Quincy’s Response:
Unfortunately, the concept of borrowing from a 401(k) plan is quite different than borrowing from an IRA. It is a prohibited transaction for you to borrow from your IRA, and also you cannot put your IRA up as collateral for a loan without it being considered to be a distribution.
Occasionally an IRA will borrow money on a non-recourse basis, but in that case the money is used by the IRA, not the IRA owner. Sorry.
By: H. Quincy Long
There is a lot of confusion over self-directed IRAs and what is and is not possible. In this article I will discuss some of the most important things you need to know about self-directed IRAs.
1) IRAs Can Purchase Almost Anything. A common misconception about IRAs is that purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA. This is false. The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles.” 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.
2) Seven Types of Accounts Can Be Self-Directed, Not Just Roth IRAs. 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 above, but they can be combined together to purchase a single investment.
3) Almost Anyone Can Have a Self-Directed Account of Some Type. Although there are income limits for contributing to a Roth IRA, having a retirement 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, the fact that you or your spouse has a retirement plan at work may 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. A Traditional IRA can also 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! All of this is in addition to any retirement plan you have at your job or for your self-employed business, including a SEP IRA, a SIMPLE IRA or a qualified plan such as a 401(k) plan or a 403(b) plan.
4) Even Small Balance Accounts Can Participate in Non-Traditional Investing. 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, a Roth 401(k), an HSA, or a Coverdell ESA, this profit can be tax-free forever as long as you take the money out as a qualified distribution. 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, your IRA can be a partner with other IRA or non-IRA investors. 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!
5) Caution: There Are Restrictions on What You Can Do With Your IRA. Although as noted above in paragraph 1 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 certain persons, called disqualified persons, from dealing with the income and assets of the plan in a self-dealing manner. As a result, disqualified persons are prohibited from directly or indirectly entering into or benefitting from your IRA’s investments. 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. Disqualified persons to your IRA include, among others, yourself, your spouse, your parents and other lineal ascendants, your kids and other lineal descendants and their spouses, and any corporation, partnership trust or estate which is owned or controlled by any combination of these persons. It is essential when choosing a custodian or administrator that the company you choose is very knowledgeable in this area. Even though no self-directed IRA custodian or administrator will give you tax, legal or investment advice, the education they provide will be critical to your success as a self-directed IRA investor.
6) Some IRA Investments May Cause Your IRA to Owe Taxes – But That May Be Okay. Normally an IRA’s income and profits are exempt from taxation until a distribution is taken (or not at all, if it is a qualifying distribution from a Roth IRA). However, there are three circumstances when an IRA may owe tax on its profits. First, if the IRA is engaged in an unrelated trade or business, either directly or indirectly through a non-taxable entity such as an LLC or a limited partnership, the IRA will owe tax on its share of Unrelated Business Income (UBI). Second, the IRA will owe taxes if it has rental income from personal property, such as a mobile home not treated as real estate under state law (but rents from real property are exempt from tax if the property is debt-free). Finally, if the IRA owns, either directly or indirectly, property subject to debt, it will owe tax only on the portion of its income derived from the debt, which is sometimes referred to as Unrelated Debt Financed Income (UDFI). This may sound like something you never would want to do, but a more careful analysis may lead you to the conclusion that paying tax now in your IRA may be the way to financial freedom in your retirement. For example, one client made a net gain of over 1,000% in less than four months after her IRA paid this tax. This is definitely a topic you will want to learn more about, but it is not something you should shut your mind to before investigating whether the after tax returns on your investment would exceed the return you might otherwise be able to achieve in your IRA.
7) An Inherited Roth IRA Can Give You Tax Free Income Now No Matter What Your Age. Many people know that a qualified distribution from a Roth IRA is tax free. To make the distribution qualify as tax free, it must be distributed after the IRA owner has had a Roth IRA for at least 5 tax years and after one of four events occurs – 1) the IRA owner is over age 59 ½, 2) the IRA owner becomes disabled, 3) the IRA owner dies and the distribution is to his or her beneficiary, or 4) the distribution is for a first-time home purchase, either for the IRA owner or certain close family members. Although the neither the original Roth IRA owner nor his or her spouse has to take a distribution (assuming the spouse elects to treat the IRA as their own), non-spouse beneficiaries of a Roth IRA do have to take distributions, normally over their expected lifetimes. However, once the five year test is met, those distributions are tax free, regardless of the age of the IRA beneficiary! Even a $100,000 Roth IRA left to a 6 year old beneficiary may generate as much as $80,496,367 in lifetime tax free distributions if the IRA can sustain a yield of 12%, which is very possible with a self-directed IRA.
8) 2010 Brings an Incredible Gift From Your Government. Most people who understand the benefits of a Roth IRA really want one, but many people have not been able to qualify for this incredible wealth building tool because of income limitations which restrict the eligibility of a person to contribute to a Roth IRA or to convert pre-tax accounts like Traditional IRAs into a Roth IRA. In 2010 the rules for conversions will change so that anyone, regardless of income level, will be eligible to do a Roth conversion. Beginning in 2010 anyone who has a Traditional IRA (including a SEP IRA), a SIMPLE IRA which has been in existence for at least two years, or a former employer retirement plan such as a 401(k) or a 403(b) can convert those into a Roth IRA and can then begin to create tax free wealth for their retirement. Even if you do not currently have an IRA but are eligible to contribute to a Traditional IRA, the contribution can be made and immediately converted into a Roth IRA. This truly is one of the most exciting tax planning opportunities to come along in a very long time!
9) There Are Millions of Dollars Available to Finance Your Real Estate Deals Right Now. We are in a very exciting time for wise real estate investors. There are a lot of super real estate bargains out there right now, but it can be very difficult for investors to get financing – unless they know the secret of private financing. There are billions of dollars of lazy IRA money sitting on the sidelines waiting for the right investment, because many people are very afraid of the stock market. Included among the many things people can invest in with a self-directed IRA are real estate secured loans or even unsecured loans. Shakespeare wrote in his play Hamlet, “Neither a lender nor a borrower be, for a loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.” I believe Shakespeare was wrong, but he might be forgiven since he did not have the advantage of knowing about self-directed IRAs. You can benefit from your knowledge of self-directed IRAs either by having your IRA be a private lender or by borrowing OPI – Other People’s IRAs – for your real estate transactions. Networking is the key to success in the area of private lending or borrowing, but there are things you must know to do it properly.
10) Use Options to Dramatically Boost Your Small IRA. Options are one of the most powerful and under-utilized tools in real estate investing today, and they work beautifully within a self-directed IRA. The consideration for the option and the property being optioned can be almost anything, not just real estate. Once an IRA owns an option, it can 1) let the option lapse (which at times is the right answer), 2) exercise the option and acquire the property, 3) assign the option for a fee (assuming the option agreement allows for assignment) or 4) agree to cancel the option for a fee with the property owner, thereby getting paid not to buy the property! Options are very flexible and can be designed to fit almost any situation. One client paid $5,000 from his Roth IRA for an option which he later canceled for a fee of over $35,000. Then he took that money, bought a property at a foreclosure auction for cash, and later sold the property for $70,000 with $5,000 down and a $65,000 seller-financed note. By using the option he was able to take his $5,000 Roth IRA and turn it into a $70,000 Roth in less than a year!
Truthfully there are many more things that you should know about self-directed IRAs. To learn more, attend one or more of Quest IRAs many free networking and educational events. You can get the entire schedule of events in addition to playing pre-recorded webinars by going to our website at www.QuestIRA.com. Happy investing!
H. Quincy Long is an attorney who holds the designation of Certified IRA Services Professional (CISP) and is President of Quest IRA, Inc., a third party administrator of self-directed IRAs serving clients in the State of Texas and throughout the nation with offices in Houston and Dallas. He may be reached by email at Quincy@QuestIRA.com, Nothing in this article is intended as tax, legal or investment advice.
© Copyright 2009 H. Quincy Long. All rights reserved.
By H. Quincy Long
Self-directed IRAs and 401(k) plans have been around for more than 25 years, but many people are just now becoming aware of how powerful this idea can be. There are currently trillions of dollars in retirement plans. Do you know how to unlock your own retirement funds as well as the retirement funds of those within your circle of influence for real estate related and other non-traditional investments? Your knowledge of self-directed retirement plans can help make you money now as well as ensuring that you retire in style.
Plans available for self-direction. A lot of retirement wealth is in traditional IRAs and employer sponsored plans. If you leave an employer, the funds in the employer plan can be moved into a self-directed traditional IRA. This includes money rolled over from 401(k) plans, 403(b) plans, 457 deferred compensation plans, and the federal thrift savings plan. Self-employed people may have their own Individual 401(k) plan, which may even include the new Roth 401(k), no matter what their income level. Other employer sponsored plans which can be self-directed are SEP IRAs and SIMPLE IRAs.
The king of all IRAs when it comes to building tax free wealth is the Roth IRA. Even if you do not qualify for a Roth IRA due to income limitations currently, in 2010 the income limitation for conversions from a traditional IRA to a Roth IRA will be eliminated. At that point even the very wealthy will be entitled to have a Roth IRA. This is a great planning opportunity.
How does paying for your child’s education or your health care expenses with tax free income sound? You can even self-direct a Coverdell Education Savings Account (ESA) or a Health Savings Account (HSA), and as long as distributions are for qualified education or health care expenses they are TAX FREE FOREVER. With an HSA you even get a tax deduction for putting the money in!
Perhaps the best news of all is that you may combine your IRAs and other self-directed plans to make non-traditional investments. Even better, you can invest your IRAs with other people’s IRAs or even non-IRA money of people you know. The key element is that you must have your plans administered at a self-directed IRA company like Quest IRA, Inc.
Make money now. We have all heard that knowledge is power. Your knowledge of self-directed retirement plans can translate into money in your pocket today. How? It’s easy! While it is true that you may not derive a current benefit from your own IRA’s investments, this does not mean that you cannot benefit right now from Other People’s IRAs (OPI). Simply become knowledgeable about self-directed plans by reading books and attending seminars or workshops, then spread the good news!
Quest IRA, Inc has many seminars and workshops to help you and those whose IRAs you want to use to make money for yourself. There are also numerous books on the market explaining the power of self-directed retirement plans, such as Hubert Bromma’s “Investing in Real Estate With Your IRA and 401(k)” which are selling quickly. For more information on seminars and workshops in your area, visit the Quest IRA website at www.QuestIRA.com Even if you don’t have a dime of retirement funds yourself, you can use your knowledge to:
* Borrow other people’s IRA money to do your deals today
* Sell real estate, notes or other non-traditional assets to people’s IRAs
* Make others aware of an opportunity to invest in your business (always be aware of securities laws when raising money)
Anytime you go to a gathering of people, there are most likely millions of dollars available for non-traditional investments in their retirement plans. It is up to you to let people know about this powerful tool, and how they can take some or all of that anemic money and put it to work in a way that benefits both you and them. You will look highly intelligent and will inspire confidence with your advanced knowledge. You owe it to yourself to learn more today. Quest IRA, Inc. can help.
Invest your own IRA in what you know best. With all your knowledge of self-directed IRAs, you will most likely want to invest your own retirement funds in non-traditional investments as well. What investments do you know the most about? Almost without exception, you can invest in what you know best with your own IRA. The law contains very few investment restrictions for retirement plans, but most custodians refuse to allow IRAs to invest in non-traditional investments such as real estate simply because they are not set up to handle them. Not true with Quest IRA, Inc.!
Quest IRA, Inc. self-directed retirement plans are under the same laws as plans at any other custodian or administrator. We are simply more flexible when it comes to administering non-traditional investments in your IRA or other self-directed plan. Quest IRA, Inc. clients have used their retirement plans to purchase all of the following and much more: real estate, both foreign and domestic, including debt leveraged real estate, real estate options, loans secured by real estate, unsecured loans, limited partnership interests, limited liability company shares, stock in non-publicly traded corporations, land trusts, factored invoices (including factored real estate commissions), tax lien certificates, foreclosure property, joint ventures, oil and gas interests and even race horse colts! You are limited only by your imagination.
Ignorance may be bliss, but it will not make you wealthy. Use your knowledge of self-directed IRAs to make money now, to help others build their retirement wealth as well as your own, and to retire in the style and comfort in which you would like to become accustomed. Contact Quest IRA, Inc. today!
By: H. Quincy Long
Personally, I think Shakespeare had it wrong when he penned this advice in Hamlet: “Neither a borrower nor a lender be; For loan oft 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 IRA, Inc. 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 IRA, Inc. 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 IRA, Inc. 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 in Texas on 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.
Many people find it very easy to see the benefits of self-directing their Roth and Traditional IRAs, SEP IRAs, SIMPLE IRAs, Individual 401(k)s, Coverdell Education Savings Accounts (ESAs) and Health Savings Accounts (HSAs) into something other than the same old boring stocks, bonds, annuities and mutual funds. The central idea of a self-directed IRA is that it gives you total control of your retirement assets. With a self-directed account you can invest your IRA funds in whatever you know best.
When I spoke recently at John Schaub’s Real Estate All Stars conference in Las Vegas, Nevada, I outlined some of the top strategies our clients have actually used to build their retirement wealth. A brief description of these strategies is included in this article. This shows the tremendous flexibility of investing through a self-directed account.
Strategy #1 – Purchasing Rental Real Estate for Cash. Even the IRS acknowledges on its website that real estate is an acceptable investment for an IRA. In answering the question “Are there any restrictions on the things I can invest my IRA in?” the IRS includes in its response that “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.” One of our clients purchased a 10 unit apartment complex for $330,000 cash. In April, 2008 his total rent collection was $5,235. Even after payment of taxes and insurance, his cash on cash return is excellent, and the client believes that the value of the property will increase significantly over time. A discussion of the relative benefits and disadvantages of owning real estate directly in an IRA is beyond the scope of this article, but for those who know how to successfully invest in real estate it is great to know that real estate is an option for your self-directed account.
Strategy #2 – Purchase, Rehab and Resale of Real Estate. In this case study, our client decided not to hold onto the real estate purchased with his IRA. The client received a phone call one evening from an elderly gentleman who said he needed to sell his home quickly because he wanted to move to Dallas with his son. After a quick phone conversation, it was clear that the price the seller wanted was a bargain even considering the needed repairs. Our client dropped what he was doing and immediately headed over to the seller’s house with a contract. The buyer on the contract was our client’s IRA, and of course the earnest money came from the IRA after the client read and approved the contract and submitted it with a buy direction letter to Quest IRA, Inc. They agreed on a sales price of $101,000. Approximately $30,000 was spent rehabbing the property with all funds coming from the IRA. The property was sold 6 months later for $239,000, with a net profit after sales and holding expenses of $94,000!
Strategy #3 – Purchase and Immediate Resale of Real Estate (Flipping). The previous two examples show the tremendous power of buying real estate for cash with a self-directed IRA. However, both of these strategies require a significant amount of cash in your account. How else can you invest in real estate if you have little cash? One of our clients was able to put a commercial piece of vacant land under contract in his Roth IRA. The sales price was $503,553.60 after acreage adjustments. Using his knowledge of what was attractive for a building site, our client was able to negotiate a sales price to a major home improvement store chain for $650,000. On the day of closing Quest, IRA Inc. received two sets of documents, one for the purchase of the property for $503,553.60 and the other for the sale of the same property for $650,000. After sales expenses, the IRA netted $146,281.40 from the sale with only the earnest money coming from the account! A word of caution in this case is that if property is flipped inside of an IRA the IRS may consider this to be Unrelated Business Taxable Income (UBTI), causing the IRA (not the IRA owner) to owe some taxes on the gain. Even if taxes had to be paid, it is hard to argue that this transaction was not beneficial to the IRA and ultimately the client! It should also be noted that in this situation everyone involved in the transaction was aware of what everyone else was doing, so there was no “under the table” dealings.
Strategy #4 – Assignments and Options – Getting Paid NOT to Buy! Another favorite strategy for building tremendous wealth without a significant amount of cash is the use of options and assignments. One of our clients put a property under contract in his daughter’s Coverdell Education Savings Account for $100. The sales price was a total of $5,500 because the house had burned down. The seller was just getting rid of the property for its lot value since he had already received a settlement from the insurance company and had purchased another house. Our client then used his contacts to find a person who specialized in rehabbing burned out houses. The new buyer was willing to purchase the property for $14,000 cash. At closing one month after the contract was signed, the seller received his $5,500 and the Coverdell ESA received an assignment fee of $8,500 right on the settlement statement. That is an astounding 8,400% return on the $100 investment in only 30 days! Even better, our client was then able to take a TAX FREE distribution from the account of $3,300 to pay for his 10 year old daughter’s private school tuition. In a similar transaction, another client’s Roth IRA recently received an assignment fee of $21,000 plus reimbursement of earnest money for a contract.
Strategy #5 – Using the Power of Debt Leveraging. One of my favorite true stories of building wealth in a Roth IRA involves purchasing property subject to a debt. If an IRA owns debt-financed property either directly or indirectly through a non-taxed entity such as a partnership or LLC taxed as a partnership, profits from that investment are taxable to the same extent there is debt on the property. One of our clients used her knowledge of real estate investing and what she learned from a free Quest IRA, Inc. educational seminar to tremendously boost her retirement savings. After noticing a large house in downtown Houston which was in bad shape but in a great location, our client tracked down the owner in California who was being sued for approximately $97,000 in delinquent taxes on the property. She negotiated a deal with the seller for her Roth IRA to purchase the property for $75 cash subject to the delinquent taxes. With closing costs her Roth IRA’s total cash in the transaction was only around $3,000. Within 4 months she was able to sell the property for a profit to her Roth IRA of $43,500! Because the property had debt on it and because her Roth IRA sold the property for a short term capital gain, the taxes on the profit were approximately $13,500. Still, using the power of debt leveraging her Roth IRA was able to achieve a 1,000% return in less than 4 months even after paying Uncle Sam his share of the profits!
Strategy #6 – Hard Money Lending. Another excellent strategy for building your retirement wealth is through lending. Loans from IRAs can be made secured by real estate, mobile homes or anything else. Some people even choose to loan money from their IRAs on an unsecured basis. As long as the borrower is not a disqualified person to the lending IRA, almost any terms agreed to by the parties are acceptable. In many states there are limits to the amount of interest that can be charged, and loans must be properly documented, but IRA law does not impose any limits other than the prohibited transaction rules. For those wanting to avoid the direct ownership of real estate within their IRA, a loan with an equity participation agreement is often used. Several of my own self-directed accounts combined together recently to make a $25,000, 7 1/2 year, 12% first lien loan against real estate with 6% in points up front. True, this is not exactly setting the world on fire as far as return on investment goes, but I was very pleased with a safe return on a relatively small amount of cash. If I get to foreclose on the collateral my accounts should be able to make a substantial profit, since the land securing the loan was appraised at $45,000. At my office we routinely see hard money loans secured by first liens against real estate with interest at 12%-18% for terms ranging from 3 months to 3 years.
Strategy #7 – Private Placements. Many of the best opportunities for passive growth of IRAs include the purchase of private limited partnership shares, LLC membership units and private stock which does not trade on the stock market. Let me give you two examples from my own retirement account investments. In one case my 401(k) plan invested in a limited partnership which purchased a shopping center in northern Louisiana. The initial investment was $50,000, and in a little over 2 years the partnership has returned $59,321. The plan’s remaining equity is estimated as of 12/31/2007 at $31,598 and the return on investment will be around 82%. Even though the property is debt-financed the taxes on the profit have been almost nothing since the plan has taken advantage of depreciation and all of the normal deductions. Once your IRA or other plan owes taxes due to debt financing, it gets to deduct a pro rata share of all normal expenses. Another of my 401(k) plan investments is bank stock of a community bank in Houston, Texas. The initial shares were sold at $10 per share in February, 2007. The book value after less than 1 year of operations was $11 per share, and shares have recently been selling to other private investors for as much as $14.25 per share! That is a great return for a completely passive investment, and when the bank finally sells the shares are expected to sell for well above these amounts.
Strategy #8 – Owning a Business in Your IRA. One of the most innovative strategies we have seen is the ownership of a business by an IRA. Although neither you nor any other disqualified person may provide services to or get paid for working at a business owned by your IRA or other self-directed account, this does not mean that your IRA cannot own a business. Some companies do market the ability for you to start a C corporation, adopt a 401(k) plan, roll your IRA into the plan, and purchase “qualifying employer securities,” but this is different than an IRA owning a business directly. For example, my Health Savings Account invested $500 for 100% of the shares of a corporation which arranges for hard money loans to investors. The company is fully licensed as a Texas mortgage broker. The structure of the company is a C corporation. Since being a mortgage broker is a business operation, profits from the venture would have been taxable to my HSA if the entity formed to own the business was not taxable itself, and the tax rates for trusts such as IRAs and HSAs are much higher than for corporations. While normally dividends from C corporations are taxable a second time to the shareholder, dividends paid to an IRA or HSA are tax free as investment income. The corporation is run by non-disqualified persons who handle the due diligence on the loans and the legal work, as well as by a licensed Texas mortgage broker who sponsors the corporation’s mortgage broker license.
Strategy #9 – Using OPI (Other People’s IRAs) to Make Money Now. Even if you have not found the investment strategy of your dreams among the strategies discussed in this article, or if you have no IRA or if you are more focused on making money now to live on, your time spent reading this article can still be of great use to you. For each of the above strategies I have focused on the possibility that your IRA could be the investor. But what if you are the recipient of the IRA’s investment money? Are you a real estate investor having a hard time finding funding for your transactions? If you know people with self-directed IRAs or people who would move their money to a self-directed account, you can borrow their IRA money and virtually create your own private bank! You can also partner with OPI where the IRA puts up the money and you share in the equity for finding the deal and managing the project. Simply by explaining to people that they can own real estate in their IRAs you may be able to sell more property, either as a real estate broker or as the seller. You can even provide financing for your sales by having OPI make loans to your buyers. Finally, OPI can be a great way to raise capital for your business venture, although you must be aware of and comply with all securities laws. One bank I know of told me that 42% of their initial capital came from retirement accounts! Although you cannot use your own retirement account to benefit yourself at present unless you are over age 59 1/2, these are just some of the ways you can use OPI to make money for yourself right now. A good network is the key to your success.
What I have discussed in this article have been some of the more common investment strategies actually used by our clients. The only restrictions contained in the Internal Revenue Code are that IRAs cannot invest in life insurance contracts or collectibles. Almost any other investment that can be documented can be held in a self-directed IRA. As long as you follow the rules and do not invest in prohibited investments, your only real limitation is your imagination!
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