A common, sneaky lending trick can wreak havoc on your real estate investing and retirement.
Real estate investors often use leverage in order to do bigger deals that offer higher returns than they could achieve using only their own capital. Borrowing money in order to expand your investing capacity can be a wonderful thing. Unfortunately, thanks to a nasty and misleading lender habit, many investors handle the borrowing process incorrectly and jeopardize their retirement savings when borrowing inside of an IRA.
Borrowing in a self-directed IRA comes with some very specific guidelines, and one of the biggest is that your loan must be a non-recourse loan. This means that if your IRA fails to make payments on the loan, the only thing the lender can do is foreclose on the property. They cannot sue you or the IRA for losses.
This is incredibly important. Self-directed IRAs that borrow using loans that are not non-recourse loans are committing a prohibited transaction. This can and often does result in the IRS assessing so many fines and fees against the IRA that its entire contents are gone by the time you are done paying them: a total implosion of your retirement savings.
Here’s that nasty habit: Sometimes even so-called non-recourse loans contain stealthy provisions known as “carve-outs.” These carve-outs essentially invalidate the non-recourse part of the loan under certain circumstances.
Banks do this because nonrecourse loans are riskier for them than more conventional loans and they would rather not make them. If you use a loan with a carve-out – even if you do not realize you are doing so – the IRS can still hold you responsible for a prohibited transaction. They can do this even if you make every loan payment on time, because the issue is not with your paying on time, but with the terms of the loan itself.
Fortunately, you can protect yourself by having a qualified attorney with expertise in self-directed IRAs review your loan documents before you sign. While it is not in the lender’s best interest to tell you about a carve-out (after all, it’s there so that their funds are better protected), it is in your lawyer’s best interest to do so!
5 Key Things to Know about Borrowing in Your Self-Directed IRA
1. You must use a non-recourse loan.
2. The IRA (and no one else, including you) must make all payments on the loan.
3. Nobody who is a responsible party on the loan can be a “disqualified person”.
4. The loan must be at a reasonable rate, especially if you are borrowing from someone you know.
5. If your leveraged investments generate income, your IRA will likely be liable to pay a special type of tax on that income called “Unrelated Business Income Tax” (UBIT).
LEVERAGE: Using borrowed capital for an investment and expecting the profits made to be greater than the cost of the loan.
SELF-DIRECTED IRA: A retirement account that allows the account holder to save money for retirement in a tax-advantaged way while investing their savings in nearly anything they like, including real estate.
DISQUALIFIED PERSON: The people and organizations with whom your IRA should never conduct transactions, including (but not limited to) yourself, most of your family and any business entities you control.