Self-directed IRAs complex, but they can be profitable

Marilyn Cotterman was fed up with her financial planner. He had invested her Roth IRA in stock mutual funds that tanked in 2008, and then put it in bond funds that yielded next to nothing. In late 2009, Ms. Cotterman, a quality assurance manager at a printing company in Brownsburg, Ind., moved the $40,000 she had with her planner into a self-directed individual retirement account so that she could invest in mobile homes.

Her portfolio today is a multiple of that initial $40,000, the 57-year-old Ms. Cotterman said. And because the 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 said of her first IRA real estate purchase. “We found someone who wanted to buy it for $10,500. We held a promissory note so that they have to pay us $215.34 a month over six years.” She's earning a net 15% on that $10,000 note, Ms. Cotterman said.

While most retirement accounts let you buy only paper securities, self-directed IRAs offered by companies such as Equity Trust Co. (which Ms. Cotterman uses), Guidant Financial Group and The Entrust Group let people invest in hard assets such as real estate and gold bullion. These IRAs, whose account fees range from $125 to about $300 a year, have become increasingly popular.

“Our asset growth rate has normally been about 15% a year, but this year, it's 25%,” said Hubert Bromma, chief executive of The Entrust Group, which is custodian for $3 billion in self-directed IRA assets.

Today's hot real estate markets are distressed ones. Many sellers end up renting in the same neighborhood. That makes for a stable rental market and depressed housing market — ideal for an investor.

“In every major metropolitan market, you face the same issues,” said Jeff Desich, chief executive of Equity Trust. “There are people now who need to rent and can't get credit anymore 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 can lead to stiff penalties if managed incorrectly. The primary mistake is self-dealing, in which you benefit financially or otherwise from the property in the account before the minimum distribution age of 591/2. That means that if the IRA owns real estate, neither you nor any immediate family member can live in it or derive rental income from it directly. Otherwise, you could invalidate your IRA's status and be subject to a 10% tax penalty for its value.

Moreover, all repairs, management costs and property taxes must be paid from account funds. You must either have a buffer or hope that the maximum allowable IRA contribution will cover them. Mr. Desich recommends that investors keep 5% to 10% of their property's value in liquid securities such as cash or bonds.

Investors can't use a traditional mortgage to finance IRA properties. The only permissible loans are so-called non-recourse ones that use the property itself as collateral. These have higher interest rates, 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,” Mr. Bromma said, adding that he sees rates of 5% to 7%.

Self-directed IRA real estate deals tend to be all-cash. For most people, the lack of easily available loans results in concentrated portfolios with a handful of properties. That's why experts recommend multifamily rental properties instead of single-family rental homes: You can lose one tenant and still have cash flow.

Kirby Scofield, realtor at Cosmopolitan Real Estate in Las Vegas, has been selling such properties for $20,000 to $30,000 per apartment. Annual net rental yields run from 12% to 25% at current prices, he said.

Ms. Cotterman invested in 20 mobile homes, 10 of them in her IRA. She prefers dealing with buyers. Her promissory note essentially makes her the lender. She still earns hefty yields because her properties are cheap and the loan value is small.

“Buyers don't care about the interest rate, just the monthly payment,” Ms. Cotterman said.

The strategy has other perks. Her properties' placement in mobile home parks means that park managers do a lot of the credit screening. They also handle evictions if residents default. She's had six defaults but said it hasn't been a problem. “You just turn around and sell the property to someone else,” she said.

Perhaps the major risk of a self-directed IRA is that it allows investment in activities that are unregulated by the Securities and Exchange Commission. The lack of oversight is a magnet for scam artists.

“As people reach retirement age, they invest in things they know nothing about in an attempt to generate big returns,” Mr. Bromma said. “Due diligence is the biggest thing people aren't doing.”