Financing Self-Directed IRAs and Solo 401ks in Real Estate Investments

[Kaaren Hall]

Introduction to Real Estate Investment through Retirement Accounts

Have you ever considered that a Self-Directed IRA or Solo 401k could be used to invest in rental real estate? Surprisingly, many people are unaware of this possibility. However, it's not just about buying real estate; these accounts can also utilize mortgage loans to facilitate the purchase. Crucially, when the IRA or Solo 401k takes out a loan, the IRS stipulates it must be a non-recourse loan, made specifically to the IRA or Solo 401k, with no personal guarantees from you. Additionally, the loan must be a portfolio loan, meaning it cannot be sold in the secondary mortgage market. Importantly, this financing option opens the door to potentially acquiring more expensive properties or multiple real estate investments.

Qualifying for Loans with IRAs

Concerning the IRA's eligibility for borrowing, since these are portfolio, non-recourse loans made to the IRA without personal guarantees, you'll find that the number of willing lenders is limited. Your personal financial situation, including income, credit, or assets, is not considered in the loan application because you are not the borrower. As a service, we can provide a list of lenders who are open to loaning money to an IRA. It's important to note that these are not lenders we endorse; we're merely offering this list as a helpful resource.

Lenders are primarily interested in the property's ability to generate positive cash flow after covering the mortgage payment and other expenses. Essentially, the rental income is what repays the loan. Additionally, lenders expect the IRA to maintain cash reserves in the account, as all property expenses must be covered by the IRA. For instance, uDirect mandates that the IRA retain a 10% cushion of the sales price after purchasing the property. Remember, personal funds cannot be used for this investment.

Understanding Lender Requirements

One example of lender criteria involves the Debt Service Coverage Ratio (DSCR). Typically, lenders want to see that the Net Operating Income is at least 125% of the loan payment, known as a 1.25 DSCR. This is the minimum cash flow requirement to qualify a property. To calculate this ratio, divide the Net Operating Income (after taxes, insurance, HOA fees, management costs, etc.) by the Principal and Interest payment on the loan. Furthermore, lenders generally require substantial down payments, often 40-50%. Discussing the rate and terms with the lender is essential for a clear understanding.

Addressing Loan Default Scenarios

In cases of loan default, it's critical to understand that with non-recourse loans, personal guarantees are not permitted. Consequently, the lender's only recourse is to foreclose on the property, attempting to recover their investment. They cannot pursue other assets owned by the IRA or by you personally.

Understanding Unrelated Debt Financed Income Tax (UDFI)

Borrowing in an IRA incurs a tax known as Unrelated Debt Financed Income Tax (UDFI), though the Solo 401k may be exempt from this tax. For example, if you finance 60% of a property, 60% of the rental income is potentially taxable. The IRA must show 60% of the rents on the 990t tax return and can write off 60% of the expenses. If there's a net profit, the IRA is responsible for the tax. The taxable percentage changes annually as the loan balance decreases and the property value fluctuates. A year and a day after the loan is paid off, UDFI no longer applies.

While the IRA owing taxes on rents and profits might seem daunting, it doesn't necessarily detract from the investment's value. It's crucial to calculate the net profit after taxes to assess the investment's viability. Consulting with a tax advisor can provide clarity in this area. Additionally, potential property value appreciation can further enhance your Self-Directed IRA's value.

Relevance of 1031 Tax Deferred Exchanges

Generally, a 1031 Tax Deferred Exchange may not be relevant since IRA-owned assets are already tax-deferred. However, selling an IRA-owned property with a loan attached could be an exception, potentially avoiding UDFI taxes associated with the sale. This is a complex topic best discussed with a tax advisor.

Final Recommendations

Your Self-Directed IRA custodian does not offer tax, legal, accounting, investment, or other professional advice. Seeking expert advice in these areas is highly recommended. This article is meant to point you in the right direction.