Is Mortgaging Real Estate in a Self-Directed IRA the Best Move? The Lender’s Perspective
Many people are interested in making real estate a part of their investment portfolios, but what they may not know is you can invest in real estate using a self-directed IRA. This method of investing in real estate allows you to take advantage of retirement account benefits such as tax exemption or tax deferment and can be a great way to build generational wealth.
In our last post, we addressed how to get a loan to invest in real estate within a self-directed IRA. This time we’re tackling the topic from a different perspective: the lender’s.
Investing In Real Estate with a Self-Directed IRA
If you’re unfamiliar with self-directed IRAs, they are similar to traditional IRAs but they allow investors many alternative investment choices. Traditional IRAs invest in stocks and bonds, while self-directed IRAs offer more than 30 potential investment asset classes.
This leaves investors open to a slew of innovative options. Real estate is traditionally viewed as an excellent investment. It appreciates over time and is less volatile than conventional assets such as stocks and bonds.
Unlike traditional IRAs that banks and brokerage firms manage, self-directed IRAs are managed by a custodian. Owners of self-directed IRAs make all the investment decisions, and a custodian will safe-keep investments and stay on top of all the complicated IRS tax rules and regulations.
In most circumstances, self-directed IRA owners will use cash for their investments. However, some investors don't want to use their entire IRA retirement savings for a real estate purchase or don't have enough money to purchase a property outright. In these cases, self-directed IRA owners can apply for a mortgage loan.
Recourse Loans Versus Non-Recourse Loans
When you’re looking at financing your real estate investment, it’s important to understand the difference between recourse and non-recourse loans.
Recourse loans are the most common type and are what people are likely familiar with. Traditional recourse loans include car, mortgage, and personal loans. This type of loan holds the loan owner accountable and generally favors the lender. If a borrower defaults on their loan, a lender will take any posted collateral as well as additional assets if money is still owed.
A non-recourse loan works differently. It is not guaranteed by anyone. If the borrower defaults on the loan, the lender only has access to the loan's collateral and may not pursue any other additional assets. Non-recourse loans are riskier for lenders.
For example, consider a lender who issues a non-recourse loan of $400,000 to a borrower making an investment. If the investment goes south and the borrower is only able to recoup $350,000 to repay their loan, the lender is going to be stuck with the $50,000 shortfall.
Self-Directed IRA and Non-Recourse Loans
Borrowers who want to mortgage a real estate property using a self-directed IRA can only apply for a non-recourse loan.
The Internal Revenue Code Section 4975 prohibits the IRA holder from personally guaranteeing a self-directed IRA loan. Recourse loans are not used for self-directed IRA loans because the banks cannot seek recourse if the loan falls through.
This leaves a non-recourse loan as the remaining option. This is not ideal for the lender as it is owned by the IRA, not the owner of the IRA. If the property goes into foreclosure, the lender does not have access to the IRA owner's assets and is not allowed to take legal action against the owner.
Naturally, most banks aren't in the practice of offering non-recourse loans. A few lenders are still willing to lend money after careful scrutiny of the IRA owner, but these loans come with demanding requirements.
Lender Terms For Non-Recourse Loans
Due to the nature of the non-recourse loan and the risks involved, lenders have leverage when it comes to loan requirements. Although lenders’ stipulations may vary, a few of the most common guidelines for non-recourse loans are:
A large down payment — usually 30%-50%
At least 10%-20% cash reserves
The loan must be for a property that is in the United States, built after 1940, and at least $70,000
Properties must be income-producing and meet the debt service coverage ratio (DSCR) — the net cash flow after paying operating expenses
An appraisal must be paid for with IRA funds — not with personal funds
IRA owners must have an excellent credit history and good financial standing
Hazard insurance must be in the IRA’s name and the lender might request the hazard insurance “loss payee” clause in the lender's name
Lenders can also add a clause known as the "bad boy carve-out" in the non-recourse contract. These clauses are meant to protect lenders from unsavory actors.
For example, if a borrower declares bankruptcy, commits fraud, does not have adequate insurance on the property, or doesn't pay property taxes on the property, the borrower will be responsible for the losses. The “bad boy carve-out” changes the terms to protect the lender if any of these extenuating circumstances occur.
Lenders hold the majority of risk with non-recourse loans so it’s reasonable that these loans are more difficult to qualify for than traditional recourse loans.
However, there is still an excellent opportunity for lenders to profit from a non-recourse loan. Due to the higher interest rates, the lender will be compensated with a higher profit return.
How to Mortgage Real Estate in a Self-Directed IRA
Here’s what you’ll need to do once you’ve decided investing in real estate through your self-directed IRA is right for you.
Open a self-directed IRA and fund the account
Determine the type of property you’d like to invest in
Find a non-recourse loan lender and assure you meet their requirements
Understand the associated fees involved such as closing costs and transaction fees - remember, these fees must be paid directly from your IRA
How Chicago Trust Administration Services Can Help
Chicago Trust Administration Services makes complicated transactions simple. Borrowers and lenders can have confidence working with us, as we understand the legalities associated with mortgaging real estate purchases with self-directed IRAs.
We’ve been helping our clients reach their retirement goals faster with innovative investment strategies for over seventeen years. We invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com.
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*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.