Posted by johhny on July 10, 2008 at 07:51:57:
Peter,
Thank you for taking the time to answer my question. I will call Equity Trust today and ASK as many questions as they’ll allow me!
johnny
Self Directed Roth IRA - Posted by johhny
Posted by johhny on July 09, 2008 at 16:15:34:
I have heard several times about how one can invest in notes through their Self directed Roth IRA and how your note will “compound in the IRA” over time, tax free(or is it deferred?).
If I open a Roth IRA account tomorrow, and to open the account I contribute say $5,000 into the IRA to open the account, and I want to buy a $20K note for $10K with my IRA, does that mean I have to wait until I have accummulated the needed $10k before I can buy that note through my IRA or can I simply buy the note with the cash I have in my savings account at my bank and just “direct it” to my IRA or deposit the note in the IRA?
Could someone just give me a basic, detailed explanation “for dummies” style, with an example of how one begins to invest in notes or mobile home parks or any other real estate through an IRA?
Thank you,
Johnny
Re: Being The Boss! - Posted by David Butler
Posted by David Butler on July 11, 2008 at 24:10:39:
Hello Johnny,
John Merchant is on point in his response here. While the Internal Revenue Code prohibits IRA holders mixing personal loans with IRA funds, self-directed IRA accounts can make use of borrowed money - as long as the credit history, income and/or assets of the account holder are not used to acquire or guarantee repayment of the loan. But be aware that there are several limitations with this path as well. Below are the several critical issues you’ll have to deal with.
First, to meet the criteria above with regard to borrowed funds… you must use non-recourse loans, i.e. a loan made directly to your IRA (not you personally or secured by any personal assets held outside of your IRA account), and must be based solely on the value of the property acquired with that debt, not the credit of whomever is the beneficiary of the self-directed IRA about to purchase the property and with no personal guarantees for repayment of the loan. And there will be some trade-offs. The primary of these is the 2nd critical limitation I mentioned above with regard to using borrowed funds to assist in you funding your deals, i.e. - the account holder must show that the rental property will provide a positive cash flow based on current vacancy and rental rates.
That’s not always easy to do, especially right now in many areas of the country, where rental property generates significant negative cash flow. However, if you do your homework, and purchase according to the philosophies and metrics I have espoused in my several articles over the past eight months here in the Cash Flow Forum…
Beware the Blue Sky–The Current Housing Market at:
http://www.creonline.com/articles/art-331.html
Priced to Own–Probabilities Producing Profits at:
http://www.creonline.com/cash-flow/article-menu.html
and most recently…
“Monkey Math & The Dead Cat Bounce” at:
http://creonline.com/articles/art-339.html
your odds improve greatly. And in that respect, the market is getting better every day. It still has a long way to go, but, if you are diligent, and disciplined in your approach, you can find deals that will work - or MAKE deals that will work. It’s not a slam dunk, lay-down proposition… but the opportunity is real, and it is out there.
The second issue you need to be aware is UDFI (Unrelated Debt-Financed Income). UDFI is produced when an IRA or other tax-advantaged entity produces income from an asset that is financed in part or whole through debt. The UDFI tax calculation is based on that portion rental income that is equal to the ratio of debt used to purchase the investment. For example, if you pay $10k for the note you mention, using your $5k IRA account, and your self-directed IRA account borrows the other $5k to provide the total $10k needed to purchase the note, through a nonrecourse loan secured by the $20k loan you are purchasing, your debt to income ratio is 50% of the purchase price. Consequently, 50% of the income generated by the note is subject to a tax calculation (because the borrowed portion is not tax-deferred money). However, the remaining 50% of the income remains tax-deferred, since it belongs to the IRA. So itâ??s a bad news/good news situation: Although non-recourse loans invite potential tax payments, those payments signify a profit!
Another issue that you have to take into account… lenders of all stripes must protect themselves from risk. Since there is no personal collateral guaranteeing non-recourse loans, and they have no recourse against the IRA or IRA holder with this kind of loan the loan typically comes with higher than normal interest rates, and lenders typically require that the IRA provide a high down payment on the collateral property. In this case, you are only looking for 50% ITV, so that isn’t so much a concern. But, in this case, you are also talking about a very small loan amount. Generally not attractive to lenders, per se. There are other lender requirements that may come into play as well, at least on bigger deals, including holding cash reserves in the IRA account to show ability to cover loan payments.
An easy solution in your particular situation here is to find another small investor, and arrange to sell him a partial purchase for the amount you need. You avoid the loan altogether, and create an easier investment scenario to manage. Say your investor is comfortable with a 12% return on his $5k investment, and likes the idea that his money only represents a 25% ITV vs. the $20k collateral. Let’s assume here a minute that at the end of the day, you sell him the first say… 44 payments, and the total hit against the note balance is $7k, including the return of his $5k investment. Then you begin receiving the remaining say, 72 payments, giving you back your $5k, plus the remaining $8k of principal, and whatever interest was in the deal, to return 16% on your $5k originally invested (your actual yield is lowered by the fact that you received no payments yourself during the first 48 months…
With a properly structured partial purchase, you pretty much cover all the necessary requirements, without even needing too. (See the entire thread at: Re: Cake Walk - Part & Partial?! at: http://www.creonline.com/cashflow/wwwboard3/messages/21964.html to get a better understanding of the “Why” of that.
Better still, you avoid UDFI altogether, because there is no loan, and there is no debt-financed income! In essence, you can have your cake, and eat it too!
But using a non-recourse loan in conjunction with your self-directed IRA monies can also create a powerful wealth-building tool, in the right circumstances. The thing is, itâ??s a tool that needs to be carefully engaged and properly utilized. Itâ??s extremely important that, in setting up your IRA investment purchases in conjunction with non-recourse loans, you work with an experienced and reputable self-directed IRA provider and tax professionals. And be aware that SDRP investing is an acquired taste that takes some getting used to. Some extra paperwork, lots of procedures, timing issues in coordinating paperwork with closing on your deals, and similar “complications” compared to straight real estate investing. But as it is for experienced CREI, Exchangors, Land Trust investors, and others who use more complex strategies to achieve better deal structures, or achieve better end results - or simply to make a deal they otherwise could not - once you become familiar with the process, it is not so mettlesome in most cases. The trick is to Keep Your Eyes on the Prize.
BTW… I seem to recall some seven or eight years ago, John Merchant here asked me to review a little IRA guide he had published. Perhaps he still has it available. Another inexpensive book I received as a gift several years back was Pat Rice’s just released book IRA Wealth for Real Estate Investment. Though I don’t recall that it offered any discussion on the partial purchase technique, it did offer several good chapters on buying notes in your SDRP, and is written in an easy to follow style.
Hope that helps clarify, and best wishes on your investing success. Many Happy Returns, and…
Have Fun For A Living!
David P. Butler
www.hotspurinvestmentgroup.com
Re: Self Directed Roth IRA - Posted by Peter_MD
Posted by Peter_MD on July 10, 2008 at 05:49:06:
Johnny:
The quick answer is that a Roth IRA account, once established, the contributions are always tax free forever since the contributions are made from after tax (discretionary income). The same income you use to pay for food and gas, etc. However, the earnings in a Roth IRA account are tax free earnings ONLY if the account has been established for 5 years and 1 day at the time the funds are withdrawn from the account and the Roth IRA account holder is at least 59 1/2 at the time of withdrawal. However, there are several exceptions and that is what you would need to pay a CPA to provide advice.
The answer to your specific question is: NO. The IRA must use 100% of the IRA funds to accomplish the transaction.
Every IRA (Individual Retirement Arrangement) established in accordance with IRS requlations can be self-directed. However, the Individual has to comply with the IRA custodian. The custodian has the control to limit investments (direct) the funds to whatever they are involved in (marketing).
The IRA holder cannot involve personal (individual) funds outside of the established IRA account with funds inside of the IRA account. The IRS regulations state this is self-dealing and the IRA holder cannot deal with a disqualified party (the disqualified party is the individual as a person). Therefore, only IRA funds can be used in any transaction involving IRA investments.
Please, you don’t know what you don’t know. Call a CPA and ask questions … or better yet, talk to one at your local Real Estate Investment Group at the next meeting. You should also contact an IRA Custodian (like Pensco or Equity Trust) and ask, ask, ask, questions until you understand the way the rules are established.
The fear is that if you violate any IRS rules (governed now by the Department of Labor regulations), the entire contents of the IRA (includes contributions and earnings), will be considered distributed and a 10% penalty will be charged by the IRS (if the individual is younger than 59 1/2) and the full amount will be considered a distribution and taxed in the year of the violation.
A good CPA and IRA advisor/custodian is needed for someone with a qualified retirement plan such as an IRA.
Ignorance is not bliss in dealing with IRA accounts. Any mistake will be costly.
Best of luck with your future investments.
Not really true - Posted by John Merchant
Posted by John Merchant on July 10, 2008 at 17:17:48:
I’ve had a number of clients buy properties and make HM loans with an LLC.
Sometimes that LLC was owned by one or more SDIRAs and also some of their non-IRA money.
There is case law supporting this and IRS challenges to this strategy have been shot down.