Non-Recourse Loans: How UBIT and UDFI Tax Affect Real Estate Investments in Your IRA

The most common way an IRA acquires assets is simply to use funds in the account to buy investments in a pure cash transaction. However, if the retirement account does not have enough capital to acquire the desired asset, it can exercise a few other options. The IRA can partner funds with another person (including your personal funds) or entity (such as another IRA), or the retirement account can borrow funds in the form of a non-recourse loan.

What is a non-recourse loan?

This type of loan is one that is secured simply by the collateral being purchased and does not have a personal guaranty. For the purpose of this article, we will only discuss real estate investments in IRAs using non-recourse loans.

When using leverage in conjunction with IRA funds to purchase real estate, IRS Section 4975 requires that the loan be non-recourse to the IRA and IRA owner. This means that if the borrower (i.e. the IRA) defaults, the lender can only take the property used as collateral for the purpose of collecting the debt. In other words, the owner of the IRA is not personally liable for debt due to default, and the lender cannot take any other funds from the IRA for repayment. The lender can only foreclose on the piece of property used as collateral to back the loan. As expected, this type of loan can be more difficult to obtain, but it is permissible under IRS rules.

As with any expense related to investments in an IRA, all payments of a non-recourse loan must be made using IRA funds and cannot be paid with personal funds of the account owner. Additionally, when your retirement plan uses a non-recourse loan to finance the purchase of an investment, the plan would be then liable for unrelated debt-financed income (UDFI) tax.

What is unrelated debt-financed income tax?

When your retirement plan uses a loan to help finance the purchase of a real estate investment, your account may be subject to taxation on the net income of the debt-financed portion of the asset. This is called unrelated debt-financed income tax (UDFI). It is commonly referred to as unrelated business income tax (UBIT). This tax also applies when property is purchased through an entity established by the retirement plan, such as a partnership or an LLC, to purchase the asset. With leveraged real estate purchases, the IRA then is in receipt of taxable income.

Taxable income is determined by comparing the value of the property to the debt-financed percentage of the property, combined with any income generated by the investment (i.e., rental income and or the sale of the property, minus expenses). In other words, the tax is assessed only on the net income generated by the debt. Any expenses and depreciation of the property can be calculated to offset the tax liability. 401(k)s and other employer-sponsored plans are exempt from this tax category.

What are the terms of a non-recourse loan?

The answer to this question varies and is dependent on the lender. Banks or other institutions that offer non-recourse loans typically require a down-payment of a certain percentage of the purchase price of the real estate investment. For example, depending on the lender’s requirements, the range of this percentage can be as low as 15 percent or as high as 40percent (or even higher depending on the condition of the property). Additional requirements generally include the property to produce a net operating income (rent minus operating expenses) that exceeds the debt payment by 15-25 percent.

There are many complicated variables you must understand when considering using these loan structures to purchase an asset in your IRA. It is critical that you consult with a CPA or other financial advisor before undertaking these transactions to ensure the process is completed properly and is compliant with IRS rules and regulations.

For additional information, see IRS Publication 598, which provides complete information on this subject.