IRS Rules
Non-Recourse Loans
You’re thinking about opening an IRA LLC because you found an amazing investment property. The only problem is that your IRA funds don’t cover the entire price. What’s an investor to do? This is a common scenario and the IRS allows you to take out a loan to purchase the property. The only caveat is that it must be a non-recourse loan. Here we will discuss the nature of a non-recourse loan, what it means financially, and what it takes to qualify.
What is a non-recourse loan?
A non-recourse loan is just like a standard bank loan, but with one big difference. In a standard bank loan, the bank is allowed to collect from the collateral, as well as from many of your personal assets. In a non-collateral loan, the bank’s collection ability is limited to the collateral itself. This means that the borrower has no personal liability for the loan.
The Takeaways
- A non-recourse loan works like a standard bank loan except for the fact that (in a case of default) the bank can only collect from the underlying property and not the borrower.
- Non-recourse loans typically have a higher interest rate due to increased underwriting and limited collection ability.
- The documentation necessary for a non-recourse loan includes proof of property income, official appraisal, purchase contract, and an IRA asset statement.
Why do non-recourse loans have to pay higher interest rates?
There are a number of factors that affect a non-recourse loan which are not relevant to standard recourse loans. It is because of these factors that banks charge higher interest rates for non-recourse loans.
Limited Collection
Since the bank is limited in its collection efforts to the collateral posted (i.e. the property,) it runs a bigger risk of default on the loan. If the borrower cannot continue to make payments and the property goes down in value, the bank will lose money on the deal.
Uncertain
Revenue Stream
A regular recourse loan will usually take into account the borrower’s current occupation and assets. A non-recourse loan (not in default) will be paid back solely through the property’s rental income. This is a less consistent income stream than with a standard loan application.
Increased Underwriting
The mortgage system is currently optimized for recourse loans for employed persons purchasing single family homes. Offering a non-recourse loan requires more extensive underwriting to financially model the expected outcome and to become proficient in the characteristics of the specific property.
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Interest rates vary based on the property, the length of the loan, and the standard interest rate in general. Currently (2021) non-recourse interest rates are between 3.75% - 5%.
Each bank has its own set of criteria for who qualifies for a non-recourse loan. Although the specifics may differ, they generally focus on the following areas:
- Borrower Worthiness – Although the lender will not be able to collect from the borrower if the property does not cover the loan, the lender may still do a credit check to assess the reliability of the borrower.
- Loan-to-Value (LTV) – A non-recourse loan will typically not be offered for more than 60%-65% of the property’s value. For example, if the official assessment of your desired property comes in at $300,000, then most non-recourse lenders will not loan you more than $195,000. In other words, your down payment will have to be at least 35% of the value of the property. (With some private lenders, or loans placed by private lenders, the LTV can be as much as 80% depending on the details of the deal.)
- Expected Income – The expected income of your property (i.e. rent) has to fully cover all the monthly payments associated with the loan. This would include the loan principal, interest, taxes, and insurance. Many lenders require that the total payments associated with the loan constitute no more than 75% of expected monthly income. The lender will also perform a historical analysis of the property’s cash flow.
Here is some of the standard documentation that banks often ask for when offering a non-recourse loan.
- Proof of Property Income – This could be a verified rent roll or copy of existing leases.
- Official Property Appraisal
- Purchase Contract – The name of the buyer would be the IRA LLC.
- IRA Asset Statement – This verifies that the IRA contains enough reserve funds to purchase the specific property and pay a certain allocation of monthly expenses. Requested reserves can be as high as 20% of the total loan amount.
Like most mortgages, obtaining a non-recourse loan will involve a lot of paperwork. It may not be difficult but it can be time consuming. (With that in mind, it’s important to start the process early. You may not be able to arrange for the loan if your timetable is too tight.)
Here are the basic steps that most banks ask for when applying for a non-recourse loan.
- Submit the requested documentation. This includes the bank’s application packet, a copy of your driver’s license, past IRA statements (which can be supplied by the Custodian,) property contract, and the investment authorization form to purchase real estate.
- Pay the appraisal fee.
- Order property insurance.
- Mail out any necessary disclosures.
- The bank will spend a few weeks to make sure that they are satisfied that the contract is titled correctly, properly executed by the Custodian, and possesses an appropriate appraisal.
- Loan documentation will then be sent to the title company or your real estate attorney. In turn, the title company will then send the documentation back to you for approval.
- Mail the documents to your Self-Directed Custodian to execute the sale.
- The documents come back to the title company and the loan is funded.
When a financial institution or private lender takes a risk on a non-recourse loan, they usually give the property an in-depth review to make sure that it is a worthwhile investment. Here are some of the factors they consider:
- Condition of the property – Ideally a lender would like to see a well maintained property which will require little rehab by a private investor. Sometimes, though, if the property has excellent potential based on price and location, the lender will give the go-ahead anyway.
- Location – The lender will be more willing to offer a non-recourse loan if they’re sold on the value of the investment. Location is obviously one of the key factors. Like most investors, the lender will be looking at the niche that the property will serve in the area and asking a few key questions. Is there population growth? What is the potential resale value? Is the area looking at local economic development?
- Property financials – Lenders look at past income history for the property, as well as current income. A property that has shown a consistent income pattern is more like to receive the loan.
- Property tenants – Non-recourse lenders will look favorably upon properties that have a strong tenant base. This includes the tenants having a track record of paying on time and showing interest in renewing their lease.