Okay, unfortunately for my literary skills, that may be the only Shakespeare line I can quote…..no sense going more into my illiteracy with the great written works of all times. But, this is a question that can come up for people with self-directed plans when, typically, purchasing real estate from their IRA or 401K.
You see, what most people fail to realize with their SD plans is that in the eyes of the IRS, it is an entity to itself. If established correctly, you can make investment choices for your plan, but you can only serve in this capacity. You cannot personally benefit from your relationship to the plan, NOR can your plan benefit from its relationship to you. This impermissible “relationship” (if it were to occur) is called “self-dealing” and your plan is not allowed to enter into this type of transaction. If it does occur, it triggers a Prohibited Transaction within the plan and now your plan is potentially subject to penalties and taxes.
This type of Prohibited Transaction – “self-dealing” – can typically occur when an individual with a SD IRA or 401K takes out a loan for an investment. For example, let’s say that John is purchasing a property that is selling for $100,000 and he wishes to use $50,000 from his SD plan and take out a mortgage for the remaining $50,000. His plan is to title the property in the name of his IRA or 401K (or an affiliated LLC owned by the IRA or 401K), and he will use incoming rental income to repay the loan.
But, and this is a big BUT, when John goes into his local bank and wants to secure a loan for this investment with his IRA or 401K, John may not be familiar (and I can guarantee you his bank will not be familiar) with IRS regulations pertaining to this subject matter. While the plan can secure a loan, it can have nothing to do and have no relationship with the account holder. Think of it this way, you (the account holder) are merely acting as the trustee, manager, etc. of the plan, and are making investment choices for the plan. To re-state, you cannot benefit in any way from your relationship to the plan, nor can your plan benefit from its relationship to you. So, now, John goes goes into his bank to request and secure a loan. Obviously, since the bank is unaware of many IRS regulations, it will require John to complete an application and, amongst other things, credit and employment history, etc. is taken into consideration for a decision on the loan. But, for the uneducated IRA or 401K account holder, they may not even be aware that they just fell into a Prohibited Transaction by completing the loan application and extending information related to their personal credit and job and wages history. Why? Because they now extended such information to the bank for the securement of the loan when, most likely, the bank wouldn’t have approved the loan without this information (again, remember, the plan must qualify for the loan on its own merits).
This now leads to the obvious question of how does your plan qualify for a loan when, unlike an individual, it has no credit history (most likely) or job? This is where the concept of a “non-recourse” loan comes into play. So, let’s examine what a non-recourse loan is so our good friend John who has the SD plan can purchase the property and carry a loan on the property….again, all through the SD plan.
Non-Recourse Loan
In the simplest of terms, a non-recourse loan is a loan whereby the SD IRA or 401K account holder is not personally liable for the repayment of the loan. The loan agreement allows no “recourse” against the individual personally or against any other funds within the SD plan. In the unfortunate instance of a default or disclosure, the lending institution can only pursue the value of the property and cannot pursue other assets owned by the account holder or the IRA or 401K. As I like to say in layman’s terms….if the property goes south, they (lender) cannot come after you. They can only go after the property.
Someone might ask, by the way, about the pros and cons associated with non-recourse lending. There can be many but I will give you one PRO and one CON that affects anyone securing a non-recourse loan. The PRO is that, as mentioned, if the property goes into default, the lender cannot come after you personally or attack any other assets of the plan. The one CON is that, typically, a non-recourse loan will hit you for an additional 1 – 3% of interest over a conventional loan.
Now that we have covered a few basics, let’s throw out some typical questions that can come up from someone interested in a non-recourse loan.
Who is Eligible for a Non-Recourse Loan?
Typically, any individual who has at least 30 – 35% of the purchase price vested as “down” money for the property purchase. This % can definitely vary by state.
Is There a Typical Down Payment Required?
Typically, 30% of the purchase price is the lowest amount that will be needed to secure the non-recourse loan. Of course, you can always come in with more of a down, but you will typically need at least 30% down.
Are Non-Recourse Loans Available in All States?
Yes, while non-recourse loans are more difficult to locate than conventional loans, not only are they available in all 50 states but you can find non-recourse lenders who will lend for all 50 states. Please remember, especially in today’s wild economy, that due to economic realities, securing a non-recourse loan in one state vs. another may require more or less vested by the plan.
What Type of Loans are Available?
Anything from a 5 year ARM to a 25 year fixed.
Are There Typical Properties that can be Purchased through Non-Recourse?
Typically, you will be looking at such loans for single family detached residential, warrantable condo’s, PUDs, duplexes, 4-plexes and multi-family. Ineligible properties typically include: residential with large acreage, raw land, farms, rural properties, manufactured or log homes, non-warrantable condos, condo-hotels, co-ops, time shares, hotels, senior or assisted living homes, non-franchise restaurants, entertainment properties, mini-storage facilities or units, and commercial property.
Okay, I Might be Interested, but how long does it take?
From the date you complete an application to the closing date, you should allow at least 45 days. Saying that, can it happen sooner or later, yes.
Scraps (my layman’s term for “other” issues) -– Of course, the lender may have other conditions for approval and documents needed to offer and issue the loan. This information is only intended to be educational and you must, obviously, contact the prospective lender for all information related to applying and qualifying for a non-recourse loan.
To Recourse or Non-Recourse?
In using your SD plan to its fullest, that may be a question you will encounter. As you can tell, there is no set answer. And, you know I am going to say this….but, even if there was a set answer, the purpose of this blog is to educate you on the process. Neither myself or PGI Agency, Inc. provides tax, legal, investment or financial advice. So, as always, you should review such important questions and tax considerations with your expert in the field. Hopefully, this gave some insight into the area of “non-recourse” lending and what you might consider if you are establishing a SD IRA or 401K for investment purposes.
BawldGuy Here: When John says ‘Recourse or Non-Recourse’ in the context of your self-directed qualified plan acquiring real estate, he’s not implying, nor should you infer, that there’s a ‘choice’ between the two. There isn’t — never — ever. It’s non-recourse or your plan is buying the real estate for cash. It’s one or the other, there’s no middle ground.
Also, though John makes the point very clearly about the lender only using the property as security, and not your personal credit worthiness, there will be a personal credit check. The reason? They need to ensure the borrower has no government tax liens recorded against them. Those would have priority over their loans.
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Which lenders do you recommend for non recourse loans less than $50K