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Investing in rental property is one of the more popular options for those with a self-directed IRA. Real estate is a solid asset with intrinsic value and can produce income both through cash flow and appreciation. This makes rental property investing a great way to build wealth.
One of the things that many investors are not aware of is the potential to utilize mortgage financing with an IRA purchase or real estate. By applying the principals of leverage, your IRA has the potential to achieve a higher cash-on-cash return and accelerate growth.
Buying a mortgage-financed property with your self-directed IRA does involve some special consideration and planning. This is a more advanced strategy, but one that can be very profitable.
Non-Recourse Loans are Required
IRS rules require that any loan obtained by IRA be non-recourse – meaning no personal guarantee from your or any disqualified party to the IRA. In guarantee from you would equate to providing your personal assets as security for the IRA’s debt. This would violate the self-dealing rules IRA plans are subject to.
There are a small number of banks that offer non-recourse loans to IRA borrowers on 1-4 unit residential properties. There ia a wider range of banks willing to lend for larger commercial projects such as apartments on a non-recourse basis. Your IRA may also obtain seller-financing or a private loan from another investor – so long as you avoid disqualified parties to the IRA.
Because a non-recourse loan creates higher risk for 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.
Be sure to discuss your project in advance with a specialty non-recourse lender. They can help ensure the property you are considering will qualify and what type of loan terms may apply.
Purchasing the Property
Once you have preliminary approval for a loan, you are ready to make an offer on a suitable property for your IRA.
The IRA-owned LLC will be the purchaser of the property. The purchase contract should reflect this. As the manager of the LLC you will execute the contract on behalf of the LLC – not in your own name.
LLC funds must be used for any earnest money deposit and any other pre-closing costs such as inspections and appraisals. It is fine to roll such costs into the closing transaction.
A 45-day close period is recommended to allow for lender underwriting and processing.
The IRA-owned LLC will be the borrower on the mortgage. Work with your lender and title company to have that properly documented.
The lender will also want to be an additional named insured on your LLC-held property insurance policy.
As the LLC manager you will execute the contracts for the real estate purchase and the non-recourse mortgage. Funds are then issued from your IRA LLC bank account to complete the purchase.
By using outside funds, the IRA does create exposure to taxation. The income attributable to the borrowed money is referred to as Unrelated Debt-Financed Income (UDFI), and that is what is being taxed. The portion of the income directly attributable to IRA capital – the down payment - is fully tax sheltered. The income the IRA receives from the non-IRA (borrowed) money is what is taxable.
Many investors panic and run the other direction when they hear there may be a tax liability inside their IRA. They are selling their IRA short in doing do.
The IRA will still very much benefit from the use of leverage and the higher cash-on-cash returns that leverage can produce. Taking the time to understand this concept can produce real benefits for your IRA.
In exchange for some administrative complexity associated with the tax filing, you can accelerate the pace of growth in your IRA.
A Solo 401(k) plan is exempted from UDFI taxation when the debt instrument is associated with the acquisition of real property. As such, the Solo 401(K) may be a better option if your investment strategy will include mortgaged property investments and you qualify to sponsor such a plan.
Running the Numbers
The following simplified example illustrates how a leveraged property purchase in an IRA compares to an all-cash strategy.
Assume your IRA has $100,000 to invest. The IRA can purchase a $100,000 property all-cash or purchase a $200,000 mortgaged property using the same $100,000 as the down payment
If the rental income of the $100,000 property is half that of the $200,000 property, and both operate at a 30% ratio of expenses to income, and both properties appreciate at 3.5% per year, the numbers would look approximately as follows:
...............................................Mortgage All Cash
Purchase Price $200,000 $100,000
Down Payment $100,000 $100,000
Mortgage Amount $100,000 $0
Interest Rate 6.25% N/A
Rent (monthly) $2,400 $1,200
Mortgage Payment $656 $0
Operating Expenses (monthly) $720 $360
Annual Net Operating Income $12,288 $10,080
Equity Increase (appreciation) $7,000 $3,500
Equity Increase $1,715 $0
(mortgage principal reduction)
UDFI Tax Amount $548 $0
Tax Preparation $400 $0
Annual Net Return $20,055 $13,580
ROI – Year 1 20% 13%
5-Year Net Return $100,275 $67,900
ROI – 5 years 100% 68%
The mortgaged property investment produced $32,000 more over a 5-year period as compared to the all-cash rental. The cost of UDFI taxation and tax preparation totaled $4,740. Spend $4,700 to make an extra $32,000 seems to make sense, does it not?
The ability to invest in debt-financed real estate within your IRA creates a great opportunity to magnify the growth of your retirement savings.
This strategy does increase your risk exposure. The IRA needs to pay the mortgage every month whether a rent check is coming in or not.
Unrelated Debt-Financed Income and the accompanying tax filing means additional bookkeeping and the necessity to bring a skilled CPA onto your team.
The potential increase in the rate of return can make the extra complexity such an investment strategy creates well worth the effort.
Brian Eastman is a principal and Senior Consultant with Safeguard Advisors, LLC, a leading provider of self-directed IRA and Solo 401(k) plans offering checkbook control. If you have questions about the usage of a self-directed retirement plan for investing in alternative assets such as real estate, please feel free to schedule a consultation.