After my previous post on investing in real estate using IRAs, I received multiple inquiries with the same question. To paraphrase the question:
“Is it possible to use leverage when buying real estate with my retirement account?”
Since many investment property acquisitions involve leverage, this is good information to know. Before discussing the steps to use leverage in real estate investing with your 401(k) plan, let’s find out how leverage can boost investment returns.
Why Leverage Is Critical For Investors
Unlike other asset classes, real estate is a capital-intensive investment. You need a sizable initial investment to purchase real estate. That’s where leverage comes in.
Leverage is borrowed capital. Using leverage is a common practice among investors and real estate management firms. Let’s take an example to simplify the concept.
For a property worth $400,000, the buyer can purchase the property by contributing 20%, or $80,000, of the net amount and borrow 80% from a financial institution (leverage). If the property appreciates 3% annually, it’ll be worth $412,000 after 12 months. You can see how the buyer boosted his net worth using leverage. Imagine if he instead bought an $80,000 full-paid property, with an annual appreciation of 3%, his net worth would only grow by $2,400.
How You Can Use Leverage When Investing With Retirement Funds
Coming back to the question, yes, investors can use leverage when purchasing real estate with their retirement accounts. However, there is a catch.
Unlike regular real estate transactions, the investor will be required to use non-recourse financing for such acquisitions. These loans don’t involve personal guarantees and are secured by collateral only, which is the property.
Why can’t you use a regular loan? Because IRC Section 4975 prohibits the owner of the individual retirement account or 401(k) account from providing a personal guarantee for the loan. Providing a personal guarantee would create a prohibited transaction, as the account owner, in this case, is a disqualified person.
What You Should Know About Non-Recourse Financing
Non-recourse financing for retirement accounts isn’t as common as a conventional mortgage. It is also different from non-recourse financing for commercial properties. In fact, most banks and lenders won’t be able to help. You would need to find a lender that specializes in IRAs and 401(k) plans. Each such lender has unique programs, some geared toward single family rentals with minimum loan amounts as low as $40,000, while others focus on commercial property with a minimum loan of $1 million. Be sure to research to find a lender and a program to fit your needs.
Another difference between conventional and non-recourse financing is the loan-to-value ratio. Conventional lenders typically will offer financing of up to 80% of the property value, or even higher in some cases, on investment property.
Non-recourse lenders typically will require 30-50% down, depending on location and property type. Because there is no personal guarantee, the lender’s risk is higher. Although the LTV is higher, don’t be discouraged as using leverage will still likely result in higher return on investment since you are using borrowed capital but benefiting from the entire property.
What About UBIT On Leveraged Real Estate?
If an investor uses leverage to purchase property inside of a self-directed IRA, a portion of the income from the financed portion of the property will be considered unrelated debt-financed income. In an IRA, UDFI is subject to unrelated business income tax, as mentioned under IRC Section 514. Some consider this to be a turn-off, and that assumption would be fair.
UBIT only applies to the income generated from the debt-financed portion of your investment. For instance, if you bought a property worth $200,000 with your retirement funds, using a non-recourse loan of $100,000, the property is 50% leveraged and therefore 50% of the income would be considered the result of using debt. Because of the use of leverage, and not retirement plan money, you would be required to pay tax on 50% of the income (after you deduct property expenses such as property tax, insurance, repairs and mortgage interest). The income must be reported on Form 990-T. You are responsible to file this form on behalf of your IRA, not yourself personally.
Pro tip: The IRS allows deduction depreciation and deductions on a pro-rata basis, thereby lowering the income subject to taxation. Be sure to consult with a qualified tax professional regarding your specific situation.
A self-directed Solo 401(k) plan is exempt from UDFI. Income from leveraged real estate inside of a Solo 401(k) will not be subject to UBIT. However, this plan is not for everyone as you are required to be legitimately self-employed or own a small business with earned income and no full-time employees other than the business owner and his or her spouse. If you qualify, though, you can enjoy additional perks such as a high contribution limit (up to $56,000 for 2019), ability to invest tax-free using a designated Roth 401(k) account, as well as being able to access up to $50,000 in your 401(k) tax-free and penalties-free via a participant loan.
Things To Remember
• To invest in real estate, your retirement plan documents must allow it.
• Beware of the IRS’s prohibited transactions rules.
• As a disqualified person, the plan participant is not allowed to perform physical work on the property, nor receive personal benefits from the investment.
• All expenses related to the investment must be paid from the retirement account.
• All income generated by the investments your IRA or 401(k) owns belongs to your retirement account.
• Consult a tax professional regarding tax consequences if you are considering using leverage in an IRA.
The Bottom Line
Using leverage to purchase real estate within a retirement plan can seem daunting for a novice. However, if you are willing to educate yourself and use leverage correctly, this strategy can boost your ability to build wealth.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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