IRAs and qualified plans can borrow funds, but the accounts themselves cannot be used as collateral for loans for personal use. The most difficult issue is finding a lender, because the loans must be nonrecoursive—financing where the property is the only collateral because you personally cannot be obligated to pay the note, according to the IRS code regarding trusts. A traditional loan provides for “recourse” to the borrower. In other words, if, for whatever reason, you can’t make the mortgage payment, the lender reserves the right to come after you personally for the balance of the loan. In a nonrecourse loan, the cash flow from the property must be sufficient to cover the mortgage payment and all expenses because the lender cannot come back to you for any shortfalls.
Most institutional lenders won’t lend to retirement plans because such loans cannot be resold in the secondary market through the usual network of mortgage bankers, brokers, and banks. Community banks and other portfolio lenders, such as hard-money or private lenders, are much more likely to make loans. Although you cannot guarantee the loan, a third party who is not related to you can. You can use other or additional collateral for the loan.
Obtaining nonrecourse loans in other countries is also difficult. Some countries treat them as commercial loans, which may be subject to different conditions. The complexity of dealing with trustees of retirement plans could delay matters and cause the seller to forego the transaction. In some cases, the lender may attempt to obtain personal guarantees aside from the loan made. Any such guarantees could cause the IRA to be subject to disqualification in the United States, but sometimes guarantees from unrelated third parties who are not disqualified persons are acceptable in foreign jurisdictions, just as they are in the United States. Working with a trustee that is familiar with international investments can help you make sure that you are working within the regulations.
Loan payments must be made by the retirement fund, either from the cash flow generated by the rental income or from existing funds in the account. If rental or other cash is not available, and the loan payment cannot be made, any payment made by a third party or by the IRA owner is automatically considered an excess contribution. Potentially, this may be considered a prohibited transaction.
If you do borrow money to purchase an asset, the debt financing is subject to unrelated business income tax (UBIT). “Debt-financed property” is an IRS term for a mortgage or loan against an asset, such as real estate. You also should be aware that the account might be taxed again when you begin taking distributions, unless you’re using a Roth IRA, where all withdrawals are tax free.
Unrelated debt-financed income (UDFI) is profit made from borrowed funds. If your net income on all your debt-financed property exceeds $1,000 in a twelve-month period, the portion of the debtfinanced property is subject to UBIT. However, if you no longer have a debt for the property in the year prior to a sale, your plan is not subject the UBIT, regardless of the amount of profit.
UBIT must be paid by the retirement plan. You can use funds from other IRAs or plans, but first you must transfer or roll over the funds to the IRA or plan with the debt. If you pay the debt with funds not in the retirement plan, it is considered an excess contribution and may be subject to penalty.
If you sell debt-financed property, you must include a percentage of any gain or loss when computing the UBIT. The percentage is that of the highest acquisition indebtedness of the property during the twelve-month period preceding the date of sale in relation to the property’s average adjusted basis. The tax on this percentage of gain or loss is determined according to the usual rules for capital gains and losses. These amounts may be subject to the alternative minimum tax. If any part of the allowable capital loss is not taken into account in the current tax year, it may be carried back or carried over to another tax year without application of the debt/basis percentage for that year.
One way to avoid UBIT is to partner your IRA with other funds. If you use your IRA funds for the down payment and your personal funds for the mortgage, capital gains from a sale would be proportionately divided between you and the IRA. In this way, the debt financing was not incurred by the IRA. This approach is also a good way to get around the problem of lenders not wanting to give loans to a retirement fund. For example, let’s say that you have a $100,000 property with a $20,000 interest vested to your IRA and $80,000 vested to you. The bank loans you the $80,000, and you personally make the payments. Any benefit from the purchase, such as rental income or income from a sale, is shared pro rata between you and the IRA. Expenses would be shared in the same way.