Use a Non-Recourse Loan to Invest in Real Estate with a Self-Directed IRA
Non-recourse loans for a self-directed IRA are used and required by the IRS when your IRA uses financing to invest in real estate. A non-recourse loan is typically secured by collateral (real property) and neither the IRA nor the account owner personally guarantees repayment of the loan. If there is a default, the lender’s only option would be to foreclose on the underlying collateral.
Non-recourse loans for a self-directed IRA are used because IRS Section 4975 prohibits you from obtaining financing for your IRA by using your personal credit for the benefit of the IRA. This prohibition extends to any disqualified individuals as well. Many lenders shy away from this type of lending, but there are a few national lenders that work with IRAs in this situation.
Understanding UDFI Tax
Your IRA is subject to unrelated business income tax (UBIT) when it earns unrelated debt-financed income (UDFI). IRAs that use non-recourse loans to help purchase an investment earn UDFI on the percentage of income attributed to the debt-financed portion of the asset. Per IRC 514, this UBIT applies to any financed asset held in the IRA, even if the IRA is not the entity applying for the financing. For example, if your IRA invests through an LLC or partnership that owns financed real estate, your IRA may still subject to UDFI tax on any income it receives.
Note: Qualified plans, like the individual 401(k) plan, do not pay UBIT on UDFI.