A Real Estate Investor’s Guide to Mortgage Regulations
It’s a common problem: Many people want to get started in real estate investment or buy more properties, but their biggest store of liquidity is in their IRAs and other retirement accounts.
Fortunately for investors in that situation, there’s a simple and straightforward solution. Rather than borrowing the money themselves, investors can simply have the IRA or other retirement account take out the loan and acquire the property.
To preserve the favorable tax treatment of the IRA, investors must follow two important rules:
1. The loans cannot come from the IRA account owner, spouse, lineal ascendants, descendants or their spouses or any entities they control (the disqualified persons rule).
2. Any such loans or mortgages must be non-recourse loans.
Non-Recourse Loans
All loans made to an IRA of any kind (Roth, SEP, SIMPLE, etc.) or to a self-directed Solo 401(k) must be made on a non-recourse basis. The lender cannot attach anything else in the account other than the specific property listed as collateral. The account owner or any disqualified person cannot sign a personal guarantee of any kind.
If the loan should go into default, the lender can foreclose on the collateral itself, but that’s all.
Real Estate IRA Loan Underwriting
Generally, the maximum loan-to-value ratio attracting funding in today’s market is 65 percent to 70 percent, meaning lenders will typically require borrowers to have at least 30 percent to 35 percent equity before originating a loan. Certain types of property may involve higher equity requirements.
If the loan should go into default, the lender can foreclose on the collateral itself, but that’s all. The lender can’t seize anything else in the IRA.
The non-recourse requirement is critical: If the IRS gets wind that the IRA owner signed a personal guarantee or otherwise granted recourse to an IRA lender to foreclose on any collateral outside the collateral itself, the IRS could disallow the entire account.
Advantages for the Credit-Challenged
In some cases, the IRA owner’s personal credit score and history are not relevant to a lender. When assessing a potential IRA loan, the lender sometimes makes the decision entirely on the collateral itself and the cash flow it generates.
Furthermore, the loan doesn’t show up on the account holder’s personal credit report in any way. It’s the IRA doing the borrowing, not the owner personally! So financing an investment within a real estate IRA will not affect the account holder’s ability to get a personal mortgage or other kind of loan.
Qualifying for a Self-Directed IRA Loan
Lenders will often require net operating income that exceeds debt payments by at least 20 percent to 30 percent. However, hard money lenders typically underwrite using the asset itself, rather than the income generated from it, as a collateral for the loan.
There is an important difference between the two approaches: A lender using a purely asset-based approach to underwriting, rather than income-based underwriting, can often lend money on properties that are not currently generating any positive cash flow at all.
Institutional Non-Recourse Lending
Expect institutional lenders to look at the following factors:
• LTV value: 30 percent to 50 percent maximum loan-to-value.
• Debt service coverage: Expect to provide a traditional lender with a pro forma cash flow projection showing income sufficient to cover the debt payments.
• Reserves: Lenders will typically want to see about 15 percent of the value of the loan in reserves within the IRA as reserves, to cover short-term emergencies.
• Value and quality of the collateral itself: HOA’s should also be fiscally sound, if applicable.
If all four requirements are met, then the institutional lender typically approves the loan.
Private Non-Recourse Lending
Self-directed IRA owners can also borrow from any number of private lenders, including individual lenders. Many IRA owners are scouring the earth looking for reasonably safe, secure loans to make with their own IRA money at competitive rates of interest.
While institutional lenders usually have to stick close to specific lending criteria, private lenders have no such limitations. Investors and lenders alike are limited only by their imaginations. In all cases, however, the loan must be non-recourse.
Hard Money Lending
Hard money lenders specialize in asset-based loans with shorter time horizons—typically not more than two to five years. Expect higher origination costs and higher interest rates than on more traditional non-recourse loans.
Tax Considerations
While profits made with an investor’s own money within IRAs are tax-deferred (or tax-free in the case of Roth IRAs), profits and earnings attributable to borrowed money are subject to a special tax called the unrelated debt income tax.
When an IRA borrows money, it must pay taxes on profits and earnings generated by that debt finance. These profits and earnings are called unrelated debt-financed income. If the account owner has leveraged the property 50 percent, then he or she will have to pay income taxes on 50 percent of the profit. On the flip side, the IRA can write off the expenses related to the debt-financed portion, in this case 50 percent.
The borrower will need to obtain a separate taxpayer identification number or EIN for his or her IRA or LLC within the IRA that is actually holding the property. The borrower must also file a Form 990-T, along with other relevant tax schedules.
Important: Use money from within the IRA to pay any taxes due. It’s the IRA paying the tax, not the account owner personally.
UDIT isn’t just applied to leveraged real estate. The tax applies to any business, enterprise or activity in a self-directed IRA that is financed with money borrowed from outside the account.
Exception: Acquisition
UDIT does not apply to the debt-financed portion of an asset if the non-recourse loan is obtained at the time the asset is acquired. •
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