Nonrecourse Loans: How They Work With Self-Directed IRAs and Solo 401(k)s

Using financing to acquire real estate inside a retirement account, such as a Self-Directed IRA (SDIRA) or Solo 401(k), can be an extremely effective way to expand your investment potential. Leverage is one of the most powerful wealth-building tools available to investors. However, retirement accounts are governed by special IRS rules, and those rules make financing very different from how you would use leverage in a personal account.

In this article, we explain:

• What nonrecourse loans are
• How it differs from a recourse loan
• Why nonrecourse loans are required under IRS rules
• The tax impacts of using nonrecourse financing inside retirement accounts
• What UBIT and UDFI are
• How to calculate UBIT / UDFI with a real example
• The special Solo 401(k) exception under IRC §514(c)(14)
• How IRA Financial helps clients navigate these rules
• Why IRA Financial’s Compliance Shield™ matters for tax reporting and annual filings

What Is a Nonrecourse Loan?

A nonrecourse loans are a type of debt where the lender’s only remedy, if the borrower defaults, is the property securing the loan. The lender cannot pursue the borrower’s other personal assets to satisfy the debt.

In everyday consumer lending, such as a personal mortgage, most loans are recourse. That means the lender can go after your personal assets if you default. That is not allowed in a Self-Directed IRA or Solo 401(k).

Nonrecourse vs. Recourse: What’s the Difference?

Feature	Nonrecourse Loan	Recourse Loan
Lender can pursue other assets beyond collateral	No	Yes
Borrower personally guarantees the loan	No	Often
Risk to borrower’s personal net worth	Low	High
Permissible in SDIRA or Solo 401(k)	Yes	No

In a nonrecourse loan, the lender’s only security is the asset itself, for example, the real estate being purchased. This is critical for self-directed retirement accounts because, under IRS rules, retirement account assets cannot be exposed to personal guarantees or personal liability.

Why Must Self-Directed IRAs and Solo 401(k) Plans Use Nonrecourse Loans?

The reason SDIRAs and Solo 401(k) plans must use nonrecourse financing goes directly back to IRS prohibited transaction rules, specifically Internal Revenue Code §4975.

IRS §4975 and Prohibited Transactions

IRC §4975 prohibits transactions between a retirement plan and a “disqualified person” that would benefit the disqualified person personally. If a retirement account signs a personal guarantee on a loan, which is what happens with recourse debt, the account holder is effectively personally benefiting from the retirement assets. That is strictly prohibited.

A nonrecourse loan avoids this prohibited transaction because:

• The retirement account itself takes the loan on behalf of the investment
• The owner does not provide any personal guarantees
• The lender cannot pursue the owner personally

This structure keeps the transaction within IRS rules and preserves the tax-advantaged status of the retirement account.

How Nonrecourse Financing Works for Retirement Real Estate or Pass-Through Business Investments

When a Self-Directed IRA or Solo 401(k) uses a nonrecourse loan to acquire real estate or certain pass-through business interests, the loan proceeds allow the retirement account to leverage its capital.

Example:

An IRA with $100,000 wants to buy a $400,000 property.

• IRA contributes $100,000 as equity
• IRA takes a $300,000 nonrecourse loan
• IRA owns 100 percent of the property through the SDIRA/IRA LLC or Solo 401(k)

Unlike personal leverage, where interest and principal payments might be deductible by the investor, the real impact inside a retirement account lies in potential Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI). We discuss that next.

UBIT vs. UDFI: What They Are and Why They Matter

What Is UBIT (Unrelated Business Income Tax)?

UBIT applies to income generated by a tax-exempt entity, such as an IRA or Solo 401(k), from a business activity that is unrelated to its exempt purpose.

For retirement accounts, UBIT generally applies when the account owns an active business that generates sales or operating income.

What Is UDFI (Unrelated Debt-Financed Income)?

UDFI is a subset of UBIT that is triggered when a retirement account generates income from an asset that is financed with debt, such as rent from real estate acquired with a nonrecourse loan.

In practical terms:

• A property owned 100 percent for cash inside an IRA or Solo 401(k) typically does not generate UDFI
• A property acquired with a nonrecourse loan may generate UDFI on the portion of income attributable to the debt financing

Calculating UDFI

To determine UDFI, you prorate the income based on the percentage of the property attributable to the loan.

UDFI = Gross income × (Average outstanding loan balance / Average total property basis)

For example, assume:

• Gross rental income: $20,000
• Loan balance: $300,000
• Property basis or acquisition cost: $400,000

Then:

• Debt ratio = $300,000 / $400,000 = 0.75
• UDFI = $20,000 × 0.75 = $15,000

That $15,000 is considered UDFI and is subject to Unrelated Business Income Tax at trust tax rates. It is typically reported on IRS Form 990-T.

UDFI and 990-T: How Taxes Are Paid

When a Self-Directed IRA or Solo 401(k) generates UDFI:

• A Form 990-T must be filed by the retirement plan
• UDFI is taxed at trust tax rates, which climb quickly because of compressed brackets
• Failure to file Form 990-T when required can result in penalties and may jeopardize the plan’s compliance status

This is why understanding and properly tracking UDFI is critical when using nonrecourse financing for real estate or other debt-financed investments inside a retirement account.

Solo 401(k) Exception for Real Estate Mortgages: IRC §514(c)(14)

Here is the good news for Solo 401(k) owners. IRC §514(c)(14) provides a specific exception for certain types of mortgage debt on real estate held in an employer plan such as a Solo 401(k).

Under this exception:

• Income from real estate held by a 401(k) plan that is financed with a mortgage may not be treated as UDFI
• As long as the financing meets the statute’s requirements, the income may be exempt from UBIT or UDFI

This makes Solo 401(k) plans particularly advantageous for real estate investing when compared with Self-Directed IRAs, which do not benefit from this exception.

Why IRA Financial Is the Expert in Nonrecourse Financing and UBIT Compliance

Nonrecourse financing and the tax consequences that come with it are complex, highly technical, and unforgiving if you get them wrong. Proper structuring is critical from the moment you plan the investment, not just at tax filing time.

IRA Financial helps clients navigate every aspect of leveraged investing inside retirement accounts:

• Structuring nonrecourse loans that comply with IRS rules
• Ensuring proper acquisition through SDIRA LLCs or Solo 401(k) plans
• Tracking debt ratios for UDFI calculations
• Preparing annual IRS Form 990-T where required
• Identifying exceptions, including IRC §514(c)(14) for Solo 401(k)s
• Providing education and compliance monitoring year after year

The IRA Financial Compliance Shield™

Investing inside a retirement account is not just about selecting the right asset. It is about structuring and documenting the investment properly so you preserve your tax advantages and manage risk.

Our Compliance Shield™ is a suite of services designed to protect your retirement account from:

• Prohibited transaction violations under IRC §4975
• Incorrect loan structures, including recourse versus nonrecourse
• Improper entity setup
• COBRA and unrelated party missteps
• Missed annual reporting obligations
• UBIT or UDFI miscalculations

With IRA Financial, you are not simply opening a self-directed account. You are gaining a compliance partner for the lifetime of the investment.

Final Thoughts

Nonrecourse financing is a powerful tool for retirement-based real estate and debt-leveraged investing. However, it comes with rules and tax consequences that are very different from personal leverage. From the strict requirements of §4975 to the nuances of UDFI and the Solo 401(k) exception under §514(c)(14), the tax and compliance landscape is complex.

With deep domain expertise in retirement tax law, IRA Financial is uniquely positioned to help investors:

• Structure their financing correctly
• Navigate UBIT and UDFI rules
• Prepare accurate annual filings
• Avoid costly IRS pitfalls

Self-directing does not have to be confusing. It simply requires expert guidance and a trusted partner.