It is a common misconception that IRS rules prohibit Self-Directed IRAs from borrowing money. In fact, IRAs take on mortgages, margin debt, and borrow for all kinds of other purposes every day. Self-Directed Real Estate IRA investors, like most real estate investors, routinely borrow money to finance purchases, and many who engage in private lending within their Self-Directed IRA borrow funds at low interest rates in order to lend at higher ones. And, of course, companies owned by IRAs issue bonds and take on bank debt and other debt financing all the time. This is true of nearly all publicly-traded companies at one time or another in their development. All of the above is possible using a Self-Directed IRA.
However, those interested in employing leverage within their Self-Directed IRAs should be very careful not to commingle their own personal funds or financial affairs with the IRA in any way. By law, all debt the Self-Directed IRA takes on must be on a non-recourse basis.
Here’s what that means:
When you have your Self-Directed IRA borrow money – whether to buy a property, or buy stocks, or to lend out, or for any other reason – the lender’s only collateral or security must be the property or assets bought with the debt or held within the Self-Directed IRA.
This is different from conventional financing arrangements, where the lender routinely requires the borrower sign a personal guarantee, putting the borrower’s personal assets on the hook in case of a default. The lender can potentially get a default judgment against the borrower, and then begin garnishing wages or seizing assets held in the defaulted borrower’s name.
An IRA is different. A Self-Directed IRA owner cannot sign a personal guarantee, nor pledge any assets as collateral other than those held within the affected IRA. If he does, the IRS could disallow the tax-favored status of the IRA.
In practice, most traditional banks do not like to lend on a non-recourse basis. Banks that do lend to Self-Directed IRAs typically require a higher down payment on real estate than traditional lenders – often between 35 and 50 percent, depending on the lender and the property.
Tax Consequences of Self-Directed IRA Leverage
If you do choose to leverage your Self-Directed IRA via borrowing, be prepared to pay taxes on part of any income or capital gains your IRA realizes. While taxes on investments made with your own money are deferred within a Self-Directed IRA (or, in the case of Self-Directed Roth IRAs, tax-free after five years), any gains or income attributable to borrowed money is subject to a special tax called unrelated debt-financed income tax, or UDIT. You may be able to avoid UDIT liability by electing to use a Self-Directed 401(K) structure, rather than an IRA.
This tax frequently catches Self-Directed IRA owners by surprise. Your tax adviser can provide more information on this specific tax and how it may affect you.