Investing with YOUR Self-Directed Individual Retirement Account (IRA) Part 2

self-directed IRAs

Individual Retirement Accounts, IRA’s, are usually started one of two ways – either by rolling over a 401(k) account from a former employer or by going to your local stock broker/mutual fund specialist/bank or other financial institution, and opening the account with a small deposit – often the minimum allowed, and then feeding it over the years, buying new shares or adding a bit from your salary each month, but never exceding the legal maximum contribution limit – $5,000 a year in 2008 and now indexed to inflation for 2009 and beyond.

Needless to say, your method of entering the IRA arena can make a big difference in the amount of money you actually have in your IRA that is available to invest.  If you have a 401(k) at work, you can sock away up to $15,500 of your own money each year, plus whatever amount your employer wants to match on top of that.  This means you can accumulate assets inside your retirement plan more than three times faster through your 401(k).  The downside of 401(k) investments, is that you are very limited in your investment choices – you can only invest in the options that your employer and benefits coordinator makes available to you.

If you want to use your savings to invest in real estate, putting them into a 401(k) won’t pay off until you leave your job and are able to roll that 401(k) over to an IRA.  So, if you plan to stay gainfully employed with your current employer long term AND you want to invest in real estate, I would consider first funding your 401(k) to max out any employer matching offered, then max-out your ROTH IRA.  You can use your IRA funds to invest in real estate if you have a self-directed custodian, which we’ll get to in a minute.

If you have funds available beyond that, you can do what I do, save them up in a non-retirement account (just cash in the bank) and put them into deals you’d like to buy yourself.  (One of the big hang-ups, which we’ll also see, with investing your IRA in real estate deals is that there are extra taxes to pay if you get a loan, and you’re not supposed to buy deals from youself (self-dealing).

Interesting Fact: Did you know 45% of employees cash out their 401(k) – and pay taxes for the priviledge – when they leave their job.

So, if you have an IRA (either traditional or ROTH) set up, let’s take a look at it… it either has a big amount of money, or a small amount of money in it.

Depending on how involved you are in real estate investing, and how much access you have to different high-quality deals that are being put together, you may or may not want to use a small IRA to invest in real estate.  For example, if you do a lot of no-money down deals where you buy houses for a dollar subject to the existing financing and that type of thing, then yes – you could pretty easily get some of those deals into your IRA even if it was small.  But watch out – you or your family members can not be the property managers for that property – you’ll have to hire an independent outide firm, which can be costly for smaller properties.

Emily Cressey

If you’re just starting your IRA now, and say you have $5,000 – $25,000 in your IRA, that might not be enough to bother with trying to get into a commercial real estate investment with.  For a high-quality commercial property, you’re going to have to put 20% down in most cases in today’s real estate environment, and that can be quite a sum.  Additionally, if there is a mortgage on the property your IRA buys, the IRA will have to pay taxes on a portion of the property’s rental income at your ordinary income tax rate (ouch).  This is called Unrelated Business Income Tax (UBIT) and it applies unless you use funds from your IRA to purchase the entire property free-and-clear.

You can find a lot of good high yield real estate investments for your self-directed IRA, but you just have to make sure you know the rules and follow them as they are very strict – penalties can include the failure (and taxation) of your entire IRA balance.

Here are some things you can invest in with your IRA:

1) Mortgages

2) Buy a property free and clear

3) Buy a property with a mortgage and pay UBIT

4) Buy a share of a company that is acquiring a piece of real estate.

When my partners in Grassland Investments and I first started putting together deals with  private investor’s money, a number of them wanted to participate in our deals using funds from their self-directed IRA.  That meant, we got to find out a lot about how that works.  It was actually very clean for the type of deals we have done.  We bascially created a new company, an LLC, that was acquiring a property using a mortgage. Our investor clients bought shares of this company for $25,000 each.  They are then entitled to distributions that the company makes, just like if they owned stock in the company.  This has worked well for our investors.

The key to investing with your self-directed IRA is to follow all the rules and avoid prohibited transactions and activities.

You will need an advisor to lead you through all the steps because they can be pretty dicey, and a mis-step is expensive!

If you are considering investing through your IRA, consider these steps:

1) Get Money Into IRA. Feed your IRA so it is big enough to have it be “worth while” to do self-directed investments.  You don’t want to pay  http://www.trustetc.com/company/fees.html to your custodian and park your money in a low-yeild savings account while you wait for a big deal to come along.  Especially if your IRA is so small, you likely won’t have enough in your account to participate in a big deal for a while yet.  When my Roth IRA was young, I started it with Vanguard.com because they had very low fees and I was able to invest in mutual funds and money market funds while I built up the account value.

2) Find an Investment. Once you have an IRA that is big enough to invest with, start looking into what type of investments you’d like to make.  If you want to stay with stocks and bonds, most any IRA custodian will do.  If you want to invest in something more unusual, like a privately held company, or real estate – as is the focus of this article – then you’ll need a self-directed custodian, finding one will be the focus of the next article.  When you identify the deal type you’d like to do, you’ll know how much money you need to invest.  Are you looking at buying $25,000 shares in a LLC that’s making an investment?  Are you buying a house for $200,000 that’s free and clear?  Are you giving a rehabber a hard money loan of $50,000?

3) Place the Funds with a Custodian.  When you are ready to invest, and I would say not TOO long before that because the annual fees can be pretty steep, go ahead and transfer your funds over to your chosen custodian.  It takes about 30 days for them to get you set up, so make sure the types of deals you’re looking at have that time frame available for the funding, otherwise, you’ll have to put your funds in earlier.

If you want to use your IRA for investing in real estate, it can be done, you just have to figure out how.  Hooking up with a good self-directed IRA custodian who specializes in facilitating investing in real estate will really help you make sure you are covering your bases.

Like many things in real estate investing, there’s a lot of detail here that it doesn’t necessarily make sense for you to master yourself.  Understand the basics, and hire a professional to help you with the specfics.   You need to work on just two things.  First – getting enough money into your IRA so that you can do the type of deals you want, and second – finding good, qualifying deals that will justify the use of your IRA funds.

Crank the numbers and look at the fees to find out how much you’ll earn on the investment, how much you’ll pay the custodian, and how that compares to your other investment alternatives.  The other thing to take a look at is how long it will take you to find a deal.

If your money is going to be out of the market for 6+ months while you look for a deal, there is opportunity cost there.  You could be earning an average of 11% on that money in the stock market or 7% on that money in bonds, so depending on your deal flow and investment savvy, bear that in mind too.

It is for these reasons that I don’t recommend starting to invest in real estate with your IRA utnil you have about $25,000 in your IRA account unless you are a real “player.” investing in real estate full time, well connected with other investors, and confident in your risk and returns on deals.

Any questions?  Let me know here…

Also, stay tuned for the next post on finding a great self-directed IRA custodian who will help facilitate your non-traditional IRA investments.

More Self-Directed IRA Investing News and Articles:

Until next time…..Emily

Tags: IRA, self-directed IRA, individual retirement account, 401k, 401(k), real estate investing, commercial real estate investing, investing your IRA in real estate, IRA real estate investing, high yeild investments, IRA custodian

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