Let’s start with the good news.
An IRA can use a mortgage to purchase real estate. Yes, you can leverage your IRA dollars to receive a higher rate of return by using other people’s money.
When most folks hear this the reaction is something like “That’s fantastic, you can’t do that with your IRA in the stock market!”
OK, now the bad news… there are catches.
Firstly, the mortgage must be “non-recourse”, meaning there is no personal guarantee from you or a disqualified party to the IRA. The lender’s only security is the property. This limits your choice of lenders dramatically, and will result in higher down payment requirements and slightly higher interest rates than you might be used to with other sorts of financing. Typically, a non-recourse mortgage for a single family home or small-plex would require 30%-40% down payment, 10 percent cash reserves, and have a rate in the range of 5.5% – 6.75%. That is still pretty inexpensive money.
Secondly – and this is the thing that scares a lot of people away– there is a tax on the profits derived from the borrowed funds. Yes, there is a tax inside the IRA, and the tax even applies to leveraged gains within a tax-free Roth IRA?
“Well, that ruins everything. Why would I want to pay a tax in my IRA?” is a not uncommon response when most folks learn about this for the first time. The answer is simple, and best phrased with a question.
Would you rather make 10% return on your IRA dollars, or does a 15.5% return sound better?
Intrigued? Read on to see how you can increase the return on investment of your IRA with the smart use of leverage.
Tax Implications of Purchasing a Property with an IRA Mortgage
Before we continue, a little more detail on the tax impacts of using a mortgage to purchase property in your IRA would be in order. The tax is being applied to Unrelated Debt Financed Income (UDFI). In more plain English, this is the income returned to the IRA through the use of borrowed money. The percentage of the income directly tied to the IRA’s capital is not taxed, but the portion of income linked to the outside capital is. When you think about it, it kind of makes sense.
So what is the tax impact? Let’s take an example where an investor uses their Checkbook IRA LLC to purchase a rental property with a cost of $100K. Rather than pay all cash with their IRA, they choose to put 35% down and borrow $65,000 from a non-recourse lender. In this case, the property would be considered 65% debt financed, and 65% of the income would be subject to UDFI taxation.
Where there are taxes, there are often times deductions, and UDFI is no exception. In our example, the investor would be able to apply 65% of the applicable expenses, including things one would see outside of an IRA like depreciation, property taxes and other costs associated with operating the property. Especially with moderately leveraged 1-4 unit properties, these deductions will dramatically reduce the taxable income.
The net taxable income after deductions is then taxed to the IRA using the trust tax rates.
In this example of a $100K property, 65% financed, with assumptions for 10% net operating income and operating expenses of 31%, the UDFI tax for the year would be about $107. That does not hurt too much, does it?
Now that we know the tax impact of UDFI is not that scary, let’s see what the use of leverage does to the return on investment for this example property.
How Does Leverage Impact Your ROI?
|Cash Investment||$ 100,000||$ 36,250 (including lender costs)|
|Gross rents ($1200/month)||$ 14,400||$ 14,400|
|Operating Expenses (31%)||– $ 4,400||– $ 4,400|
|Mortgage Payments||$ 0||– $ 5,148|
|Cost of UDFI||$ 0||– $ 107|
|Annual Cash Flow||$ 10,000||$ 4,504|
|Equity Increase (Mortgage Principal Paid)||$ 0||$ 1,114|
|Total Return||$ 10,000||$ 5,618|
|Return on Investment||10.00%||15.5%|
Analyzing Your Return
That’s not too shabby. Even with the extra cost of mortgage payments and UDFI taxation, this property produced 5.5% better return. If you invested the same $100,000 in both cases, say by purchasing multiple properties, your IRA would receive $5,500 more per year through the use of leverage. After 10 years, you’ll have made over $55,000 more on that $100,000 of initial principal than you would with all cash transactions!
This has been a very basic example of how using leverage can increase your returns when operating long term rental property. There are, of course, other situations you may encounter as an investor where the implications of debt financing get more complex. The sale of a property with outstanding debt will have tax implications under UDFI, for example. If, rather than renting out a property, you are using borrowed money to flip a house, the gains are subject instead to Unrelated Business Taxable Income (UBTI). We’ll come back to some of those topics in future articles.
The ability to use leverage in a self-directed IRA is a game changer, and a significant advantage over conventionally available IRA investment choices. That said, the use of IRA mortgages is not for everyone. Like most investments, there are risk/reward considerations. Many investors prefer the security of not having to make mortgage payments from their IRA… whether there are rents coming in or not. For those investors willing to take on the added risk and complexity associated with UDFI taxation, however, there can be big rewards.