Investing in real estate with self-directed IRAs

James A. Jones for InvestorBeat writes: Real estate investors are finally enjoying the rebound in the markets, but financing remains tight. Investors often overlook a little known source for funds, namely, their own retirement accounts.

A Self-Directed IRA, or SDIRA, is an IRA that allows its holder to invest in alternative assets other than stocks, bonds and mutual funds such as real estate.

They have been around for over 30 years, yet still make up only 1% of the $6 trillion retirement market. However, in recent years SDIRAs have exploded at 25%+ growth annually. A little known IRS code, 4975, serves as the basis and the “bible” for guiding IRA providers and IRA holders.

For most SDIRA investors, real estate is the most popular investment.

Many investors own their own home and know the value of long-term appreciation.

Types of real estate investments in SDIRA’s can include:

• Residential or commercial real estate
• Unimproved land
• Rental houses
• Multiple-occupant dwellings
• Office buildings
• Foreclosed properties
• Deeds and mortgages
• Renovations

Lending money from an IRA with secured mortgages is popular as is promissory notes. As with any investment, one must have experience with assessing lender risk, the ability to secure the loan to an asset, and knowing the rate that the market will bear for that type of loan.

Rates can vary, and tend to be much higher than traditional lending sources such as banks and mortgage companies. It is not unusual to see rates in the 12-18% range when lending money from an IRA.

There are 3 simple steps to getting started when looking to invest using your IRA:

• Open up a self-directed IRA account.
• Fund the self-directed IRA account by transferring funds from your other IRA.
• Direct the Custodian to make the investment.

After you open a SDIRA account and transfer funds, you can then make an offer in the name of the IRA, i.e. ABC Custodian FBO Jim Jones IRA #12345. The next step is to complete a purchase and sale agreement, and a Buy Direction Letter with the Custodian closing on the property. Your IRA now effectively holds the real estate.

It is important to note that Self-Directed IRA providers can only provide education on IRS and IRA rules and regulations and do not and should not give advice in this area. While we have explored an alternative to Wall Street, as with any investment decision, individuals are reminded of the need to do their research and practice due diligence. You should always follow and obtain the advice of qualified advisers, attorneys and accountants.

Now that you have been introduced to self-directed IRAs, or SDIRA, and what they can do for real estate investors, it’s time to learn what an investor cannot do with their SDIRA.

You may have heard of a “Checkbook IRA,” which is a marketing term for investing your IRA into a newly created LLC that is owned by the IRA with a checking account created for the LLC. This is not an actual type of IRA product.

LLCs can be used for various reasons, and not all are related to real estate. When deciding to use an LLC, you should consider the following:

• Are you going to have multiple investors’ other than yourself investing into an entity?
• Are you going to have multiple tenants (real estate) or multiple limited partners (hedge fund)?
• Are you going to buy multiple assets (several properties, several hedge funds, or several promissory notes)?
• Are you going to have to write and receive multiple monthly checks?
• Do you want to avoid transaction fees and annual custodial fees for each asset you own?

Choosing an LLC is solely dependent on the goals and needs of the IRA holder. Typically, if the IRA holder is going to make one purchase to hold long term with minimal need for checks to be sent from the IRA for expenses, repairs etc., there is no need for the LLC. With the LLC, the IRA holder has the ease of writing checks on behalf of the LLC.

They can benefit anyone who is self-employed and can be a real estate investor’s best retirement plan.

It is important to clarify that the IRA is the “Member” of the LLC, and while the IRA holder can be the “Manager” of the LLC, they cannot pay themselves a salary to do so.

This leads to the discussion on prohibited transactions. Prohibited transactions mainly revolve around the people involved in the transactions. Those who are not allowed to have any interaction with the IRA are known as prohibited people. Prohibited people include the IRA owner, their spouse, and the owner’s lineal such as child, grandchild, great-grandchild etc and lineal relatives.

One type of prohibited transaction is the sale, lease or exchange of property between an IRA and a prohibited person. Lending money from an IRA to a prohibited person is also not allowed. IRA holders cannot furnish goods or services between an IRA and a prohibited person. Transferring income or assets or use of them by an IRA to a prohibited person is the final prohibited transaction.

Examples of prohibited transactions are:

• An IRA holder buys his wife’s first starter condominium.
• An IRA holder buys a condo for her son to use while at college.
• An IRA holder buys commercial property and then leases it to himself for his office.
• An IRA holder lends money from her IRA to her father for medical expenses.

SDIRAs are in fact, incredibly versatile giving investors a multitude of financial options.

It is important to know that your IRA can do business with the above disqualified persons if you come together at the same time on a new asset with no prior interest or ownership of any of the involved parties. The initial capital contributions will forever create an established ownership percentage among all parties.

An example is as follows:
A married couple finds a rental property for $100,000, and each has an IRA worth $50,000 each. They would come together at the same time, put down an initial deposit, let’s say $2,500 each, title the deed as each 50% owners, then both close with $47,500 each. The numbers could be 60/40, 80/20, but again the initial capital contribution dictates the percent of ownership and ultimately profit realization.

While self-directed IRAs seem to have a lot of rules and restrictions, they are in fact, incredibly versatile giving investors a multitude of financial options. They can benefit anyone who is self-employed and can be a real estate investor’s best retirement plan. As long as you understand what an SDIRA is capable of, you can use it to its full potential to ensure you always have money somewhere to invest with.