A non-recourse loan is simply a loan that does not require a personal guarantee. That means that in the event of default, the only recourse the lender has is to foreclose on the property. For self-directed IRA account holders this distinction is important. Since non-recourse loans do not require a personal guarantee, they are suitable as a means for adding leverage to self-directed IRA accounts.
The IRS expressly prohibits IRA account holders from providing personal guarantees on behalf of their accounts, however, with a non-recourse loan the IRA or LLC is the borrower, not the account beneficiary.
While non-recourse loans sound great, and they can be extremely useful in the right situations, it is important to understand the drawbacks.
Terms Are Worse Than Traditional Mortgages
Since lenders have limited resource in the event of default, naturally the terms for these type of loans are not going to be nearly as favorable for borrowers as traditional mortgages. Actual terms will vary by lender and property, however, here are some general numerical comparisons to demonstrate the differences.
Unrelated Business Income Tax (UBIT)
When considering a non-recourse loan for self-directed IRA accounts one thing most people aren’t aware of, is that by leveraging an IRA account you are then subject to UBIT. Calculating this tax can get complicated, but the basic principal is that the IRS wants to collect taxes on the portion of income derived from the leverage.
So, for example, if you purchased a property for $300,000, and obtained a non-recourse loan for $150,000 (50% leveraged), the IRS would expect you to pay UBIT on 50% of the income generated by the leveraged asset. Now, you do have the ability to apply certain deductions and so on, but it can get complicated fast. Here is a link to the actual IRS code in reference.
Before you obtain a non-recourse loan, it is a good idea to meet with a tax professional who is well versed with UBIT. Make sure you at least have a grasp on the tax impact you will face before you go down the non-recourse road.
Limited Providers & Hard To Get
Lastly one of the major issues with non-recourse loans, is that they are incredibly hard to get. There are only a handful of lenders who actually offer them, and they are extremely picky on the types of properties they lend on. Since their only recourse is the property itself, they want to make sure that the likelihood of default is minimal, and that if they do have to foreclose they property will more than cover the loan.
One of the common things they do to control risk is require debt service ratios around 1.25. This means that the income generated from the property has to cover any expenses (including the mortgage) and then some. Finding a property with that sort of debt service ratio isn’t easy in many major markets. Another thing they do is watch out for volatile real estate markets. If you are buying a property in a place they deem ‘high-risk’ you might not be able to get a loan at all, or may be faced with a max-LTV of around 40%.
It is also common for non-recourse lenders to restrict the types of properties. First Western Savings Bank, for example, does not lend on properties built prior to 1940, and will also not lend on raw land, restaurant buildings or motels. In addition, even though these are non-recourse loans, the lenders want to make sure you have enough extra funds set aside in your IRA to cover payments for awhile. They typically require reserves in your IRA around 15% in order to cover payments in the event of vacancies, and so on.
Non-recourse loans are not inherently bad, but they do come with some negatives that investors need to be aware of. In the right situation, though, they can help investors increase the earning power of their IRAs, but it is all dependent on the investment opportunity.