then, the first $1,000 of your net income from the property is not subject to tax.
Using our previous example you will remember that we had a loan of $100,000. Let’s also say that you put down $100,000 so that the total purchase price was $200,000. Finally, let’s say you found some good renters and your net income after expenses is $1,500.
Since the first $1,000 is not subject to tax, only $500 will be used in the UBTI calculation. ($1,500 – $1,000 = $500).
The tax is based on the relationship between the average amount of debt on the property during the preceding twelve months and the property’s average tax basis. Here tax basis is the purchase price, increased by improvements or decreased by depreciation, during the same period.
In our example our ratio looks like this:
Basis (purchase price) $200,000
Ratio equals $100,000/$200,000 = 50%
We then apply the ratio to the income that is subject to the UBTI tax.
$500 x 50% = $250
The $250 is then taxed at the current rate for trusts. The trust tax rates, like other tax rates, are a moving number.
Here we will use a trust tax rate of 37.5%.
$250 x 37.5% = $93.75
The $93.57 is your tax liability.
You should notice that as the debt is reduced, the UBTI tax is decreased proportionately.
In our next article, we’ll present information on how you can use your IRA to establish a Tenancy-in Common (TIC) allowing the concurrent ownership of property between two or more parties. Stay tuned!