The benefits of IRAs are well-understood. Tax deferral itself provides a kind of leverage – allowing investors to put a greater amount of money to work than they would be able to in a taxable account.
However, with the traditional kind of investments most consumers make in their IRAs – stocks, bonds, mutual funds, CDs and annuities – the potential for leverage is limited.
There is nothing in the law, however, that restricts you to the ordinary. The tax code actually provides very few restrictions on what investors can invest in within their IRAs, and how they can go about it. Specifically, the tax code prohibits IRA owners from using their accounts to buy collectibles, alcoholic beverages, jewelry, life insurance, and certain formats of precious metals. The law also prohibits using the IRA to benefit yourself or certain family members or advisors personally while the assets are still in the IRA. Everything that is not specifically forbidden in the tax code is permitted. Among the most popular investments for self-directed retirement accounts is real estate, – which is traditionally leveraged. Your IRA can also engage in private lending or own a closely-held small business, which may have to borrow to meet cash flow needs. Your IRA can borrow money to leverage any of these activities – potentially boosting returns.
Benefits of Leverage
Leverage – the investing of borrowed money – allows you to purchase a relatively large asset and benefit from its growth and income, all with a comparatively small out-of-pocket outlay.
Leverage can also help you diversify your portfolio. For example, if you have a $300,000 balance in your IRA, you can use it to invest in one $300,000 property – or use leverage to enable you to put $100,000 down on three properties. You then reap the benefit of capital growth and income generation of a $900,000 portfolio, minus interest and expenses.
If you do elect to purchase real estate in your IRA, using a special kind of account called a self-directed IRA, any loans your IRA takes out must be non-recourse. That is, the lender may have no lien or claim on any asset outside the IRA itself. The loan can be unsecured, or secured by property or assets which the IRA itself owns. You cannot make a personal guarantee to the lender on behalf of the IRA.
You must also comply with restrictions on counterparties:
- You cannot borrow from or lend to your IRA directly, nor can your spouse or any entity either of you control.
- Your ascendants and descendants also cannot lend to or borrow from your IRA, nor may their spouses or any entities they control.
- Professionals who advise you concerning your IRA cannot lend money to nor borrow from your IRA, nor may any entities they control.
- You cannot stay in any property owned by your IRA, even overnight, and even to make repairs, even if you pay your IRA a market rate to rent the property.
Leveraging Within your IRA
Typically, when you utilize a non-recourse lender to finance a real estate transaction within your IRA, you should be prepared to put up about 35 percent of the property’s purchase price . Reserves are required , as well as the usual closing costs, insurance premiums and property taxes due at signing. There is little opportunity for “creative financing” in this kind of IRAs. The more money you put down, though, the lower your overall risk.
You may find that mortgage rates on your IRA are somewhat higher than the norm in owner-occupied residences. However, these loans are not exotic instruments at all, and can be had for rates very similar to those on other investment properties.
Other Uses of Borrowing
IRA borrowing isn’t just limited to making asset purchases. There are also unlimited opportunities for owner financing that may qualify for non-recourse loans. Certain lease options may also qualify for non-recourse loans, as may contracts for deeds and many other types of arrangements. Remember that IRS rules limit you from contributing more than $5,000 per year in new money to any combination of IRA accounts. For those over age 50, the limit is $6,000. For cash needs over and above your allowable contributions, it is perfectly acceptable to borrow money to finance operations, repairs, improvements and other investments and expenditures within your IRA. However, regardless of the purpose of the loan, the same rules and restrictions on loans within an IRA apply.
While assets in IRAs generally defer income and capital gains tax until the assets are distributed, IRAs may still be subject to a special tax on unrelated business income. The unrelated debt income tax (UDIT) may apply on any profits within the IRA that are attributed to leverage, in proportion to the leverage amount. This could also be true of any assets your IRA owns as part of a partnership. The reason? The IRS did not want to grant a substantial business advantage for non-taxable entities, including non-profits but also IRAs – engaged in business activities. For more information on the unrelated business income tax, see IRS Publication 598.
As always, you should be aware that while leverage can boost potential returns, it can also boost risks, as well. While you cannot lose more than you have in your IRA - thanks to the IRS prohibition on any borrowing in an IRA other than non-recourse debt.
Cash Flow Factors
Because of the restriction on investing new money in your IRA property, it is doubly important to maintain cash or other liquid reserves within the IRA itself. It is also important that the investment, whether it is real estate or something else – be cash flow positive: If your asset is bleeding red ink because of a vacancy, you have a very narrow window available for cash infusion from outside the account. Fortunately, with down payments in the 35 percent range and up, this is a relatively uncommon occurrence for real estate investments. If you want a larger window, you may consider a self-directed SEP IRA or Solo 401(k), both of which feature much larger contribution limits – as much as $49,000 per year, depending on your circumstances . As a point of interest, Solo 401(k)s are not subject to UDIT, in some circumstances.
Leverage should be employed judiciously, with a healthy respect for potential downside risks. For more information or a no-obligation consultation, please don’t hesitate to call American IRA, LLC at 1-866-7500-IRA(472).