Leverage is a powerful way to increase the income performance of investments. Many self-directed plan investors know this and use non-recourse mortgages to acquire income property.
Not as many people are aware of the possibilities surrounding refinancing property in an IRA.
Non-Recourse Mortgages are Required
Any debt instrument an IRA uses must be non-recourse in nature. That means you as the IRA account holder or any other disqualified person to your IRA cannot pledge a personal guarantee. To do so would be providing a benefit to the IRA and would result in a prohibited transaction.
There are only a handful of banks that offer non-recourse loans to self-directed IRA and Solo 401(k) plans nationally. The leading national lenders are:
While there may be a local or regional bank you can work with that offers non-recourse loans, be sure they understand the IRS rules associated with IRA debt.
It is also possible to obtain a non-recourse loan from a private party, so long as they are not a disqualified person to your IRA.
Current Economics Create Opportunity for Refinancing
Two factors are combining to make this a great time to research refinancing opportunities.
Interest rates are currently low. While non-recourse debt always costs a touch more due to the higher level of risk for the lender, we are seeing rates that are better than they have been in years past. Interest rates are ranging from the high 4% range on 3/1 ARM loans to the mid 6% range on a longer term fixed-rate loan.
Property values have increased dramatically in the last few years in all kinds of markets across the country. For investors who have held a property several years, that means an increase in equity value that can be tapped with smart financing strategies.
1- Refinance an Existing Mortgage
Simply reducing the cost of an existing loan can improve the performance of your IRA’s investment property. If the interest rate reduction produces savings that exceeds the cost of refinancing, then your IRA wins.
If you have held a property for some time and paid down significant principal, that might allow you to move to a shorter-term loan that will have a lower overall cost while still retaining positive cash flow.
2 – Pull Cash from an Existing IRA Property
Property values have been rising dramatically for the last several years. If your plan has owned a property for some time, it is likely worth a good bit more than the original purchase price.
Whether you paid all cash originally or have a mortgage on a property, there is probably equity available to be tapped into.
By refinancing an existing loan or simply putting a favorable and low-rate mortgage on an existing wholly owned property, you can free up some of that equity for other investments.
Of course, any such equity belongs to the plan and not to you personally. If you pull cash from an IRA property, that cash has to be reinvested by the IRA. You can use that additional capital to purchase another property, invest in a private equity fund, lend to other investors, or whatever you think will produce the best returns.
So long as the income you can produce with a new investment is higher than the borrowing cost, you will be improving the overall performance of your IRA or 401(k) plan.
3 – Buy All Cash, Then Add a Mortgage
One of the challenges for many investors and home buyers in the last 18 months or so has been a very competitive bidding market for properties.
Stronger offers win, and an all-cash offer is sometimes needed to get a property under contract. For plan investors with accumulated retirement savings, this can be a competitive advantage.
Just because you acquire a property with a cash purchase, however, does not mean you need to leave all that cash tied up in a single property.
After you have closed, you can then work with a non-recourse lender to obtain financing. The end result is not very different from purchasing a property with a loan to begin with, but you put your plan in a more competitive bidding position.
4 – Rehab, Then Add a Mortgage
Because the property is the only security for the loan, most non-recourse lenders are conservative with their underwriting. If a property needs significant repairs before it can be put into service as a rental, such as more than about $10,000 of work, they might not be willing to lend.
In this type of scenario, you can purchase a property all cash with your IRA then refinance once it has a renter in place. Alternately, you can use a private loan or hard money to get the property purchased and fixed up, then refinance into a less expensive longer term non-recourse loan.
This approach is very common with investors using the buy, rehab, rent, refinance, repeat strategy of investing (BRRRR).
5 – Consolidate IRA Mortgage Debt
If you have multiple properties in your self-directed IRA or Solo 401(k), you may be able to tune things up a bit with a portfolio loan. Some non-recourse lenders will provide a loan that is collateralized by several properties. This can simplify the lending relationship and reduce some cost overhead.
If you have a mix of properties with or without financing in place, or with a mix of different loans, such a consolidation may be able to reduce your overall financing costs or free up capital for additional investments.
Keep Your CPA in the Loop
When an IRA utilizes borrowed capital, it creates taxable Unrelated Debt-Financed Income (UDFI). The portion of income the IRA receives that is attributed to the borrowed money is taxable. Because deductions like interest payments and depreciation apply, the net tax cost is not generally significant. Leverage boosts return. The tax on UDFI dents but does not negate that boost.
Any time you have exposure to UDFI, it is important to consult with your licensed tax counsel in advance so you can prepare appropriately. This is especially true in the case of refinance transactions, which can change the tax profile of an existing investment or introduce taxation to a deal that was not initially taxable.
For investors who qualify for a Solo 401(k) plan, life is a lot simpler. A Solo 401(k) is exempted from UDFI on debt associated with the acquisition of real property.
This kind of topic is exactly why we just love self-directed IRA plans. Leverage is one of the most powerful investing tools around. In a conventional IRA allocated into stocks and funds, you simply cannot take advantage of this great tool. Once you take full control of your retirement savings in a self-directed IRA or Solo 401(k), you can start playing the game like an expert, and take full advantage of advanced concepts like leverage.