Non-recourse loans are used by self-directed IRAs to leverage buying power, most often to invest in real estate. But what exactly are recourse loans vs non-recourse loans? This article explores the differences and explains how non-recourse loans work in your IRA to help you build wealth for retirement.
You may know more about recourse loans vs. non-recourse loans than you think you do. Conventional mortgage and automobile loans are typically recourse loans. Non-recourse loans are generally found in many commercial real estate transactions. Read on to discover more details of each loan, and how non-recourse loans work in a self-directed IRA.
Most of us are familiar with recourse loans that are offered by banks and traditional lending institutions. These loans are secured with collateral, typically the property they are used to purchase. The borrower is also personally responsible for repaying the loan debt. So, not only can lenders take possession of the collateral if the borrower defaults, they can also pursue the borrower’s other assets (including wages) to ensure the debt is paid in full.
Non-recourse loans are also secured by collateral, but they are not personally guaranteed by the borrower. If the borrower defaults, the lender cannot access the borrower’s personal assets or wages as they can in recourse loan transactions. The only way lenders can recapture the loan balance in a default scenario is by taking possession of the collateral attached to the loan. The lender cannot sue or otherwise pursue other legal action against the borrower. Non-recourse loans are the types of loans the IRS permits IRAs to use to buy investments.
How Non-Recourse Loans Work in IRAs
Using non-recourse loans to finance a real estate investment in an IRA is strategy that helps extend the purchasing power of your IRA.
Even though you’re the IRA owner, the IRS prohibits you from extending credit or personally guaranteeing a loan for the benefit of your IRA. So, the loan is titled in the name of your IRA as the borrower. All payments are made from funds in your IRA. If the loan goes into default, the lender cannot go after anything other than the real estate used as collateral to back the loan. This means that any additional funds or investments in your IRA are off limits, and your personal funds and assets are off limits, too.
- The loan is made to your IRA, in the name of the IRA.
- You cannot personally guarantee the loan.
- When non-recourse financing is used, the income the IRA receives is subject to unrelated debt-financed income (UDFI) tax.
- UDFI tax applies only to the debt-financed portion of the investment. For example, if an IRA makes a down payment of 30 percent and finances the balance of the purchase, then 70 percent of the income the IRA receives from the investment is subject to UDFI tax.
- UDFI tax is calculated at trust tax rates (because IRAs are considered trusts). As the IRA pays down the loan or the investment increases in value, the percentage of income subject to UDFI tax decreases.
UDFI tax may come as a surprise to some, since retirement plans are tax-sheltered entities. But, pursuant to IRC 514, when using a loan to help purchase the asset, UDFI tax does come into play if your investment earns income (like multifamily property or other rentals in your IRA). However, if an IRA is subject to UDFI tax, the IRA can take deductions and depreciation to limit the impact of UDFI tax. It’s important to note that unlike IRAs, qualified plans such as 401(k)s are not subject to UDFI tax. So, make sure you consult with the proper professional to ensure you understand your plan’s tax liability in these transactions.
If you have questions about how non-recourse loans work in your IRA, contact us today. Advanta IRA provides free consultations and we are always eager to explain how these powerful accounts can help you build the retirement income you desire.