Investing in real estate with a self-directed IRA

Chance to invest in hard assets can lead to big returns, but rules are complex

Nov 28, 2012 @ 11:32 am

IRA, retirement, investing, real estate
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Marilyn Cotterman was fed up with her financial planner. He had invested the 57-year-old's Roth IRA in stock mutual funds that tanked in 2008, and then he put it in bond funds that yielded next to nothing. So in late 2009, Cotterman, a quality assurance manager at a printing company in Brownsburg, Indiana, decided to move the $40,000 she had with her planner into a self-directed IRA so she could invest in mobile homes.

Today, Cotterman says her investments yield double-digits and her portfolio is a multiple of that initial $40,000. Because her self-directed account is still a Roth IRA, her gains and income accrue free of taxes. “We bought a $6,000 mobile home and fixed it up,” she says of her first IRA real estate purchase. “We found someone who wanted to buy it for $10,500. We sold it to them but held a promissory note on the home so that they have to pay us $215.34 a month over a six-year period.” After factoring in costs, Cotterman says she's earning 15 percent on her $10,000 promissory note.

While most retirement accounts let you buy only paper securities, self-directed IRAs offered by companies such as Equity Trust (the company Cotterman uses), Guidant Financial and The Entrust Group allow individuals to invest directly in hard assets such as real estate and gold bullion. Such IRAs, which have annual account fees ranging from $125 to about $300, have become increasingly popular. “Our asset growth rate has normally been about 15 percent a year, but this year it's 25 percent,” says Hubert Bromma, chief executive of the Entrust Group, custodian for $3 billion in self-directed IRA assets.

Today's hot real estate markets are distressed ones in Florida, Nevada, Michigan, Arizona and California. Many of the sellers are people who got ahead of themselves in the housing bubble and now wind up renting in the same neighborhood. That makes the rental market stable while the housing market is depressed -- the ideal scenario for a real estate investor. “In every major metropolitan market, you face the same issues,” says Jeff Desich, chief executive of Equity Trust. “There are people now who need to rent and can't get credit any more to buy, so there's a pool of homes that have been reduced dramatically in price.”

Tax twists

Self-directed IRAs are complex legal structures that, if managed incorrectly, can lead to stiff penalties from the Internal Revenue Service. The primary mistake is any appearance of self-dealing, where you benefit financially or otherwise from the property in the account before the minimum distribution age of 59 1/2. That means if your IRA owns real estate, you or any immediate family members can't live in it or get any rental income from it directly. Otherwise, you could invalidate the status of your IRA account and be subject to a 10 percent tax penalty for the account's value.

Moreover, all repairs, management and property tax costs must be paid with the IRA's funds. So you must either have a buffer in the account to pay for unforeseen expenses, or hope that the annual maximum allowable IRA contribution, currently $5,000, will cover costs. You can't even make repairs by yourself without your own “sweat equity” being considered a contribution to the account. Desich recommends that investors keep 5 percent to 10 percent of their property's value in liquid securities such as cash or bonds to cover future repairs.

Nor can investors employ a traditional mortgage to finance IRA properties. An IRA account doesn't allow its owner to be held personally liable for any unpaid debt. The only permissible loans are so-called non-recourse loans that use the property itself as collateral. These have higher interest rates than conventional mortgages, and any income earned with the portion of the property owned with this leverage is considered outside the IRA and fully taxable. “Such loans aren't always easy to find,” says Bromma. The rates he sees range from 5 percent to 7 percent.

All-cash deals

As a result, most self-directed IRA real estate deals tend to be all-cash. For most people, the lack of easily available leverage creates concentrated portfolios of a handful of properties. That's why experts recommend multi-family rental properties with two to four apartments, instead of single-family rental homes; if you lose one tenant, you still have a second apartment rented. Las Vegas realtor Kirby Scofield, of Cosmopolitan Real Estate, has been selling such properties at prices ranging from $20,000 to $30,000 per apartment. Annual rental yields after expenses run from 12 percent to 25 percent at current prices, he says.

Cotterman has investments in 20 mobile homes, 10 of which are in her IRA. She prefers dealing with buyers because she feels they have more respect for her property than renters do. With her promissory note, she essentially becomes their mortgage lender and is still able to earn hefty yields because her properties are cheap and the value of the loans she offers is small. “Buyers don't care about the interest rate, just the total monthly payment,” she says.

Her strategy has additional perks. Since her properties are in mobile home parks, the park managers do a lot of screening for her as to the credit quality of the buyers. Residents also have to pay lot rent to be in the parks. If they default, they often default on both their lot rent and Cotterman, so the park does the evicting for her. She's had six defaults, but says it isn't a problem because of the low cost and high turnover. “You just turn around and sell the property to someone else,” she says.

Avoiding scams

Perhaps the biggest risk of self-directed IRAs isn't tenants bolting or tax twists but what you choose to put into it. Self-directed IRAs allow you to invest in things that aren't normally regulated by the SEC. Since companies like Entrust are just custodians, they don't check the legitimacy of what you buy. This lack of oversight is a magnet for scam artists with promises of easy returns. That's why in August the North American Securities Administrator's Association issued an Investor Alert citing these risks.

Entrust offers seminars that try to teach people how to avoid common scams. The most important thing is simply to make sure any deal is completely legit. "As people reach retirement age, they get desperate because they haven't saved enough," says Bromma. "They invest in things they know nothing about in an attempt to generate big returns. Unfortunately, there are so many bad people out there operating Ponzi schemes, trying to rip people off. Due diligence is the biggest thing people aren't doing."

--Bloomberg News--

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