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How my real estate note deal will earn $30,000 tax free

BLOG Dustin White 11-27-13

I recently received a call from a man who inherited a Real Estate Contract on an undeveloped piece of land.  The man had no desire to collect monthly payments until the contract paid off and asked if I wanted to purchase his interest in the contract.  The Real Estate Contract had a face value of a little over $41,000.00 and the buyer was paying 6% interest.

I did some research on the property and came up with an amount that I was willing to pay for the contract.  My father who taught me pretty much everything I know about investing has always told me two things: “It never hurts to ask” and “Always offer low and expect a counteroffer”.  I called the man and offered him $22,000.00 cash for the contract and to my surprise he accepted without even making a counteroffer.

I was thrilled that he accepted my offer, but there was one problem.  I had no cash in my Roth IRA.  Luckily, I know other people who are always looking for investment opportunities.   I asked an investor friend of mine to loan me the full $22,000 at 7% interest on a promissory note, which would be secured by the Real Estate Contract.  The investor was a friend of mine that was not related to me, so he was not a disqualified party to my IRA.  Also, remember that you are allowed to have loans in your IRA as long as they are non-recourse loans.

The Real Estate Contract has a current balance $41,000 at 6% interest with a monthly payment of $420.00.  This contract will pay off in 134 payments (a little over 11 years).  The promissory note with my investor friend has a face value of $22,000 at 7% interest with a monthly payment of $400.00 and will pay off in 66 payments (5 ½ years).  The $420 a month I receive from the Real Estate Contract is enough to pay the payment on the Promissory Note, so that’s not something I’ll have to worry about unless the buyer stops paying. 

I won’t receive any money for 5 ½ years and the contract will not be completely paid off for 11 years, but keep in mind that I can’t take IRA distributions until I’m 59 ½ years old anyway and on top of that I have ZERO money invested in this deal.  Since I used borrowed money from a non-recourse loan to buy the investment I will have to pay UBIT (unrelated business income tax) on the profit generated from the investment.  Since you do not pay any tax on distributions from a Roth IRA, the IRS requires that you pay UBIT to keep investors from getting away with paying no tax at all.             

In summary, the buyer of the contract will end up paying my Roth IRA $56,280.00 over the next 11 years in principal and interest.  Out of that I will have to pay my investor friend $26,400.00 in principal and interest over the next 5 ½ years for the money he loaned me on the promissory note.  This leaves $29,880.00 that will go into my Roth IRA.

Author Dustin White is vice president of marketing and business development at Sunwest Trust.


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