by Guest Contributor By Roger St.Pierre, Sr. VP First Western Federal Savings Bank
Taking loans for your IRA assets? If your IRA borrows money, it must be in the form of a non-recourse loan. Non-Recourse Loans for your self-directed IRA are a great way to add leverage to that real estate purchase in your account. You don’t have to pay all cash for that rental/investment property, therefore making your hard earned funds go further.
How it works
You can put 40% down, and finance 60% of the purchase price with a non-recourse loan. Terms up to 25 years are available, so payments are low and you get positive cash flow from your rental property. The tenant is essentially making the payments for your self-directed IRA over time so that ultimately the loan will be paid off by rental income and the property will become a free and clear asset of your retirement plan. All loan payments flow from the IRA, just as all rental income generated by the property flows into your IRA. A good property inside of your self-directed retirement plan will provide positive cash flow, and in the right market, appreciate in value as well.
There are several differences between a regular real estate loan that you would normally use to buy a piece of rental property and an IRA non-recourse loan. The first is that the owner/borrower is the IRA and not you personally, so you don’t provide personal financial or income information since you as the person are not borrowing the money, your IRA is. These types of loans do not show up as an obligation on your personal credit report.
Second, qualifying for the loan is based upon the positive cash flow the rental property will generate after all expenses, and the idea that there will be a cushion of liquidity left in the IRA after closing to be there for unexpected repairs, lack of rental income, or other unforeseen expenses. We like to see that Net Operating Income is at least 125% of the loan payment. This is also known as Debt Service Coverage Ratio (DSCR). A 1.25 DSCR is the minimum cash flow needed to qualify a property from a cash-flow perspective. In order to calculate this ratio, simply take your Net Operating Income after taxes, insurance, HOA fees, management, etc. and divide that figure by the Principal and Interest payment on the loan.
No personal guarantees on non-recourse loans
Since you cannot personally make the loan payments or pay for repairs and maintenance on the property, a 15% of loan amount liquid reserve requirement is required to be held in the IRA. Those liquid funds inside of the IRA should be there for those times when the rental income alone may not pay for all the costs of owning and maintaining the property, or tenant turnover.
What about default?
The last major difference is that should there be a default on the loan, the bank can only foreclose and take the property back to try to sell and recoup the loan funds. The bank cannot go after you personally, or any other assets within the self-directed retirement plan that owns the property that borrowed the money. And you do not personally sign for the loan.
Unrelated Debt Financed Income tax (UDFI)
When an IRA borrows funds it can lead to a tax called UDFI (Unrelated Debt Financed Income Tax). You can read more about this tax at www.IRS.gov Pub 598. We recommend you discuss this with your tax advisor.
So to recap, the positive cash flow left from the rental income the property generates after all expenses is what pays the loan back, and 15% of the loan amount kept in reserves in the IRA is necessary for contingencies. Next time you are considering purchasing an investment property with your SDIRA, think about the power of leverage and using a non-recourse loan to increase your rate of return and add purchasing power to your IRA.
By Roger St.Pierre
Sr. VP
First Western Federal Savings Bank
NMLS#768919
