Self-Directed retirement plans grant investors access to a vast number of investment opportunities. Something that investors may not be aware of, though, is the self-directed account’s ability to leverage investments using non-recourse loans. In this article, we will discuss the definition, benefits, and specifics of non-recourse loans as they pertain to self-directed retirement plans.
What is a Non-Recourse Loan?
A non-recourse loan is a powerful tool that self-directed retirement plan holders can use to borrow money or leverage their investments. A non-recourse loan is a type of leverage where the lender only lends against the asset purchased by the debt. Financing with non-recourse loans means that in the event of default, the lender cannot seize any assets held by you or your retirement plan. Lenders can only seize the asset for which you are borrowing the funds to purchase as you have provided no personal guarantees. For example, non-recourse loan collateral would be the property funded by the loan. This provision is essential for self-directed accounts, as it allows the retirement plan to remain in compliance with IRS guidelines while still utilizing leverage to obtain investments. More on that later.
What Can a Non-Recourse Loan Do for My Self-Directed Retirement Plan?
So why would someone want to utilize a non-recourse loan in their self-directed retirement plan? What benefit could it provide you? First, non-recourse leverage can significantly expand your investment options. Using debt can grant your retirement plan access to assets that it otherwise would not have been able to invest in or purchase. Real estate is one of the most common assets purchased using non-recourse loans in retirement plans. If your self-directed retirement plan is unable to cover the cost of the property in its entirety at closing by only using equity, utilizing a non-recourse loan to raise funds necessary to purchase the property is a way to accomplish that goal.
A second, and closely-associated benefit of a non-recourse loan within your self-directed retirement account, is asset diversification. Imagine you have $100,000 in your self-directed retirement plan. You want to purchase a property worth around $100,000 with your IRA but you do not want to spend the entire balance of your retirement account to obtain the property. You take out a $50,000 non-recourse loan in the name of your retirement account to help purchase the property. By utilizing the powerful tool of a non-recourse loan in your retirement account, you can free up funds in your IRA to invest in other assets to add diversification to your portfolio, which is a vital investment strategy and your portfolio’s best friend.
Can I use a Recourse Loan in My Retirement Plan Instead?
What about traditional recourse loans? Is my retirement plan able to take debt in which I sign personal guarantees? In short, the answer is no. The reason why your retirement plan can only utilize non-recourse loans is thanks to IRC § 4975 (c)(1)(B). In this section of the Internal Revenue Code, the IRS prohibited the extension of credit between a disqualified party and a retirement account. This prohibition means two things: the retirement account cannot loan money to a prohibited party, and a prohibited party cannot loan money to or personally guarantee a loan to your retirement account. Click here to learn more about prohibited parties.
The retirement account is the only qualifying factor in receiving a non-recourse loan. The non-recourse loan is not given based on the account holder’s (or disqualified party’s) personal credit or assets. Taking a loan in your retirement plan for investment purposes that guarantees your personal assets would be considered a prohibited transaction. Personally-guaranteed loans can have significant consequences on how the purchased asset is handled from a tax perspective.
What Should I Keep in Mind Before Taking a Non-Recourse Loan?
When considering a non-recourse loan in your retirement account, you need to consider several factors. The first point to consider is that non-recourse loans to a retirement account are somewhat of a niche undertaking. Not every financial institution that offers loans as a regular part of their business can or should undertake a loan relationship with a retirement plan. A few reasons financial institutions wouldn’t offer non-recourse loans for retirement plans include a lack of administrative feasibility and awareness of the IRS prohibitions. Therefore, it is essential to use a financial institution that regularly handles non-recourse loans to retirement plans or perhaps even specializes in them. Doing this could save you a world of trouble.
A second point to consider is that most non-recourse loans typically require a significant downpayment from the retirement account in order to lend funds. It is not uncommon to require a 30% or 40% downpayment for a non-recourse loan. A large downpayment makes sense because of the limited recourse that the lender has in the event of default. Remember that the lender can only possess the asset used to obtain the loan if there is a default. A larger downpayment also reduces the lender’s exposure in this situation.
A third point to consider before obtaining a non-recourse loan is the tax implications that come into account when leveraging your investments. While the leveraged asset is held within a tax-advantaged account, there can be taxes that apply in certain circumstances when utilizing leverage. When an IRA takes a non-recourse loan, the income associated with the debt taken by the IRA becomes subject to a tax called Unrelated Debt Financed Income Tax (UDFI). However, Individual 401(k) plans are not subject to UDFI, thanks to a provision in IRC Section 514(c)(9). This lack of taxes makes Individual 401(k) plans an exceptionally powerful vehicle for retirement plans. If you are interested in learning more about Individual 401(k) plans, you can do so here.
In conclusion, non-recourse loans are a powerful tool that can help guide you towards bigger and greater opportunities that could have been otherwise unavailable to your retirement account. If you have any questions about this article or would like more information, please feel free to contact Midland at 239-333-1032 or visit www.midlandtrust.com.
MIDLAND TRUST IS NOT A FIDUCIARY: Midland’s role as the custodian of self-directed retirement accounts is non-discretionary and administrative in nature. The account holder or his/her authorized representative must direct all investment transactions and choose the investment(s) for the account. Midland has no responsibility or involvement in selecting or evaluating any investment. Nothing contained herein shall be construed as investment, legal, tax, or financial advice or as a guarantee, endorsement, or certification of any investments.