Can a Self-Directed IRA Loan Money?

A Self-Directed Individual Retirement Account (SDIRA) offers broader investment opportunities than traditional IRAs, allowing diversification beyond typical stocks and bonds. This flexibility leads to questions about SDIRAs and loans: whether an SDIRA can lend money, or if the SDIRA or its owner can borrow funds. Understanding the regulations is important for maintaining the SDIRA’s tax-advantaged status. This article clarifies scenarios involving SDIRA lending and borrowing.

Lending Money from an SDIRA

A Self-Directed IRA can function as a lender by investing in various debt instruments. This approach allows the SDIRA to earn interest income, which grows tax-deferred or tax-free within the account, contributing to retirement wealth. Common types of loans an SDIRA can make include private promissory notes, real estate mortgages, and other debt-based investments. When the SDIRA lends money, the account holder, not the individual, sets the loan terms, such as the amount, interest rate, repayment schedule, and whether the loan is secured or unsecured.

SDIRA lending involves adhering to strict Internal Revenue Service (IRS) rules regarding “prohibited transactions.” These are improper uses of an IRA account or its assets by the IRA owner, beneficiary, or any “disqualified person.” The IRS defines disqualified persons to include the IRA account holder, their spouse, ancestors (parents, grandparents), lineal descendants (children, grandchildren), and their spouses. Additionally, any entity where the IRA holder or other disqualified persons hold 50% or more ownership, as well as fiduciaries or service providers to the IRA, are considered disqualified.

Specific actions that constitute prohibited transactions when an SDIRA is lending money include making a loan directly or indirectly to a disqualified person, or engaging in any transaction that provides a direct or indirect personal benefit to a disqualified person. For example, an SDIRA cannot lend money for a down payment on a home for the account holder’s child, as this directly benefits a disqualified person. Similarly, personally guaranteeing a loan taken by the SDIRA for an investment is a prohibited transaction, as it provides a personal benefit to the account holder.

All lending transactions undertaken by an SDIRA must be at “arm’s length,” meaning they should be conducted as if between unrelated parties, and solely for the benefit of the IRA itself. The consequences of engaging in a prohibited transaction are severe. The IRA is considered to have lost its tax-advantaged status as of the first day of the year in which the transaction occurred. The entire fair market value of the IRA’s assets at that time is then treated as a taxable distribution to the IRA owner. If the IRA owner is under age 59½, this deemed distribution will also be subject to an additional 10% early withdrawal penalty, in addition to regular income tax. Beyond the IRA owner, a disqualified person who participates in a prohibited transaction may face an initial excise tax of 15% of the amount involved. If the transaction is not corrected promptly, an additional tax of 100% of the amount involved may apply.

SDIRA Borrowing Money

While less common, a Self-Directed IRA can, in certain circumstances, borrow money to leverage an investment, particularly for real estate acquisitions. This typically involves obtaining a non-recourse loan, which means the loan is secured by the acquired property itself, and the lender’s recourse in case of default is limited solely to that property. The IRA, not the individual account holder, is liable for the loan, ensuring the account holder’s personal assets are protected.

When an SDIRA utilizes borrowed funds for an investment, it triggers specific tax implications under the Internal Revenue Code, primarily related to Unrelated Debt-Financed Income (UDFI). UDFI is income generated from property acquired with borrowed funds within a tax-exempt entity like an IRA. A portion of this income is then subject to Unrelated Business Taxable Income (UBIT). UBIT is a tax imposed on income from a trade or business regularly carried on by a tax-exempt entity, or income derived from debt-financed property. This means that a percentage of the income generated by the debt-financed asset within the SDIRA becomes taxable, potentially reducing the overall tax advantages for that specific investment. The UBIT is paid by the IRA itself, not the individual account holder, and is calculated using trust tax rates.

Borrowing from Your Own SDIRA

A common question among SDIRA holders is whether they can take a personal loan directly from their own Self-Directed IRA. The IRS rules are clear and unequivocal on this matter: IRAs, including Self-Directed IRAs, are not permitted to lend money to the account holder or any disqualified persons. For IRAs, any attempt by an account holder to borrow funds from their own SDIRA is considered a prohibited transaction. The consequences of such a transaction are substantial. The entire amount of the “loan” is treated as a taxable distribution from the IRA. This means the funds are immediately included in the account holder’s gross income for that tax year. Furthermore, if the account holder is under age 59½ at the time of the prohibited transaction, an additional 10% early withdrawal penalty will apply, in addition to regular income tax. These rules are designed to prevent the personal use of retirement funds before retirement age, ensuring the funds are preserved for their intended purpose.