Owning income-producing real estate in your self-directed IRA is a great way to diversify and build wealth.
Real estate is a solid asset with value cycles that are largely decoupled from the stock market and the daily news cycle. A well-selected rental can produce consistent cash flow as well as the potential for appreciation over time.
When you add the power of leverage to your IRA property investment, the potential rewards are significant.
By using borrowed capital, the IRA can extend its purchasing power and create a higher cash-on-cash return for each dollar deployed.
Buying a property with your self-directed IRA using a mortgage does involve some special consideration and planning.
As part of our ongoing How-To Series, we wanted to touch on some of the key factors that go along with such a strategy.
From having a plan in place to purchasing the property, here’s what you need to know about buying an IRA rental property using mortgage financing.
1. Have Your Plan in Place First
As with any real estate investment made using a self-directed IRA, the first step is to have your plan in place before you write an offer.
The IRA must be the purchaser, and all funds for earnest money must come from the IRA. You cannot use personal funds to lock up a contract for your IRA.
It typically takes 3-4 weeks to establish and fund a self-directed IRA.
Most lenders that work with IRA properties will take about 45 days to process and fund a loan, which makes it even more critical to have the IRA in place before writing an offer.
2. Non-Recourse Loans are Required
If you were to pledge a guarantee, then you would be providing your personal assets as security for the IRA’s debt. This would violate the self-dealing rules that surround IRA plans.
There are a handful of banks that offer such non-recourse loans to IRA borrowers on 1-4 unit properties.
If you are working on a larger commercial property such as an apartment or office complex, there are a wider range of banks willing to lend on a non-recourse basis.
It is also possible to obtain seller-financing or a private loan from another investor – so long as you avoid disqualified persons to the IRA.
Make sure you discuss your project in advance with a specialty non-recourse lender such as those listed on our Vendor Resources page. They can tell you if the property you’re considering will qualify and what type of down payment and reserve requirements may apply.
Because a non-recourse loan without a personal guarantee is higher risk to the bank, the terms you can expect will be more conservative. Typical residential non-recourse loans will offer 60-65% loan to value and require 10-15% liquid reserves in the IRA.
3. Purchasing the Property
Once you have your plan in place and preliminary approval by your lender, you are ready to make an offer on a suitable property for your IRA.
The IRA-owned LLC or trust will be the purchaser of the property, and the contract should be written to reflect this.
You will execute the contract on behalf of the entity — not in your own name.
Any earnest money deposit must be paid with IRA funds. The same is true for any other pre-closing costs such as inspections and appraisals.
Give yourself at least a 45-day close period to allow for lender underwriting and processing.
The IRA-owned LLC or trust will be the borrower on the mortgage.
The lender will need to be an additional named insured on your plan’s insurance policy.
At the closing, you will execute all contracts for the real estate purchase and the non-recourse mortgage. You can then issue funds from your IRA’s bank account to fund the purchase.
4. Tax Considerations
When an IRA uses debt-financing to make an investment, there is a small tax burden that applies.
The income directly attributed to IRA capital — the down payment — is fully tax sheltered.
The portion of the income that the IRA receives from the non-IRA (borrowed) money is what is taxable.
The leveraged income is referred to as Unrelated Debt-Financed Income (UDFI), and that is what is being taxed.
Many investors act like a spider landed on them when they hear there may be a tax liability inside their IRA.
While the income generated by UDFI does come with some tax cost and an additional administrative burden, the IRA will still benefit from the higher cash-on-cash returns that leverage can produce.
A Solo 401(k) plan is exempted from UDFI taxation when the debt instrument is associated with the acquisition of real property.
For those investors who qualify, the Solo 401(k) can be a better option if your investment strategy will include mortgaged property investments.
5. Running the Numbers
Following is a simple example to compare a leveraged property investment with an all-cash purchase by the IRA.
Assume you have $100,000 of IRA money to invest. Your IRA can purchase a $100,000 property all-cash or use that same $100,000 to make a down payment on a $200,000 property.
Assuming the rental income of the $100,000 property is half that of the $200,000 property, that both operate at a 30% ratio of expenses to income, and that they will appreciate at 3.5% per year, the numbers would look roughly like the following:
|Monthly Operating Expenses||$720||$360|
|Annual Net Operating Income||$12,244||$10,080|
|Equity Increase (appreciation)||$7,000||$3,500|
|Equity Increase (mortgage principal reduction)||$1,972||$0|
|Annual Net Return||$20,262||$13,580|
|Year 1 ROI||20%||13%|
|5-Year Net Return||$146,723||$67,900|
|Year 5 ROI||146%||68%|
The leveraged investment produced an additional $78,823 of income over a 5-year period as compared to the all-cash property.
The cost of UDFI taxation and tax preparation totaled $4,732. To put that in perspective, would you spend $4,700 to make an extra $78,800?
The ability to hold debt-financed real estate in an IRA creates real potential to magnify the growth of your retirement savings.
This strategy is not without risk, however. Your IRA will need to be prepared to pay the mortgage every month, whether there is a tenant in the property or not.
The need to file a tax return for the IRA’s Unrelated Debt-Financed Income introduces an additional bookkeeping burden and the necessity to bring a skilled CPA onto your team.
When weighing the potential increase in the rate of return, however, the reward may justify the extra complexity such an investment strategy creates.