There is a lot of confusion over self-directed IRAs and what is and is not possible. In this article we will disprove some of the more common self-directed IRA myths.
Myth #1 – Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.
Truth: The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles”, which are defined to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the United States or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).
Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA. A “self-directed” IRA allows any investment not expressly prohibited by law. Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.
Myth #2 – Only Roth IRAs can be self-directed.
Truth: Because of the power of tax free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments. As a result, it is a surprisingly common misconception that a Roth IRA is the only account which can be self-directed. In fact, there are seven different types of accounts which can be self-directed. They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA). Not only can all of these accounts invest in non-traditional investments as indicated in Myth #1, but they can be combined together to purchase a single investment.
Myth #3 – I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.
Truth: Almost anyone can have a self-directed account of some type. Although there are income limits for contributing to a Roth IRA (in 2008 the income limits are $169,000 for a married couple filing jointly and $116,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either. With a Traditional IRA, you or your spouse having a retirement plan at work does affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA. There are no upper income limits for contributing to a Traditional IRA. Also, a Traditional IRA can receive funds from a prior employer’s 401(k) or other qualified plan. Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined. If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level. With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever! It’s the best of both worlds. All of this is in addition to any retirement plan you have at your job or for your self-employed business.
Myth #4 – I can’t have a self-directed 401(k) plan for my business because I am self-employed and file a Schedule C for my income.
Truth: You can have a self-directed SEP IRA, a SIMPLE IRA or a 401(k) plan even if you are self-employed and file your income on Schedule C of your personal tax return. With a SEP IRA, you can contribute up to 20% of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C) or 25% of your wages from an employer, up to a maximum of $46,000 for 2008. With the SIMPLE IRA, you can defer up to the first $10,500 of your net earnings from self-employment (calculated by multiplying your net Schedule C income by 0.9235% for SIMPLE IRA purposes), plus an additional $2,500 of your net earnings if you are age 50 by the end of the year, plus you can contribute an additional 3% of your net earnings as an employer contribution. Beginning in 2002 even self-employed persons are entitled to have their own 401(k) plan. Better yet, in 2006 the Roth 401(k) was added, allowing even high income earners to contribute after tax dollars into an account where qualified distributions are tax free forever! With an Individual 401(k) you can defer up to $15,500 (for 2007 and 2008) of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C), plus an additional $5,000 of your net earnings if you reach age 50 by the end of the year, plus you can contribute as much as an additional $30,500 based on up to 20% of your net earnings for 2008 (or 25% of your wages from an employer). This means that a 50 plus year old self-employed person can contribute up to $51,000 for 2008!
Myth #5 – Because I have a small IRA and can only contribute $5,000, it’s not worth having a self-directed IRA.
Truth: Even small balance accounts can participate in non-traditional investing. Small balance accounts can be co-invested with larger accounts owned by you or even other people. For example, one recent hard money loan we funded had 10 different accounts participating. The smallest account to participate was for only $1,827.00! There are at least 4 ways you can participate in real estate investment even with a small IRA. First, you can wholesale property. You simply put the contract in the name of your IRA instead of your name. The earnest money comes from the IRA. When you assign the contract, the assignment fee goes back into your IRA. If using a Roth IRA, this profit is tax-free forever! Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee. Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller. Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however. Finally, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.
Myth # 6 – If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.
Truth: A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC. Effectively you have “checkbook control” of your IRA funds. Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments. This is simply not true. Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Quest IRA, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary. Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties. This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes. Nonetheless, you must educate yourself completely as to the rules before deciding on this route. Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!
Myth #7 – I can borrow money from my IRA to purchase a vacation home for myself.
Truth: Although the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited. If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.
Essentially, the prohibited transaction rules were made to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person. Investment transactions are supposed to be on an arms length basis.
As a result of these legal restrictions, a loan from your IRA or staying at a vacation home owned by your IRA, even if fair market rates are paid for interest or rent, would be prohibited.
Myth #8 – With a self-directed IRA, I can borrow my IRA funds to purchase real estate and then put all the profits back into the IRA.
Truth: When real estate or any other asset is purchased within a self-directed IRA, the money never leaves the IRA at all. Instead, the IRA exchanges cash for the asset, in the same way that an IRA at a brokerage house exchanges cash for shares of stock or a mutual fund. Therefore, the asset must be held in the name of the IRA. For example, if Max N. Vestor were to purchase an investment house in his self-directed IRA, the title would be held as “Quest IRA, Inc. FBO Max N. Vestor IRA #12345-11.” Since the IRA owns the asset, all expenses associated with the asset must be paid by the IRA and all profit resulting from that investment belongs to the IRA, including rents received and gains from the sale of the asset.
Myth #9 – If my IRA buys real estate, it must pay all cash for the property. An IRA cannot buy real estate with debt.
Truth: An IRA can own debt-financed property, either directly or indirectly through a non-taxed entity such as an LLC or partnership. Any debt must be non-recourse to the IRA and to any disqualified person. An IRA may have to pay Unrelated Debt Financed Income Tax (UDFIT) on its profits from debt-financed property. In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt. For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable. Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth. The same leverage principle applies inside or outside of your IRA – you can do more with debt-financing than you can without it. One client was able to build her Roth IRA from $3,000 to over $33,000 in less than 4 months even after paying the taxes due by taking over a property subject to a debt and selling the property to another investor!
Myth #10 – An IRA cannot own a business.
Truth: A self-directed IRA is an amazingly flexible wealth building tool and can own almost anything, including a business. However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid. Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up. Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business. A solution to this problem may be to have the business owned by a C corporation or another taxable entity.
1) Not understanding the “self-directed” part of self-directed IRAs.
Unlike more traditional brokerage style IRAs, self-directed IRAs do not come with any tax, legal or investment advice, nor do self-directed custodians and third party administrators offer or endorse investment products. Self-directed means just that – it is self-directed and you must find your own investments and decide how you want to structure those investments. If you make a million dollars in your self-directed IRA all the glory belongs to you, but if you lose everything you have there is no one to blame but yourself.
2) Not investing in what they know best, but rather investing in something they know nothing whatsoever about.
One of the primary benefits of a self-directed IRA is that it allows you to invest in what you know best, especially if that is not the more traditional IRA investments like stocks, bonds, mutual funds or annuities. Some people get very excited about the idea of self-direction and invest in something they know nothing about, which often leads to an investment disaster. Most of my mistakes in investing have been because I have strayed from what I know how to do best.
3) Not understanding the disqualified persons and prohibited transaction rules.
Disqualified persons are those persons who are deemed to be too close to make a transaction within your IRA an arms-length transaction, which means these persons cannot enter into transactions with your IRA nor can they benefit from those transactions, either directly or indirectly. Prohibited transactions are what your IRA cannot do with any disqualified person. The penalty for entering into a prohibited transaction is DEATH (of the IRA that is) along with taxes and penalties. If you have a self-directed IRA you must have a good basic understanding of these rules as they apply to your investing strategy.
4) Not vesting assets correctly – all assets in self-directed IRAs should be vested as follows: “Quest IRA, Inc. FBO Your Name IRA #Your IRA Number.”
A lot of time is spent in attempting to get clients, title companies, and investment providers to understand that all assets must be vested in a specific way in order to be held within a self-directed IRA. Common errors include failing to vest in the name of the custodian or administrator at all, or only putting the client name after the “FBO” so that it appears we are holding the asset on behalf of the individual instead of the individual’s IRA. Another common mistake is where the client attempts to use their own Social Security Number instead of that of the IRA or the administrator or custodian’s trust tax identification number.
5) Failing to submit proper paperwork to allow smooth opening of IRAs and processing of transactions.
Another large time waster is chasing down paperwork from improperly completed documents for opening the IRAs, for transferring money into the IRAs and for transactions. This leads to a frustrated client and frustrated staff. Taking the time to learn how to properly submit paperwork and allowing yourself enough time to do so is critical in successfully navigating the self-directed IRA world. Remember, it is better to ask questions in advance than to submit incorrect paperwork and cause a delay.
6) Not understanding what they are investing in.
This is a big one. It is almost incomprehensible to me how some people don’t have any understanding of what they are investing in at all. For example, a person called the other day and thought she had a note and an option agreement. Instead, she had a simple option where she had paid $28,000 for an option to buy 50% of the property for $10. This was meant to help the owner out of foreclosure. The homeowner had the right to buy back the option at a profit to the IRA of about $5,000. The good news is that it worked for a time period and the homeowner got to stay in the house for an extra two years. The bad news is that the homeowner still wasn’t fiscally responsible and the IRA lost every dime when the lien holder foreclosed. Since all the IRA had was an option (not a note as she thought) she could not even sue to recover some of her money, and even if she had exercised her option her IRA would have only owned half of the house.
7) Not understanding Unrelated Business Income Tax and how it may affect your IRA.
IRAs may be taxed in three circumstances. First, if it runs a business, either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC. Second, if the IRA owns and rents out personal property (rents from real property are exempt from this tax). Third, if the IRA owns debt-financed property, again either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC. Just to be clear, it is not necessarily all bad to make investments which cause your IRA to pay tax, especially within a Roth IRA or other tax free account, but it is something you should understand up front.
8) Trusting someone with your hard earned IRA money without doing proper due diligence and proper paperwork.
Let me give you a hint – con men are very good at what they do. Make sure you understand what you are investing in, and do your due diligence on the investment and on the person you are investing with before making an investment decision. Also, make sure you have proper paperwork. I wouldn’t loan money to my own mother without proper documentation! Proper paperwork protects both your IRA and the person your IRA is investing with. Think about what would happen if either you died or the person you invested with died. Would either party’s heirs understand what the investment was all about? Even if you trusted the person you invested with absolutely, would their heirs know about your handshake deal and honor it? Probably not! An excellent rule of thumb in investing is that if it sounds too good to be true it probably is. Also, a common thread in scams is that it must be done NOW or you will miss out on this incredible opportunity! This is an attempt to draw you in without allowing you time to think about or due diligence on the investment.
9) Failing to follow proper strategy when loaning your IRA to other investors.
There are at least 10 simple rules to follow when lending your IRA money out (or even your personal money). They are:
a) Do not loan on something you wouldn’t be excited to own if the borrower defaults.
b) Generally, do not advance money for repairs until the repairs are done, and then inspect the repairs before advancing the funds.
c) Do not loan to someone you would feel uncomfortable foreclosing on!
d) If the loan goes into default, do not delay – take action immediately!
e) Collect interest monthly so you will know if the borrower is getting into trouble.
f) If you are unsure about a loan, hire a professional to help you evaluate the deal (at the borrower’s cost, of course!).
g) Get title insurance on your loan. If done at closing the incremental cost to the borrower is very small.
h) Verify that hazard and, if necessary, flood and wind insurance are in place naming your IRA as an additional insured.
i) Insist on evidence that taxes, homeowners association dues and hazard insurance are paid when they come due during the term of the loan.
j) Get a personal guarantee when lending to a non-individual borrower or a weak borrower.
10) Attempting to figure out how to get around the rules to get a benefit for themselves or other disqualified persons rather than simply investing within the rules.
It seems to be very tempting for people to want to use their own IRAs to make money or obtain some other benefit for themselves or other disqualified persons right now instead of letting all the benefits go to the IRA so that they have a nice retirement. To make matters worse, a lot of gurus are teaching how to hide the fact that you are violating the rules instead of teaching people how to use the rules properly to their advantage. My personal motto is, use the law to your advantage but don’t abuse the law. After all, the “R” in IRA stands for Retirement. It is not an INA (or Individual NOW Account)! To make money now, use OPI (Other People’s IRAs), and to make money for your retirement, use your own self-directed IRA.
Investing in real estate notes with your IRA is one of the most popular self-directed IRA investments available. But with this popularity comes common mistakes when people lend their IRA (and non-IRA) money out, secured by liens on real estate. Follow these 10 tips to avoid potentially costly mistakes when choosing real estate as an IRA self-directed investment.
1) You may end up owning this piece of real estate if your borrower defaults. Never loan on something you wouldn’t want your IRA to own. The risk of loaning your IRA investments toward real estate notes is matched by the reward: I routinely see yields from these loans at 12% and higher; however, borrowers can default and you may be left with the property in foreclosure. If you would be upset by the potential of taking over this property in foreclosure, you probably should not make the loan.
2) Do not advance IRA money for home repairs until the repairs are finished; then have the repairs inspected before advancing the money. This is one of the biggest mistakes that I see clients make with their IRAs. They fund the full loan amount expecting that the repairs will be done on the property, but the borrower will actually need a little more money on another. If the loan goes bad, the IRA could end up with a property that hasn’t had the necessary repairs.
3) Do not loan money to someone you would feel uncomfortable foreclosing on. William Shakespeare wrote in Hamlet, “Neither a borrower nor a lender be/ For loan oft loses both itself and friend/ And borrowing dulls the edge of husbandry.” For the most part, I cannot agree with this advice, because lending and borrowing money drives our economy and increases economic activity. However, the part about a loan losing a friend is absolutely correct, in my opinion. If foreclosing on your borrower would cause you heartache, it is better not to make the loan. I have seen friendships destroyed over a loan gone bad.
4) If the loan goes into default, take action immediately. No one wants to admit that he or she has made a mistake in self-directed investing, but delaying action can be costly. You can always stop the foreclosure process once it has begun, but you cannot complete the process unless you start it.
5) Collect interest monthly so you will know if the borrower is getting into trouble. Many borrowers, especially investors, would prefer to pay interest at the end of the loan. But this exposes the lender to additional risk. The purpose of collecting payments monthly is both to:
- Make sure the borrower remembers that he or she has to do something with that property in order to avoid the pain of the payment
- Let you know if the borrower is in trouble because he or she starts missing payments
Keep in mind that unless you have contracted for monthly payments, you may not be able to foreclose, even if you do discover that the borrower is in financial trouble, because the loan may not be in default. This has actually happened to some of my clients.
6) If you are unsure about how to evaluate the loan, hire a professional to help you. Although a hallmark of the self-directed IRA is that it is “self-directed” — meaning that you make your own decisions and find your own investments — most IRA owners either do not possess sufficient knowledge or, in my case, sufficient time, to properly evaluate a loan transaction. My solution is to hire a professional to help me with the deals. He checks out the borrower, coordinates with the title company, orders the appraisal and usually a survey, makes sure insurance is in place and generally evaluates the loan. Naturally, he charges a fee for this service, which is passed through to the borrower on top of any interest and fees that my retirement plan may charge. This increases the cost of the loan; but in this case, the non-Biblical version of the golden rule applies, which is “He who has the gold makes the rules.”
7) Get title insurance for the loan. The purpose of title insurance is to shift risk away from you and to the title company. In Texas, where my office is, the incremental cost of title insurance is very small when issued in conjunction with an owner’s title policy. Regardless of the cost, making sure that your IRA is protected from title flaws is important.
8) Verify that hazard and, if necessary, flood insurance is in place, naming your IRA as an additional insured. It is very easy to miss this issue when you are trying to get everything completed right before a closing. Borrowers may get insurance at the last moment and simply forget to add your IRA as an insured. But if something goes wrong, you will want to make sure your IRA is named on the check.
9) Insist that the borrower provides you with evidence of payment when property taxes and homeowners association fees become due. The same thing would apply to hazard and flood insurance premiums, although normally you would receive notice of cancellation for non-payment of those bills. Depending on where you live, property tax bills can increase quickly due to penalties and court costs, which reduces your equity position in the property.
10) Get a personal guarantee if lending to an entity or to an individual with some weakness. When things are going well, you might be tempted not to insist on a personal guarantee, and indeed many borrowers will resist this. However, as we all have discovered recently, circumstances do change, and a personal guarantee may be helpful in collecting the debt. I collected on a note once where the property had decreased substantially in value due to vandalism and market conditions. Instead of foreclosing, I had my lawyer send a letter explaining to the guarantor, who had a significant amount of assets, that he was personally liable on the debt and that if he were unable to satisfy the note, I would pursue legal action against him and the borrower. A week later, a cashier’s check showed up that satisfied the lien.
There’s more to know when considering real estate for your self-directed IRA
This list of suggestions is not meant to be exhaustive. Other issues you will need to understand include:
- Your lien position (personally, I only invest in first-lien loans)
- Any state usury laws that might apply to the loan
- At least a general idea of what the foreclosure process is in your state, in case the loan goes into default
Always get good legal counsel to assist you with loan documentation. Because the borrower traditionally pays for all expenses including legal fees, there is no reason not to have an attorney draw up loan documents.
Lending can be an excellent investment in an IRA. It is relatively easy to do and, if done correctly, has a comparatively low risk. Getting to know successful real estate entrepreneurs who borrow your IRA money may also lead to other, intangible benefits as well. Finally, be sure to learn the pointers for buying real estate with your self-directed IRA before you take any actions.
H. Quincy Long is a certified IRA services professional (CISP) and an attorney and is the president of Quest IRA, Inc., with offices in Houston and Dallas, Texas, as well as, Mason, Michigan. Email him at[email protected].
Nothing in this article is intended as tax, legal or investment advice.
Personally, I think Shakespeare had it wrong when he penned this advice in Hamlet: “Neither a borrower nor a lender be; For loan often loses both itself and friend, And borrowing dulls the edge of husbandry.” Perhaps he may be forgiven for his error, however, since Shakespeare suffered from a lack of the tremendous benefits of a truly self-directed IRA.
Money in self-directed IRAs can be loaned out to any person who is not a “disqualified person.” While this means that you cannot loan yourself or other related disqualified persons money from your self-directed IRA, you can loan the money to anyone else. Loans can be secured by real estate, mobile homes, equipment or anything you like. If you are really a trusting soul, you can even make a loan from your IRA unsecured (although in that case I personally would tend to support Shakespeare’s advice).
First, let’s look at it from the borrower’s perspective. At our office we offer a seminar entitled “Make Money Now With Self-Directed IRAs.” One of the ways you can make money for yourself right now with your knowledge of self-directed IRAs is by creating your own “private bank.” To do this, simply share the news that an IRA can be a private lender, refer people with IRA money to Quest to open a self-directed IRA, and then borrow their IRA money for your own financing needs.
With private financing the loan terms can be whatever the borrower and the lender agree to within the legal limits. If you know a person who is getting 5% in a “safe” IRA at a bank, and you can offer them 9% secured by a first lien on real estate with only a 70% loan to value, would they be happy with that? Even with a higher interest rate, private financing can work for you. IRA loans can be done quickly and without a lot of fees or fuss, which may mean you can get a deal which might be lost if you had to wait on the bank. This is especially true in distressed sale situations, such as a pre-foreclosure purchase.
From a lending perspective, your IRA can grow at a nice rate while someone else does all the work. In a typical hard money loan, the borrower even pays all of Quest’s modest fees as well as any legal fees for preparation of the loan documents. True, you won’t hit a home run with lending, unless you are fortunate enough to foreclose on the collateral. But the returns can be quite solid. For example, by making very conservative hard money loans my Mom’s IRA has grown by about 10.5% in one year. This is much better than the amount she was earning in her money market fund before she moved her IRA to an Quest self-directed IRA.
Even small IRAs can combine with other self-directed accounts to make a hard money loan. My brother recently combined his Roth IRA, his traditional IRA, his wife’s Roth IRA, his son’s Roth IRA, his Health Savings Account (HSA), and 5 other IRAs to make a hard money loan. The smallest IRA participating in this loan was for $1,827.00! Each IRA made 2% up front and 12% interest on an 18 month loan, secured by a first lien on real estate with no more than 70% loan to value.
One thing to avoid in hard money lending is usury. Usury is defined as contracting for or receiving interest above the legal limit. The usury limit varies from state to state, with a few lucky states having no usury limit at all on commercial loans. Some people have the theory of “What’s a little usury among friends?” However, if the investment goes bad and your IRA has made a usurious loan, the consequences of the borrower making a claim of usury could include the loss of all the principal of the loan plus damages equal to 3 times the interest. Some states even have criminal usury statutes. It is best to consult with a competent attorney prior to making a hard money loan to make sure your IRA does not violate any usury laws.
To see how well hard money lending can work, let me give you an actual example. One of our clients made a hard money loan from his IRA to an investor who purchased a property needing rehab. The terms of the loan were 15% interest with no points or other fees except for the attorney who drew up the loan documents. The loan included not only the purchase price but also the estimated rehab costs. The minimum interest due on the loan was 3 months, or 3.75%. The investor began the rehab by having the slab repaired, and before he could take the next step in the rehab process, a person offered him a fair price for the property as is. The investor accepted the offer, and they closed about 6 weeks after the loan was initiated.
From the investor’s perspective, was this a good deal? Yes, it certainly was! True, he was paying a relatively high interest rate for the time he borrowed the money. However, he was able to purchase a property with substantial equity which a bank most likely would not have loaned him money to buy due to the condition of the property. Also, while the interest rate was high, the cost of financing was actually comparatively low. With a normal bank or mortgage company there are fees and expenses incurred in obtaining the loan. Common fees include origination fees, discount points, processing fees, underwriting fees, appraisal fees and various other expenses relating to the loan. On the surface an interest rate may be 8%, but the cost of the financing is actually higher than 8% since a borrower has to pay the lender’s fees in addition to the interest on the loan. Spread out over a lengthy loan term these additional fees do not add much to the cost of the financing. However, if an investor has to pay all of these fees up front and then pays the loan off in only 6 weeks, the cost of the financing goes way up.
In this case the investor’s total loan costs were limited to 3 months minimum interest at 3.75% plus $300 in attorney’s fees for preparing the loan documents. Best of all, the investor walked away from closing with $20,000 profit and no money out of his pocket! Far from “dulling the edge of husbandry” this loan actually made the “husbandry” (ie. the purchase and resale of the property) possible. Incidentally, the purchaser of the property was absolutely thrilled to get the property at less than full market value so that they could fix it up the way that they wanted it.
What about the lender in this case? The lender was also quite happy with this loan. His IRA received 3 months of interest at 15% while only having his money loaned out for 6 weeks. For the 6 week period of the investment, his IRA grew at a rate of approximately 30% per annum! Although his yield was above the legal limit for interest inTexason loans secured by real estate, prepayment penalties are generally not included in the calculation of usury here, so there was no problem. The investor was happy, the new homeowner was happy, and the lender was happy. Anytime you can create an investment opportunity with a win-win-win scenario, you should.
When I lecture about hard money lending, I ask the audience what they think is the worst thing that happens if you are a hard money lender. Invariably, most people in the audience answer that you have to foreclose on the property. Nonsense! If you are doing hard money lending correctly, the worst thing that can happen is that the borrower pays you back! Unfortunately, this is a common risk of hard money lending. Most hard money loans are made at 70% or less of the fair market value of the property. If you are fortunate enough to foreclose on a hard money loan, your IRA will have acquired a property with substantial equity while the investor did all the work of finding and rehabbing the property!
While it is true that foreclosing on a property owned by a friend may cause an end to that friendship, a properly secured hard money loan will at least not “lose itself” as Shakespeare asserts. In fact, it may lead to substantial profit for your IRA! To avoid losing a friend, simply don’t loan money from your IRA to someone you would feel bad foreclosing on. In order to be a successful hard money lender, you do have to be prepared to foreclose on the property if necessary.
In modern times I believe the proper advice, at least in the right circumstances, is “Either a lender or a borrower be!” You can make more money for yourself right now by borrowing OPI (Other People’s IRAs). Borrowing from someone else’s IRA can even lower the total cost of your financing compared to a conventional loan from a bank or mortgage company, especially on short term financing. From a lending perspective, your IRA can make great returns by being a hard money lender, either through higher than average interest rates or, better yet, through foreclosing on property with equity. You may find that hard money lending from your self-directed IRA is a great way to boost your retirement savings without a lot of time and energy invested on your part.
Jill Chodorov, an associate broker with Long & Foster, writes an occasional column about local market trends and housing issues.
The nauseating drop in the value of my retirement accounts in the last month got me thinking. Why can’t I invest my retirement funds in what I know and understand?
I know real estate. I have been investing in real estate and servicing clients as a licensed real estate agent for two decades.
I don’t know the stock market.
Every year at tax time, I dutifully deposit the allowable contribution into my Individual Retirement Account (IRA) to lower my income tax liability. And every year I repeat the annual glassy-eyed review of the cryptic stats and financials of the funds in which I invest.
So I launched a quest to devise a new investing strategy for myself, and I learned that there is a little-known investment vehicle that would allow me to invest my retirement funds in what I know best — it is called a self-directed IRA (SDIRA).
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A SDIRA allows alternative investments using your retirement savings. Real estate is an example of an alternative investment.
Just as Fidelity or TIAA-CREF are custodians of IRAs for investing in traditional products, such as funds, stock and bonds, there are a handful of custodians of SDIRAs.
“This is not a get-rich-quick scheme,” said John Paul Ruiz, director of professional development of the Entrust Group. “It is a legal alternative for investing your retirement funds.”
The Entrust Group is a custodian of SDIRAs.
“Self-directed IRAs are not for everyone,” Ruiz said. “It is best for those who know real estate or have a real estate expert to guide them.”
I pass that test. I live, eat and breathe real estate everyday.
According to Ruiz, you also need an attorney, CPA or financial planner who is fully educated and experienced in the IRS rules for SDIRAs, including record keeping, qualified transactions and distributions — to name a few.
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“I would not have a practice if people didn’t mess this up,” said Thomas Kolb, an employee benefits attorney in Washington.
“People want to invest in all sorts of things but they can’t get their hands on money to do the deal,” Kolb said. “Using retirement funds is perfectly legal, if done the right way.”
Kolb said the biggest takeaway he can offer is “handle with care.”
SDIRAs come with many rules. It must be held at a custodian. The legal title of the real estate must be in the name of the SDIRA. All expenses on the property need to be paid from the SDIRA, and all income from rent or sale of the property must stay in the SDIRA.
In addition, there are many prohibited transactions. For example, the property cannot be for your own use or that of a family member. And you can’t buy the property from yourself with your SDIRA.
There are other drawbacks to SDIRAs.
The North American Securities Administrators Association (NASAA) released an “informed investor advisory” about the risks and rewards of SDIRAs on its website.
“Occasionally, an investor is approached by a promoter offering an investment opportunity,” the advisory says. “Fraud promoters can deceive investors into believing that their investments are legitimate. “
A third-party custodian does not research or perform due diligence reviews for clients, the advisory warns.
“It’s my impression that the IRS has very few agents that focus on IRA enforcement,” said Kolb.
On the upside, NASAA notes that “a self-directed IRA means you, the customer, have complete decision-making power on your investments. Unlike a stock, bond or mutual fund, where others either manage or control the investment, you are in total control of calling the shots.”
That is a compelling reason to use SDIRAs, in my opinion. If you have seen the movie “The Big Short,” you may have realized how little any of us know about the Wall Street game, except for Wall Street.
“The ideal investor is someone that has knowledge in a certain area and can utilize that knowledge to grow their IRA account,” said Mick Hersh, COO of STC, Inc. in Hagerstown, Md., an administrator of SDIRAs.
“You can invest in what you know and still get the tax advantages of a traditional IRA,” Hersh said.
All SDIRA custodians charge fees, just like the custodians of traditional IRAs. “Some custodians charge by transaction, and some charge an annual fee based upon the value of assets in the SDIRA,” Hersh said.
If the property is rented, a transaction would include each time you deposit rent or pay an expense on the property.
“In this case, it may be best to pay an annual fee,” Hersh said.
Do many people know about SDIRAs? Or am I stepping out on the cutting edge?
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“Very few people know this is an option,” said Peggy Cramer, vice president of communications for Pensco Trust Company, another custodian of SDIRAs. “Only 2 percent of the $7.3 trillion invested in IRAs are in SDIRAs.”
SDIRAs are becoming more popular, however.
“Self-directed IRAs are growing by 21 percent year-over-year and investing in real estate is most common,” Cramer said.
Some other allowable investments in a SDIRA include mortgage notes, tax liens, precious metals and private placement loans.
“I saw an article about it 10 years ago in Realtor Magazine,” said Vincent Hurteau, principal broker of Continental Properties in Washington, when asked how he first learned about SDIRAs. “Enron was infamous at the time.”
Hurteau was concerned about his retirement funds, so he rolled over most of his traditional IRA funds into a SDIRA with which he has purchased real estate.
“A lot of people are scared about it,” Hurteau said about SDIRAs. “But I love it.”
Here are some websites to learn more about SDIRAs:
The maximum limits you can contribute to your IRA account in 2013 are as follow:
2013 IRA Contribution Limits
Roth IRA: $5,500/($6,500 if over 50 years of age)
Traditional IRA: $5,500/($6,500 if over 50 years of age)
SEP IRA: $51,000
SIMPLE IRA: $12,000
Coverdell ESA: $2000