Your Self-Directed Retirement Account
Albert Einstein is quoted as saying “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
At Think Realty, we celebrate real estate investment as an asset class that embodies appreciation or compounding value as a property that is almost alone with substantial income when this investment is rental houses or thoughtful buy and renovate, (aka find, fix and flip).
Even after saying this, Internal Revenue Service regulations have created a tax-deferred method of allowing an investor to compound this interest even more effectively, and that is by using a Self-Directed Individual Retirement Account.
What is an SDIRA?
Self-directed individual retirement accounts (SDIRA) are powerful tools for creating wealth. Few investors (and even many income real estate owners) realize they can use this strategy to invest in what they know: real estate. Fewer still know that, depending on the type of SDIRA they use, they can write checks giving them to access their retirement funds immediately to act on deals and they can even take out loans on behalf of their SDIRA.
But, as a wealth-building vehicle, SDIRAs require more time and commitment than conventional retirement accounts because it is defined as “self direct.” This means that the investor should have 100% control of where his or her money is invested.
You have to educate yourself on what you can and cannot invest in, what works and what are prohibitive actions that could result in disqualification of your transactions and loss of tax-deferred status, not to mention you have to do due diligence before making real estate purchases.
Once you have invested in a property, you need to manage its renovation, find tenants (or hire a property management company) and, at some point, oversee its sale, all at arm’s length so you do not jeopardize your tax-deferred status.
Is an SDIRA right for you?
Invest in What You Know
A basic SDIRA is very similar to a conventional individual retirement account (IRA) — both share the same contribution and distribution rules — except, with an IRA, the custodian limits your investments choices while, with an SDIRA, you make the decisions, and your choices are virtually limitless.
“Your imagination is really the limit,” says Jason Craig, president of The Entrust Group, who has one client who uses his SDIRA to invest in cows overseas. The only restriction is you can’t invest in life insurance policies or collectibles, he adds. Everything else is fair game, including businesses, promissory notes, precious metals and even cows.
This allows you to invest in what you know, which for real estate investors is real estate, and it allows you to diversify. You don’t have to limit yourself to stocks and bonds. You can purchase real estate, and either flip it and put the funds back into your SDIRA, or you can hold it for cash flow that feeds your SDIRA.
“It puts you in control,” Craig says. “I never would have thought about investing in cows, but you can.”
Real estate is a great option for an SDIRA, though, because it’s secured by a title guaranteed with title insurance. If you purchase a property with the intention of using it as a rental, you can earn a monthly income for the SDIRA (versus small dividends from stocks and bonds, if you’re lucky). You can also insure your property against damage and loss.
Plus, you don’t have to limit yourself to single-family residences. Using your SDIRA, you can invest in multifamily properties, commercial real estate, undeveloped land, mortgage notes, trust deeds, REITS, mineral rights, water rights and more.
Three Main Types of SDIRAs
The vehicle you use to invest your self-directed funds depends on your circumstances and your goals.
IRAs come in a variety of flavors, the two most familiar being the conventional and the Roth IRAs. With a conventional IRA, you receive the tax benefit at the time of contribution; your withdrawals are taxed. But, with a Roth IRA, you do not receive a tax deduction when you contribute. Instead, you can withdraw your retirement funds tax-free at any time. (Other types of IRA impose a 10 percent penalty on early withdrawals, plus taxes owed.)
Most retirement accounts have a self-directed option, so this distinction is crucial. A conventional SDIRA gives you a tax benefit at the time you contribute while a self-directed Roth IRA defers them. In other words, you pay taxes upfront on the Roth IRA but can access them tax-free at a later date. This can have significant ramifications. Consult a tax professional to determine which option is best for you (or if something else is better still).
For conventional and Roth SDIRAs, you will have to work with a custodian. Even though you chose what to invest in, you would have to ask custodian for the funds to make the investment. The custodian writes the check on behalf of your SDIRA, an option that can have drawbacks, especially when actively investing in real estate.
“When you are more involved, buying distressed properties, buying at auction, that is really inconvenient,” says Dmitriy Fomichenko, president of Sense Financial.
That’s why an IRA LLC, or checkbook IRA can be good options for some real estate investors, he says. You write the checks. There’s still a custodian, but he is only the custodian of the limited liability company (LLC) that you direct him to set up for you. As manager, you are in charge of making purchases within the LLC. Not only does this eliminate the risk of missing a real estate opportunity because you cannot act immediately, but it also eliminates custodian fees.
Craig explains that most custodians charge on a per asset basis, so if you own two pieces of real estate in a traditional SDIRA, you will be charged for two assets. But, if you own one LLC, even if it owns five properties, you are charged for only one asset. The downside is that you don’t have a custodian in charge of following all of the regulations, and there’s a lot of recordkeeping involved.
If you want to be able to manage your own funds within the account but don’t want to deal with the recordkeeping, some companies offer an answer. The Entrust Group, for one, offers a hybrid option called the myDirection Card, Craig says. A prepaid Visa card, it can be used to purchase assets, goods and services for your IRA, so for example, if you want to by a property at auction, you can do so without involvement of the custodian. However, the custodian would still oversee the legalities.
For investors willing to spend the time educating themselves on IRA regulations, though, an IRA LLC gives you flexibility and saves you custodian fees.
You have a third major option when it comes to self-directing your retirement accounts. In addition to the conventional, custodial IRA and the IRA LLC, you may be able to invest using a self-directed Solo 401(k). To qualify, you must either be self-employed or have a small business that has no employees, with a few exceptions including your spouse. Fomichenko says, in his experience, most full-time real estate investors would qualify.
If you do qualify, the Solo 401(k) is created as a trust, and investments are made by the investor. There is no custodian, so you save money in custodian and transaction fees.
Plus, you can contribute up to $58,000 per year to a Solo 401(k). If your spouse is an employee, you can double that amount, meaning that a family can shelter more than $100,000 per year. “That’s a huge tax savings feature,” Fomichenko says.
And, if you need cash, you can withdraw it from your Solo 401(k) as a loan of up to $50,000 without penalties as long as you pay it back to the account within five years. (With an unsecure loan, you have to pay the funds back in five years. However, if it is a secured loan, you have 30 years to pay it back.)
“A Solo 401(k) also gives you the ability to invest tax-free using a Roth sub-account,” Fomichenko says. “You have the ability to completely avoid taxes. I don’t know of any other way you can generate income without paying taxes on it.”
The Solo 401(k) also gives you the opportunity to invest in a collectible, like artwork, if you want, or to engage in a real estate transaction that might otherwise be off limits using a self-directed IRA, such as purchasing a rental property for your son or daughter to live in while away at college.
As great an opportunity as SDIRAs can be, you do have to be careful. One wrong step can jeopardize your tax benefits. Education is key. You have to continually educate yourself on the IRA regulations, but there are a few basic principles anyone, even someone using a custodian, should understand.
First, you don’t own the assets in your IRA, self-directed or not — the IRA does — so if you take action on behalf of your SDIRA, such as putting $1,000 of your personal money down as earnest money, you void the deal automatically for your SDIRA. You can still purchase the property using your personal funds, but your SDIRA can’t participate.
Similarly, you can’t benefit directly from an investment, so forget about buying a vacation rental that you personally use during the summer. In general, you have to keep all investments in your SDIRA at arm’s length, otherwise the IRS determines you’ve engaged in self-dealing.
The list of individuals the IRS has labelled “disqualified persons” doesn’t end with you, though. It extends to your spouse and lineal descendants, meaning your parents and children. (Siblings are exempt.) For the real estate investor that means your SDIRA can’t purchase a rental property for your parents or children to live in, of course, but it also means that your SDIRA can’t enter into a transaction with either.
As an example, if your daughter asks you to invest with her in a commercial property, you can do so with personal funds but not with your SDIRA funds. Your daughter is a disqualified person (as is any corporation, partnership or estate that she owns, either individually or with others, more than a 50 percent interest). However, if your brother approaches you with the same deal, your SDIRA can partner with him.
But, these prohibitive actions are not limited to purchasing a property or enjoying a property owned by the SDIRA. A disqualified person also can’t sell, exchange, or lease any property to the IRA; lend money or extend credit to it; provide goods or services; or transfer to or use something owned by the SDIRA.
Some prohibitive actions are obvious; others not so much. You can’t personally pay for a new roof for your property if the funds are not available in the SDIRA. That makes sense. But, you also can’t personally repaint the bathroom (you have to hire painters), and you can’t hire your teenage son to mow the lawns at your rental property.
Before you do anything, ask yourself whether the transaction benefits you or another disqualified person, and then to be on the safe side, ask your self-directed provider or real estate attorney.
Not Just Contributions
Few people truly recognize the potential for income generation that an SDIRA provides, says Matt Allen, director of IRA lending for North American Savings Bank and author of “Leverage Your IRA — Maximize Your Profits with Real Estate.” The IRS allows you to borrow money to purchase assets in your SDIRA, so your funds go a lot further, potentially increasing your returns.
Let’s say you have only enough money in your SDIRA to finance a down payment. You don’t have to wait until you have accumulated enough through contributions to purchase a property outright; you can get a loan, make the purchase and either start cash flowing a rental or flip for a profit.
Or, let’s say you do have enough money in your SDIRA to purchase a property outright. You could do that, or you could use the money as down payment for two or three properties. By financing those properties with a loan, you grow your portfolio quicker and increase your potential earnings.
“A non-recourse loan gives you tremendous options,” Allen says. “You can use your money to buy multiple properties or to buy a more expensive property than you could buy without a loan.”
However, you can’t just walk into any bank and get a loan for your SDIRA. You have to get a loan through a company that specializes in non-recourse lending, meaning that the loan is secured by the collateral (in this case, real estate) and there is no recourse against the SDIRA owner or the balance of his retirement account. North American Savings Bank has been providing non-recourse loans since 2005, Allan says, and a host of other lenders do also.
Because the SDIRA owner isn’t personally guaranteeing the loan, there is no income, employment verification or minimum credit score required for loan approval. The loan is secured by the property. Also, since the loan is recorded under the Tax ID Number of the entity on the title and not the SDIRA owner’s Social Security number, the loan isn’t reported to the credit bureaus.
To qualify, you will need to have a minimum of 30 to 40 percent of the purchase price vested in your SDIRA, and of course, the property can’t benefit a disqualified person in any way. Also, typically, the property will be required to generate sufficient Net Operating Income (rental income minus operating expenses) to exceed the debt payments by 25 percent. Once the loan is approved, payments are made by the SDIRA to the bank.
Allen warns, though, that you need to be careful about how far you stretch your finances to make additional investments. If you use all the funds available to you in your SDIRA to purchase property and then something goes wrong with a roof, he explains, the funds for its repair have to come out of your SDIRA. You can’t use personal funds to pay for the roof, and that’s going to leave you in a difficult situation.
In this scenario, you can make a contribution to your SDIRA if you haven’t already maxed out for the year, and you could possibly get a loan for the SDIRA, but there’s no need to put yourself in this position in the first place. Always leave yourself enough reserves to cover repairs, vacancies and other expenses.
A Word of Caution
SDIRAs can be a tremendous wealth-building tool, but they are not for everyone, especially the non-custodial options. You really need to know the laws and understand what you can and can’t do, Allen says. If you don’t have the time to educate yourself on the IRS regulations or the time to dedicate to making smart real estate investing decisions, then this may not be the best route for you.
On the other hand, if you are willing to do your due diligence, you’ll be hard pressed to find a better way to grow your real estate portfolio and build wealth for your retirement. Allen says it’s unfortunate that most real estate investors don’t even realize that you can use your retirement funds to invest in what you know.
“You don’t have to stick with stocks and bonds,” he says. “You can diversify your portfolio with real estate.”
Ensuring Responsive Service & Turnaround Rates
No matter how you choose to go about selecting who will take care of your SDIRA account, the real test is that company’s willingness to help you and its responsiveness to your transaction and report requests. Simply spend time on the Web and talking to custodian or administrator clients researching customer service and response reports. Self styled leadership and size is often an impediment to agility. The providers of custodial or administrative SDIRA services are not exempt from this rule.
What You Can Invest In
You aren’t limited to investing in rental properties with your self-directed individual retirement account (SDIRA). Here are some other ideas:
Fix and flips: Instead of purchasing a single family-home to use as a rental property, you can purchase a distressed property, rehab it and resell for profit.
Multifamily: This can be anything from duplex to a massive apartment complex. It’s a step up from the single-family model, but so are the potential profits.
Commercial: Some of the same principles apply as with rental properties and multifamily. You have tenants. They pay rent. Partner with an experienced commercial real estate investor to learn the ropes.
Raw land: Vacant or raw land is usually undeveloped. You purchase with the hope to eventually sell it to a commercial or residential developer. In the meantime, you’re responsible for paying the annual property taxes.
Trust deeds: A more passive and less hands-on approach, trust deeds are short-term loans for a trust to buy real estate.
REITS: With a real estate investment trust (REIT), you invest in a company that owns, manages and operates commercial or residential properties. These constitute another passive investment vehicle.
Secure notes: Similar to a traditional bank mortgage, secure notes offer an opportunity to lend money that a borrower pays back over time plus interest. Collateral can be residential, industrial and commercial real estate, as well as heavy equipment.
Editor’s Note: As with any investment decision, we urge you to seek the counsel of a qualified professional regarding use of monies in your self-directed individual retirement account. Think Realty, Affinity Media Services LLC, its owners, contractors, distributors and their respective representatives do not render tax, legal, accounting, investment or other legal advice nor do we promote any one individual or entity in providing those services nor do we guarantee the level of effectiveness or success of any investment or tax strategies discussed herein.
About the Author:
Teresa Bitler is an Arizona-based freelance writer. Contact her at email@example.com.
Certified IRA Services Professional
The Entrust Group
Equity Trust Company
Horizon Trust Company
The IRA Club
North American Savings Bank