A non-recourse loan allows a Self-Directed IRA to finance part of a real estate purchase without the IRA owner personally guaranteeing the debt. The loan is secured by the property owned by the IRA, and if the loan defaults, the lender’s recovery is generally limited to that property. For real estate IRA investors, this type of financing can help preserve IRA cash, increase purchasing power, and make larger property purchases possible. However, debt-financed IRA investments may also create unrelated debt-financed income, or UDFI, which can have tax implications.
A non-recourse loan is a popular strategy that can help you grow your self-directed IRA. How well you live in your retirement years depends on what you do with your money today. Let's look at how this loan works and the benefits it provides real estate IRA investors.
Recourse Loan vs. Non-Recourse Loan
You've likely heard about a recourse loan. It is a traditional loan where the borrower puts up collateral for the lender to secure the loan. Recourse loans reduce the bank's risk. For example, if the borrower doesn't pay, the lender doesn't just take the property but can go after other personal assets to satisfy any outstanding loan balance.
An auto loan is a type of recourse loan. The lender can repossess and sell the vehicle to recover the debt if the borrower defaults on the loan payment. If the car sells for less than the loan balance, the bank can sue the borrower for the money owed, forcing the borrower to liquidate other assets to settle the loan.
Another example of a recourse loan is a home loan or mortgage loan. If the borrower defaults, the lender can seize the property (state laws may vary). Recourse loans have a personal guarantee, this means you are personally liable for the outstanding debt.
What Is a Non-Recourse Loan?
Non-recourse loans are secured by collateral, but the bank or non-recourse lender can only sell the pledged collateral or asset to recover the loan in the case of default. For example, a self-directed IRA can get an non-recourse loan. If the borrower or self-directed IRA in this case defaults, the bank can sell the property or go into foreclosure to recoup its loss.
Non-recourse loans favor the borrower because their personal finances aren't at risk for liquidation to repay the faulted loan, there is no personal liability. The lender or bank cannot take legal action against the borrower. Usually, the borrower's credit score is not impacted with this type of non-recourse debt either.
The non-recourse loan lender cannot obtain a deficiency judgment to garnish the debtor's wages, seize other property, or take money from their bank account. However, they can still go after the asset or property to repay the loan.
Because the bank takes the hit, these loans usually have a higher interest rate and strict borrowing prerequisites the borrower must meet for the self-directed retirement plan to obtain the loan. The loan terms may also be different than what is considered common and the mortgaged property must have positive cash flow.
Another important thing to keep in mind with these types of loans is that your IRA may generate taxable income. This taxable income (UDFI) is explained in detail here.
UDFI and Tax Considerations
When a Self-Directed IRA uses borrowed money to purchase real estate, a portion of the income may be considered unrelated debt-financed income, or UDFI. This can create unrelated business income tax, commonly called UBIT, on the debt-financed portion of the investment.
This does not necessarily mean investors should avoid non-recourse financing, but it does mean they should understand the tax impact before moving forward. Investors should speak with a qualified tax professional to review how UDFI may apply to their specific investment.
Nonrecourse financing is not new. There are many non-recourse financing companies nationwide. Here you can find a list of some companies and private lenders that our clients have used in the past:
Best Non-Recourse Lenders List >
How Your Self Directed IRA Benefits
Consider this scenario: You want to use your self-directed IRA to purchase real estate. Your IRA or retirement plan applies for the non-recourse loan and the real estate secures the debt.
Some of your IRA's funds and the non-recourse loan buy the property, allowing other funds in your IRA to remain invested and continue gaining interest.
For example, let's say you have $200,000 in your IRA and find an investment property for $200,000. You don't use all the money in your IRA, but maybe $100,000, then you can get a non-recourse loan in the name of the Self-Directed IRA to make up the difference. That leaves $100,000 in your IRA that continues to earn interest and grow.
These types of loans are typically used to allow you to have available capital in case the property needs repair or renovations or to invest in commercial real estate. Using a non-recourse loan helps to expand your investment options. It allows you to diversify instead of keeping your eggs in one basket.
It's a massive win for you and your IRA. Non-recourse lending benefits your IRA by leveraging the bank's money. In addition, the principal in the IRA is protected and can be used for other investment instruments.
Succeed With a Strategy
Don't fall for the set it and forget it. Most people set up auto-deposit to fund their retirement accounts, then forget about it. They hope it will all work out, or they're worried that they haven't saved enough. Unfortunately, it is a dangerous strategy because it can leave you with unwanted surprises when it comes time for you to retire.
Using a self-directed IRA puts you in the driver's seat, allowing you to determine how it will grow. Your knowledge base expands as you learn how best to manage your money for retirement. You can confidently layout investment strategies that can enhance your portfolio.
It is powerful to feel that you are adequately prepared to retire. When you have diligently worked to employ financial strategies to grow your retirement accounts, it removes the anxiety of uncertainty.
Learn More About Self-Directed IRAs and Non-Recourse Loans
When you reach retirement and it's your turn to sleep till noon, travel when you want, for however long you want, or see a film in the middle of the day, you don't want to be bogged down with financial concerns.
Learn how a non-recourse loan and self-directed IRAs can provide significant benefits for a worry-free retirement. Put us on your calendar and schedule a consultation so you can begin putting your self-directed IRA to work for you.
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