One of the biggest misconceptions investors have about Self-Directed IRAs is that everything inside the account is automatically tax deferred or tax free. In many cases, that is true. But when you introduce borrowed money into the transaction, the rules can change.
David and Tom Moore, co-founders of Equity Advantage, explain that when an IRA uses a non-recourse loan to acquire property, part of the investment may become subject to taxation. That can come as a surprise, especially for investors who assume everything inside the IRA remains tax deferred or, in the case of a Roth IRA, tax free.
How a Non-Recourse Loan Changes IRA Tax Treatment
Many investors use non-recourse loans to expand what they can buy inside a Self-Directed IRA. But what many people do not realize is that borrowing money can also change the tax treatment of their investment.
When a Self-Directed IRA uses a non-recourse loan to purchase property, the investment is funded by both qualified funds already inside the IRA and borrowed money. Unfortunately, those two sources of money are not treated the same way for tax purposes.
The portion funded by the IRA receives the tax-deferred treatment investors generally expect from a retirement account. The borrowed portion, however, can create a tax obligation because those funds are not part of the IRA.
Many investors focus on the opportunity that leverage creates because borrowing allows an IRA to acquire a larger property than it could purchase with cash alone. But what often gets overlooked is that leverage can also create taxation inside the account.
An EUBIT Tax Example
If a property is purchased with 50% IRA funds and 50% borrowed money, you could end up paying taxes on essentially half of the property’s net operating income.
The percentages will vary depending on how much leverage is used, but the basic idea stays the same. Once borrowed money becomes part of the investment, a portion of the income may become taxable.
That’s what catches many investors off guard. They assume everything inside the IRA receives the same tax treatment, only to discover that leverage changes the equation.
Why the EUBIT Tax Actually Belongs to the IRA
This is one of the most common points of confusion for investors.
When investors hear that leverage can trigger a tax, they often assume they will receive a personal tax bill. However, the tax belongs to the IRA, not to you personally.
That distinction matters.
The tax liability stays within the retirement account and does not become a personal tax obligation just because the IRA used borrowed money. Depending on how the account is structured, the EUBIT tax may be paid by the IRA itself or by an IRA LLC.
Weighing the Pros and Cons of Leverage
Borrowing money can dramatically increase what a Self-Directed IRA is able to invest in, but it can also create major tax consequences many investors do not expect. Taking the time to understand how leverage affects the tax treatment of an investment can help you determine whether a non-recourse loan is the right move.
If you are considering using a non-recourse loan inside your Self-Directed IRA and want to understand how that may affect your taxes, contact Equity Advantage today to explore your options with an expert.
The Guys With All The Answers…
David and Thomas Moore, the co-founders of Equity Advantage & IRA Advantage
Whether working through a 1031 Exchange with Equity Advantage, acquiring real estate with an IRA through IRA Advantage or listing investment property through our Post 1031 property listing site, we are here to help Investors get where they want to be. Call them today! 503-635-1031.
FAQs About Self-Directed IRAs, EUBIT and 1031 Exchanges
Can a Self-Directed IRA use a non-recourse loan to buy real estate?
Yes. A Self-Directed IRA can use a non-recourse loan to purchase real estate. In that situation, part of the investment is funded by IRA money and part is funded by borrowed money, which can affect how income from the property is taxed.
Why can leverage inside a Self-Directed IRA trigger EUBIT?
EUBIT can apply because borrowed money is not treated the same way as qualified IRA funds for tax purposes. When leverage is used, a portion of the income generated by the investment may become subject to taxation.
Does the EUBIT tax belong to the IRA owner personally?
No. The tax belongs to the IRA, not the individual account holder. Depending on how the account is structured, the EUBIT tax may be paid by the IRA itself or by an IRA LLC.
