Investing with a Non-recourse Loan and a Checkbook IRA

The Checkbook IRA and the Solo 401k enable investments in both traditional and non-traditional assets, such as real estate.  Plan participants can invest funds into a wide range of real estate opportunities, from foreclosures to rental properties. 

Many participants prefer to finance their investments in full from their Checkbook IRA or Solo 401k account.  However, if additional funding is needed, the IRS does allow the use of non-recourse loans in conjunction with the IRA and Solo 401k. 

Recourse loans cannot be used with the Checkbook IRA

Although the recourse loan is the most common type of loan offered by financial institutions, it cannot be used with the Checkbook IRA and Solo 401k.  Recourse loans are guaranteed by the individual seeking the loan.  In the case of an IRA, the account owner would have to guarantee the loan to the IRA account.  This would be considered self-dealing by the IRS and thus be prohibited according to IRC Section 4975. 

The IRS does allow a non-recourse loan to be used with the Checkbook IRA and Solo 401k for financing an investment property.  A non-recourse loan uses only the purchased property as collateral; the individual is not liable in the case of default.  Because the non-recourse loan does not involve the account owner, its usage is not considered a prohibited transaction.

Non-recourse loans and UBTI tax

It’s important to note that the use of a non-recourse loan with a Checkbook IRA triggers Unrelated Business Taxable Income (UBTI) tax.  The gains generated by the investment are considered as Unrelated Debt Financed Income (UDFI) and are thus subject to the UBTI tax.  The tax is levied on the portion of the income in proportion to the percentage of the investment that is financed by the debt.  For example, if 50% of the investment is purchased with debt financing, then 50% of the income generated by the investment would be subject to the UBTI tax.

While UBTI rates are high (typically 35%), the IRS does allow the tax base to be reduced by a pro rata portion of deduction and depreciation of the property.  Because the IRA is being treated as a tax-payer in this case, the IRS gives it the ability to reduce its tax base. 

The Solo 401k differs from the Checkbook IRA in that gains from a debt-financed investment using a Solo 401k are not subject to UBTI tax.  The plan is exempt from the tax as outlined in IRC Section 514.