When investing in rental property the use of debt-financing can be a valuable tool.  An investor who borrows money can multiply the purchasing power of their capital to acquire more properties or properties of higher quality.  So long as the income received is greater than the cost of debt, this use of leverage can boost the cash-on-cash returns for each dollar invested.

For investors with a self-directed IRA or Solo 401(k) the ability to finance investments in this fashion can be a real game changer.  While it is possible to use leverage in conventional financial investments such as options or margin trading, there is considerable risk in taking on debt obligations with volatile assets.  Many IRA and 401(k) plans do not even provide the option to make leveraged investments.

Since real estate is more stable in value, it is better suited to the use of financing.  Bringing this tool into your retirement savings strategy can help you accelerate the growth of your nest egg.

There are some special considerations that apply when using debt-financing inside of a self-directed retirement plan.

1 – IRS Rules Require Non-Recourse Loans

Because IRS rules prohibit any direct or indirect benefit between a plan and a disqualified person, all debt instruments used in an IRA or 401(k) must be non-recourse.  That simply means there is no personal guarantee from you as the plan account participant or any disqualified person to the plan.

For you to pledge your assets as security for the plan’s debt would produce a prohibited transaction with severe tax consequences.  This is specifically outlined in Internal Revenue Code section 4975,(c)(1)(B) which states that a prohibited transaction occurs if there is any direct or indirect “lending of money or other extension of credit between a plan and a disqualified person”.

2 – Banks That Offer Non-Recourse Loans

Most banks do not offer non-recourse loans for 1 to 4-unit residential property.  Non-recourse lending is more common in larger commercial real estate projects, and more banks tend to offer non-recourse loans for apartment, office, retail, and industrial properties.

Following are 4 banks that actively loan nationwide to retirement plans for residential properties on a non-recourse basis.

There are a handful of local or regional lenders that will offer non-recourse loans, but they are not generally as knowledgeable about dealing with retirement plans and may not be competitive on rates or terms.  If you have a good relationship with a local lender, certainly ask, but it is not usually worth an extensive local search to identify a lender.

3 – Other Types of Lenders

The bank lenders above take a conservative approach to underwriting and may not be willing to lend in certain situations they deem too risky.

There are some private debt funds and hard money lenders that will lend more aggressively on projects such as new construction or properties needing significant rehab.  Expect to pay a higher interest rate for these types of loans.

It is also possible to utilize seller financing or create your own sources of private lenders.  Just be sure to avoid disqualified persons.

The only IRS requirement is that the note not have a personal guarantee.  Any legitimate lending vehicle without such a guarantee is acceptable.

4 – Typical Lending Terms

Terms change depending on the economic climate, so be sure to reach out to a few lenders and learn about current lending arrangements.  Common lending guidelines include:

• Down payment of at least 30%.  Condos as high as 50%
• 10% – 15% cash reserves in the plan
• Terms range from 5/1 ARMS to 25-year fixed-rate loans
• Rates will generally be 1% – 1.5% higher than a typical investor loan with a personal guarantee.  A range of 5.25% – 7.5% is common, depending on the loan terms.

5 – Properties that Can be Financed

Because the property is the only security for the loan, non-recourse lenders look for low risk deals.  Banks like clean, tenant-ready properties in stable neighborhoods.

A variety of property types can be financed, including 1 to 4-unit residential, larger multi-family residential, commercial properties, and even income producing farms in some cases.

The bank lenders will not usually finance fix and flip transactions, properties built before 1940, raw land, or new construction.  Some lenders will not finance restaurants, motels or similar properties where the income is tied to a services business rather than the rental of the property itself.

For projects the banks will not touch, you may need to look to private real estate debt funds or private lenders.

6 – Re-Finance Loans are an Option

It is possible to apply financing to a property already held by your IRA or 401(k) plan.

Many investors like to start out simple and pay all cash for a property.  This minimizes both risk and complexity.  Once a property is performing well inside their retirement plan, they may choose to take on debt-financing.  The resulting cash liquidity can then be used by the IRA or 401(k) to acquire another property and accelerate portfolio growth.

Another case where using a refinance strategy makes sense is for new construction or rehab properties.  A non-recourse lender may not be willing to loan the capital for the early-stage project.  Once the property is completed and rent-ready, or after it has a history of rental income, a bank may be willing to lend.  The initial phase can be financed all cash by the IRA or 401(k), or the plan can use more expensive hard money capital on a short-term basis to get the property stabilized before re-financing.

Be sure to discuss any such strategy with a non-recourse lender before starting.  You want to be confident of the ability to obtain a loan and know the requirements for refinancing.

7 – Portfolio Loans

Because banks that offer non-recourse loans are generally lending their own money, they have flexibility to do some kinds of deals you might not seen in a normal environment where a bank originates a loan that is then sold off to investors.

Most lenders will not provide financing for low cost properties.  Unless they are lending about $50K, it just is not profitable to them.  However, if your IRA acquires 3 inexpensive properties all cash, a lender might bundle those properties as collateral for a single loan you can use to acquire more.

We have also seen an investor pledge equity in several mid-range residential properties to obtain a non-recourse loan on a small apartment complex purchase with his IRA.

8 – Be Aware of Tax Implications

When an IRA utilizes mortgage financing to acquire property, taxable Unrelated Debt Financed Income (UDFI) is generated.

The portion of the income generated through the use of borrowed, non-IRA funds is taxable.

The impact of the tax is often minimal.  A $100,000 rental property that is 50% debt financed and produces 10% returns would incur an annual tax bill of less than $200, for example.  The IRA is still very much receiving the benefit of leveraged returns, with just a small bit of friction in the form of taxation.

Be sure to consult with your licensed tax professional to understand the administrative and tax filing requirements as well as the potential tax-cost you can expect.

Use our calculator to compare the expected return on investment for an all cash real estate purchase versus a leveraged purchase through a non-recourse loan.

A Solo 401(k) is exempted from tax on UDFI when the debt is used for the acquisition of real property.

9 – Appropriate Expectations are Necessary

A lot of investors try to compare the performance of using non-recourse debt for an IRA property with investments they might make outside of their retirement plan.  This can lead to disappointment.  When you can place a personal guarantee on a loan, the lender will give you more favorable borrowing terms including lower down payment requirements and lower interest rates.  It is just not an apples-to-apples comparison.

The better approach is to look at a leveraged rental property investment in your IRA as compared to making that same investment on an all cash basis.  Alternately, you can compare a financed rental investment to what your IRA or 401(k) could produce when limited to investing in publicly traded financial products.  When viewed in this way, the benefits of leverage become clear.

10 – Leverage can be Powerful

Wisely used debt can help you grow your tax-sheltered retirement savings more aggressively than investing on an all cash basis.

The strategy is not without risk, as your IRA or 401(k) will need to pay the costs of borrowing whether there is cash flow from the property or not.  Because of the tax implications of UDFI, extra complexity in terms of bookkeeping and tax filings will apply for IRA investors.

For investors who are able to scale the equity value of their IRA real estate portfolio faster, or generate higher cash-on-cash return for a particular project, the rewards are well worth it.