Checkbook IRA LLC Pros and Cons with Quincy Long Hosted by Cash Flow Depot (Teleconference)

A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA. These have been under attack by the IRS. Click the link below to listen to Quest IRA President H. Quincy Long talk about the dangers of Checkbook Control IRA LLCs
Click Here To Listen

The Dangers of Checkbook Control IRAs

A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA. These have been under attack by the IRS. Click the link below to listen to Quest IRA President H. Quincy Long talk about the dangers of Checkbook Control IRA LLCs.

Click Here To Listen

Six Widely Held Untruths About Self Directed IRAs

By H. Quincy Long for Self-Directed Source Blog

There is a lot of confusion over self-directed IRAs and what is and is not possible. In this article we will discuss six of the biggest self-directed IRA myths.

1)      Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

FALSE! According to the Internal Revenue Code for IRAs, the only disallowed investments are life insurance contracts and in “collectibles”, which are defined by the IRS to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the U.S. or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

With 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 non-traditional 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, precious metals, limited liability companies, limited partnerships, trusts and a whole lot more.

2) Only Roth IRAs can be self-directed.

False. Because of the superior tax-free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments. As a result, it is a surprisingly common misconception that a Roth IRA is the only account that can be self-directed. In fact, there are seven different types of accounts that can be self-directed. They include 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 any of these accounts invest in non-traditional investments as indicated in Myth 1, but they can be combined to purchase a single investment.

3) I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

False. Almost anyone can have a self-directed account of some type! Although there are income limits for contributing to a Roth IRA (in 2011 the income limits are $179,000 for a married couple filing jointly and $122,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no Roth IRA age limit either. With a Traditional IRA, you or your spouse having a retirement plan at work does 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. Also, a Traditional IRA can 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! It’s the best of both worlds. All of this is in addition to any retirement plan you have at your job or for your self-employed business.

4) If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

False. A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC. Effectively you have “checkbook control” of your IRA funds. Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments. This is simply not true. Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Entrust Retirement Services, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary. Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties. This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes. Nonetheless, you must educate yourself completely as to the rules before deciding on this route. Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!

5) Because I have a small IRA and can only contribute $4,000, it’s not worth having a self-directed IRA.

False. Even small accounts can benefit from non-traditional investing. Small accounts can be co-invested with larger accounts owned by you or even others. 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! There are at least 4 ways you can participate in real estate investment even with a small IRA. First, you can wholesale property.  Simply put the contract in the name of your IRA instead of your name, and have the earnest money come from the IRA. Then, when you assign the contract, the assignment fee goes back into your IRA. 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 acquire property in your IRA subject to existing financing or using a non-recourse loan from a bank, a hard moneylender, a financial friend or a motivated seller. Realize, however, that profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT). Lastly, as mentioned above, your IRA can partner with other IRA or non-IRA investors.

6) An IRA cannot own a business.

False. A self-directed IRA is an astoundingly flexible wealth building tool, and it can own almost anything, including a business. However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid. Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up. Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business. A solution to this problem may be to have the business owned by a C corporation or another taxable entity.

Why Your IRA May Owe Taxes: To Pay or Not to Pay? – That is the Question

By: H. Quincy Long

A. Introduction

Many people are surprised to learn that, as discussed below, there are 2 ways in which an IRA or 401(k) investment in an entity may cause the retirement plan to owe tax on its income or profits from that investment. This does not necessarily mean that you should not make an investment which subjects your retirement plan to taxation. It does mean that you must evaluate the return on the investment in light of the tax implications.

B. Unrelated Business Income (UBI)

The first situation in which a retirement plan might owe tax on its investment is if the entity invested in is non-taxable, such as a limited partnership or an LLC treated as a partnership for tax purposes, and the entity operates a business. Although investment in an entity which is formed for the purpose of capital investment, such as the purchase and holding of real estate, should not generate taxable income for the retirement plan (unless there is debt financing, as discussed below), any income from business operations would be considered Unrelated Business Income (UBI) for the plan. UBI is the income from a trade or business that is regularly carried on by an exempt organization and that is not substantially related to the performance by the organization of its exempt purpose, with the exception that the organization uses the profits derived from this activity. Exclusions from UBI include dividends, interest, annuities and other investment income, royalties, rents from real property (but not personal property), income from certain types of research, and gains and losses from disposition of property (except property which is considered to be inventory).

Example. Ira N. Vestor has a large rollover IRA from a former employer and wants to help out his friend, Will B. Richer, who is starting a new restaurant business. Will offers Ira a 25% ownership interest in his new business, Eat Richer Restaurants, LLC. Ira believes Will is going to be a huge success, and wants to grow his IRA. The LLC will be taxed as a partnership. Ira will not be paid and will have no part in the management or operation of the business. Because the LLC is taxed as a partnership, the IRA must pay taxes on its share (whether or not distributed) of the gross income of the partnership from such unrelated trade or business less its share of the partnership deductions directly connected with such gross income.[1]

C. Unrelated Debt Financed Income (UDFI)[2]

A second situation in which a retirement plan may owe tax is when the plan or an entity invested in by the plan owns debt financed property. Anytime a retirement plan owns debt financed real estate (with a possible exception for 401(k) plans, discussed below), either directly or indirectly through a non-taxable entity, the income from that investment is taxable to the retirement plan as Unrelated Debt Financed Income (UDFI). The amount of income included is proportionateto the debt on the property. Your retirement plan is only taxed on the debt financed portion and not the entire amount of income.

Definition of “Debt Financed Property.” In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the taxable year (or during the 12-month period before the date of the property’s disposal if it was disposed of during the tax year). If your retirement plan invests in a non-taxable entity and that entity owns debt financed property, the income from that property is attributed to the retirement plan, whether or not the income is distributed.

Calculation of UDFI. For each debt-financed property, the Unrelated Debt Financed Income is a percentage of the total gross income derived during a tax year from the property. The formula is as follows:

Average Acquisition Indebtedness x Gross Income from

Average Adjusted Basis Debt-Financed Property

Once the gross UDFI is calculated as above, your retirement plan is entitled to most normal income tax deductions including expenses, straight line depreciation and similar items that are directly connected with income from the debt financed property, plus an automatic deduction of $1,000.

Capital Gains Income. The good news is that if there has been no debt owed on the property for at least 12 months prior to the sale, there is no tax on the capital gains. However, if a retirement plan or a non-taxable entity owned by the retirement plan sells or otherwise disposes of debt-financed property and there has been acquisition indebtedness owed within 12 months prior to the date of sale, the retirement plan must include in its taxable income a percentage of any gain or loss. The percentage is that of the highest acquisition indebtedness with respect to the property during the 12-month period preceding the date of disposition in relation to the property’s average adjusted basis. The tax on this percentage of gain or loss is determined according to the usual rules for capital gains and losses. This means that long term capital gains are taxed at a lower rate than short term capital gains.

Example. Ira N. Vestor wants to use his IRA to invest in a limited partnership, Pay or Go, L.P., which will purchase an apartment complex. The lender requires a 20% cash down payment, and will not permit subordinate financing. Because the property is 80% debt financed, Mr. Vestor’s IRA will owe a tax on approximately 80% of its net profits from the limited partnership (the percentage subject to tax changes as the debt is paid down and the basis is adjusted). When the property sells, Mr. Vestor’s IRA will have to pay capital gains tax on the debt financed portion of the profits. Only the profits from the rents or capital gains from the sale that are attributable to the debt financing are taxable to the IRA. For example, if the gain on the sale of the apartment complex is $100,000, and the highest acquisition indebtedness in the 12 months prior to the sale divided by the average adjusted basis is 75%, then $25,000 of the gain is tax deferred or tax free as is normal with IRA’s, while the IRA would owe tax (not Mr. Vestor personally) on $75,000.

D. Exemption From Taxes on UDFI for 401(k) Plans

One piece of great news for those with self-directed 401(k) plans is that plans under §401 of the Internal Revenue Code (IRC) enjoy an exemption from the tax on UDFI in certain circumstances. This exception to the tax is found in IRC §514(c)(9), and applies only to “qualified organizations.” Qualified organizations include certain educational organizations and their affiliated support organizations, a qualified pension plan (ie. a trust qualifying under IRC §401), and a title-holding company under IRC §501(c)(25), but only to the extent it is owned by other qualified organizations. IRAs are trusts created under IRC §408, not IRC §401, so the real estate exception to the UDFI tax does not apply to IRAs. The good news is that plans such as the Quest Individual (k) Plan do qualify for this exception under the right circumstances.

There are six basic restrictions which must be met for the exemption from the UDFI tax to apply. They are:

1) Fixed Price Restriction. The price for the acquisition or improvement must be a fixed amount determined as of the date of the acquisition or the completion of the improvement.

2) Participating Loan Restriction. The amount of any indebtedness or any other amount payable with respect to such indebtedness, or the time for making any

3) payment of any such amount, must not be dependent, in whole or in part, upon any revenue, income, or profits derived from such real property.

4) Sale and Leaseback Restriction. The real property must not at any time after the acquisition be leased by the qualified organization to the seller of the property or to certain related persons, with certain small leases disregarded.

5) Disqualified Person Restriction. For pension plans, the real property cannot be acquired from or leased to certain disqualified persons described in 4975(e)(2), with certain small leases disregarded.

6) Seller Financing Restriction. Neither the seller nor certain related disqualified persons may provide financing for the acquisition or improvement of the real property unless the financing is on commercially reasonable terms.

7) Partnership Restrictions. Partnerships must meet any one of three tests if the exemption from the tax on UDFI is to apply to the qualified organizations who are partners. First, all of the partners can be qualified organizations, provided none of the partners has any unrelated business income. Second, all allocations of tax items from the partnership to the qualified organizations can be “qualified allocations,” which means that each qualified organization must be allocated the same distributive share of each item of income, gain, loss, deduction, credit and basis. These allocations may not vary while the qualified organization is a partner in the partnership, and must meet the requirement of having a “substantial economic effect.” Third, and perhaps most commonly, the partnership must meet a complex test called the “Fractions Rule” (or the “Disproportionate Allocation Rule”).

Even with the restrictions, there are circumstances where this exemption can work. For example, one client rolled over her IRA into a 401(k) plan she created for her home based interior decorator business. The 401(k) plan then purchased 2 apartment buildings with non-recourse seller financing (which was on commercially reasonable terms). Not only is the 401(k)’s rental income exempt from the tax on UDFI, but so will the capital gains be exempt. If there is a concern about asset protection, a title holding §501(c)(2) or §501(c)(25) corporation can be formed, and the exemption will still apply.

But the best news of all is that we now have the Roth 401(k). Starting in 2006, if your plan allows it, you can defer part of your salary into a Roth 401(k). For 2007 and 2008, the maximum salary deferral into a Roth 401(k) plan is $15,500 ($20,500 if you are 50 or over). This doesn’t include the profit sharing contribution of the plan which can be up to 25% of the wages or net income from self-employment. Although the salary deferrals are post tax (meaning you still have to pay income, social security and Medicare taxes on the amount deferred into the plan), qualified distributions from the account are tax free forever. Unlike the Roth IRA, there is no maximum income restriction. Combining the power of an Quest self-directed Roth 401(k) and the real estate exception for 401(k) plans under IRC §514(c)(9) means you can use Other People’s Money to purchase real estate and NEVER PAY TAXES on the income and capital gains!

E. Frequently Asked Questions on Unrelated Business Income Tax (UBIT)

Q. If the profits from an investment are taxable to an IRA, does that mean it is prohibited?

A. Absolutely not! There is nothing prohibited at all about making investments in your IRA which incur tax.

Q. But if an investment is taxable, why make it in the IRA?

A. That is a good question. To figure out if this makes sense, ask yourself the following key questions. First, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA? For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain! Second, what plans do you have for re-investing the profits from the investment? If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc. At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have. Third, what would you pay in taxes if you made the same investment outside of the IRA?[3] The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA. Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment.

Q. If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?

A. Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA). The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investment which will cause the IRA to pay taxes. Also, bear in mind that companies which are publicly traded also pay taxes before dividends are paid, and the value of the stock takes into consideration the profits after the payment of income taxes. In that sense, even stock and mutual funds are subject to “double taxation.” In my view, the double taxation issue should not be your focus, but rather merely a factor in your analysis. Is the IRA glass 1/3 empty or 2/3 full? At least the IRS is a silent partner.

Q. If the IRA makes an investment subject to tax, who pays the tax?

A. The IRA must pay the tax.

Q. What form does the IRA file if it owes taxes?

A. IRS Form 990-T, Exempt Organization Business Income Tax Return.

Q. What is the tax rate that IRAs must pay?

A. The IRA is taxed at the rate for trusts. Refer to the instructions for IRS Form 990-T for current rates. For 2005, the marginal tax rate for ordinary income above $9,750 was 35%. Capital gain income is taxed according to the usual rules for short term and long term capital gains. Remember, in the case of UDFI the IRA only pays tax on the income attributable to the debt and not 100% of the income.

Q. Where can I find out more information?

A. Visit our website at www.QuestIRA.com for more information. Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered in IRS Publication 598, which is freely available on the IRS website at www.irs.gov. The actual statutes may be found in Internal Revenue Code §511-514.

F. Solutions to the UBIT “Problem”

Is there any way to get around paying this tax? The short answer is yes. Investments can often be structured in such a way as to avoid taxation. Dividends, interest, investment income, royalties, rents from real property (but not personal property), and gains and losses from disposition of property (unless the property is debt financed or is considered “inventory”) are all excluded from the calculation of taxable income to the retirement plan. Some examples of how you might structure a transaction in ways that are not taxable to the retirement plan include:

Example. Suppose in the Eat Richer Restaurants, LLC example above the LLC elected to be treated as a corporation instead of a partnership, or a C corporation was formed instead (IRA’s may not own shares of an S corporation). Because the entity has already paid the tax, the dividend to the IRA would be tax free or tax deferred. This may not be acceptable to other shareholders, however.

Example. Instead of his IRA directly in Pay or Go, LP, Ira N. Vestor could have made a loan instead. The loan could have been secured by a second lien on the property (which may not be permitted by the first lienholder, however). The loan could even be secured by shares of the LP itself, possibly with a feature allowing the loan to be converted at a later point to an equity position in the LP (a “convertible debenture”). Caution: With lending there may be state or federal usury limits on how much interest may be charged, and if the debt is converted into equity the IRA may then owe taxes at that time.

Example. Another choice for investing without the IRA paying taxes is to purchase an option instead. When your IRA owns an option to purchase anything, it can 1) let it lapse, 2) exercise the option, 3) sell or assign the option (provided the option agreement allows this) or 4) release the owner from the option for a fee (in other words, getting paid not to buy!).

G. Conclusion

From a financial planning perspective, the question becomes “Should I avoid doing something in my IRA which may incur UBIT?” Many people just say “Forget it!” when they learn a certain investment may subject the IRA to UBIT. Or worse yet, they ignore the issue and hope they won’t get caught. However, being afraid of UBIT is short sighted and ignores the opportunity it presents for building massive wealth in your retirement plan. Remember, making an investment which may subject the IRA to UBIT is not a prohibited transaction, it just means the IRA has to pay a tax. The best financial advice on UBIT is simple: “Don’t mess with the IRS!” If the IRA owes UBIT, make sure it is paid. After analyzing a transaction, you may come to the conclusion that paying UBIT now in your IRA may be the way to financial freedom in your retirement. Like I often say, “UBIT? You bet!”

The Truth About Self-Directed IRAs and Other Accounts

There is a lot of confusion over self-directed IRAs and what is and is not possible.  In this article we will disprove some of the more common self-directed IRA myths.

 

Myth #1 – Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

Truth:  The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles”, which are defined to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the United States or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

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.

 

Myth #2 – Only Roth IRAs can be self-directed.

Truth: Because of the power of tax free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments.  As a result, it is a surprisingly common misconception that a Roth IRA is the only account which can be self-directed.  In fact, 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 in Myth #1, but they can be combined together to purchase a single investment.

 

Myth #3 – I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

Truth: Almost anyone can have a self-directed account of some type.  Although there are income limits for contributing to a Roth IRA (in 2008 the income limits are $169,000 for a married couple filing jointly and $116,000 for a single person or head of household), having a 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, you or your spouse having a retirement plan at work does 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.  Also, a Traditional IRA can 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!  It’s the best of both worlds.  All of this is in addition to any retirement plan you have at your job or for your self-employed business.

 

Myth #4 – I can’t have a self-directed 401(k) plan for my business because I am self-employed and file a Schedule C for my income.

Truth: You can have a self-directed SEP IRA, a SIMPLE IRA or a 401(k) plan even if you are self-employed and file your income on Schedule C of your personal tax return.  With a SEP IRA, you can contribute up to 20% of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C) or 25% of your wages from an employer, up to a maximum of $46,000 for 2008.  With the SIMPLE IRA, you can defer up to the first $10,500 of your net earnings from self-employment (calculated by multiplying your net Schedule C income by 0.9235% for SIMPLE IRA purposes), plus an additional $2,500 of your net earnings if you are age 50 by the end of the year, plus you can contribute an additional 3% of your net earnings as an employer contribution.  Beginning in 2002 even self-employed persons are entitled to have their own 401(k) plan.  Better yet, in 2006 the Roth 401(k) was added, allowing even high income earners to contribute after tax dollars into an account where qualified distributions are tax free forever!  With an Individual 401(k) you can defer up to $15,500 (for 2007 and 2008) of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C), plus an additional $5,000 of your net earnings if you reach age 50 by the end of the year, plus you can contribute as much as an additional $30,500 based on up to 20% of your net earnings for 2008 (or 25% of your wages from an employer).  This means that a 50 plus year old self-employed person can contribute up to $51,000 for 2008!

 

Myth #5 – Because I have a small IRA and can only contribute $5,000, it’s not worth having a self-directed IRA.

 Truth: Even small balance accounts can participate in non-traditional investing.  Small balance accounts can be co-invested with larger accounts owned by you or even other people.  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!  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, this profit is tax-free forever!  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, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.

 

 Myth # 6 – If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

 Truth: A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC.  Effectively you have “checkbook control” of your IRA funds.  Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments.  This is simply not true.  Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Quest IRA, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary.  Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties.  This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes.  Nonetheless, you must educate yourself completely as to the rules before deciding on this route.  Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!

 

Myth #7 – I can borrow money from my IRA to purchase a vacation home for myself.

 Truth: Although 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 disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. 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.

As a result of these legal restrictions, a loan from your IRA or staying at a vacation home owned by your IRA, even if fair market rates are paid for interest or rent, would be prohibited.

 

Myth #8 – With a self-directed IRA, I can borrow my IRA funds to purchase real estate and then put all the profits back into the IRA.

 Truth: When real estate or any other asset is purchased within a self-directed IRA, the money never leaves the IRA at all.  Instead, the IRA exchanges cash for the asset, in the same way that an IRA at a brokerage house exchanges cash for shares of stock or a mutual fund.  Therefore, the asset must be held in the name of the IRA.  For example, if Max N. Vestor were to purchase an investment house in his self-directed IRA, the title would be held as “Quest IRA, Inc. FBO Max N. Vestor IRA #12345-11.”  Since the IRA owns the asset, all expenses associated with the asset must be paid by the IRA and all profit resulting from that investment belongs to the IRA, including rents received and gains from the sale of the asset.

 

 Myth #9 – If my IRA buys real estate, it must pay all cash for the property.  An IRA cannot buy real estate with debt.

 Truth: An IRA can own debt-financed property, either directly or indirectly through a non-taxed entity such as an LLC or partnership.  Any debt must be non-recourse to the IRA and to any disqualified person.  An IRA may have to pay Unrelated Debt Financed Income Tax (UDFIT) on its profits from debt-financed property.  In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt.  For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable.  Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth.  The same leverage principle applies inside or outside of your IRA – you can do more with debt-financing than you can without it.  One client was able to build her Roth IRA from $3,000 to over $33,000 in less than 4 months even after paying the taxes due by taking over a property subject to a debt and selling the property to another investor!

 

 Myth #10 – An IRA cannot own a business.

 Truth: A self-directed IRA is an amazingly flexible wealth building tool and can own almost anything, including a business.  However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid.  Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up.  Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business.  A solution to this problem may be to have the business owned by a C corporation or another taxable entity.

Frequently Asked Questions About Buying Debt Financed Real Estate in an IRA

Good news!  You can buy real estate in your traditional, Roth, SEP, or SIMPLE IRA, your 401(k), your Coverdell Education Savings Account for the kids, and even in your Health Savings Account.  Even better, your IRA can borrow the money for the purchase or even take over a property subject to existing financing.  What could be better than building your retirement wealth using OPM (Other People’s Money)?  However, there are some restrictions which you must be aware of when using your IRA to purchase debt financed real estate.  Below I answer a series of frequently asked questions regarding the purchase of debt financed real estate in an IRA.
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Q.        Is it really legal to buy real estate in an IRA?

A.        Yes.  Even the IRS agrees that real estate is a permitted investment.  In its answer to the question “Are there any restrictions on the things I can invest my IRA in?” the Internal Revenue Service states “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”

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Q.        Can my IRA buy real estate with a loan or take over a property subject to an existing loan?

A.        Yes.  An IRA may borrow money to acquire real estate or take over a property subject to an existing loan, provided that the loan is non-recourse to the IRA and to any “disqualified person.”  This means that typically the lender may only foreclose on the property in the event of a default.  Even if there is a deficiency, the lender cannot come after the rest of the IRA’s assets, nor can the lender come after the IRA owner or any other disqualified person.  Neither the IRA holder nor any other disqualified person is permitted to sign a personal guarantee of the debt.

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Q.        Where can I get a non-recourse loan for my IRA?

A.        There are at least four sources for financing which do not violate the non-recourse requirements for IRA’s.  First, there is seller financing.  Most sellers understand that if the loan goes into default they get the property back anyway, so asking for the loan to be non-recourse should not be too difficult to negotiate.  Second, there is private financing from financial friends.  If you cultivate a reputation as a professional real estate investor, there should be no reason that your financial friends would not loan your IRA money on a non-recourse basis, either from their own funds or from their own IRA’s.  I have seen

IRA’s borrow the money for both the purchase and the rehab on a non-recourse loan!  Third, there are banks and hard money lenders.  Non-recourse loans are not the norm, so many banks will turn you down.  However, there is at least one bank that lends in all 50 states, and in Houston I have had at least 3 local banks and 2 hard money lenders make non-recourse loans to IRA’s.  Finally, as mentioned above, you could take over a property subject to an existing loan, provided the originator of the loan is not you or another disqualified person.

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Q.        Is there any tax effect of having an IRA own debt financed real estate?

A.        Yes.  Income and gains from investments in an IRA, including real estate, are normally not taxed until the income is distributed (unless the distribution is a qualifying distribution from a Roth IRA, a Coverdell Education Savings Account, or a Health Savings Account, in which case the distribution is tax free).  However, if the IRA owns property subject to debt, either directly or indirectly through an LLC or a partnership, it may owe tax on the net income from the property or partnership.

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Q.        If the profits from an investment are taxable to an IRA, does that mean it is prohibited?

A.        Absolutely not!  There is nothing prohibited at all about making investments in your IRA which will cause the IRA to owe taxes.

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Q.        But if an investment is taxable, why do it in the IRA?

A.        That is a good question.  To figure out if this makes sense, ask yourself the following key questions.  First, what would you pay in taxes if you made the same investment outside of the IRA?  The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA.  Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment.  Second, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA?  For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain!  Third, do you have plans for re-investing the profits from the investment?  If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc.  At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have.

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Q.        If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?

A.        Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA).  The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investments which will cause the IRA to pay taxes.  Keep in mind that companies which are publicly traded already have paid taxes before dividends are distributed, and the value of the stock takes into consideration the profits after the payment of income taxes.  In that sense, even stock and mutual funds are subject to “double taxation.”

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Q.        If the IRA makes an investment subject to tax, who pays the tax?

A.        The IRA must pay the tax.

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Q.        What form does the IRA file if it owes taxes?

A.        IRS Form 990-T, Exempt Organization Business Income Tax Return.

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Q.        What is the tax rate that IRA’s must pay?

A.        The IRA is taxed at the rate for trusts.  Refer to the instructions for IRS Form 990-T for current rates.  For 2005, the marginal tax rate for ordinary income above $9,750 was 35%.  Capital gain income is taxed according to the usual rules for short term and long term capital gains.

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Q.        Is there any way to get around paying this tax?

A.        Yes.  In some ways it may be considered a “voluntary” tax, since investments can often be structured in such a way as to avoid taxation.  Some ways to structure your IRA investment to avoid taxation include loaning money instead of acquiring the real estate directly or purchasing an option on the real estate, then assigning or canceling the option for a fee.  These techniques have a disadvantage in that they may not result in as much profit to the IRA, but will generally be free of tax.  There is also an exemption from this tax for 401(k)’s and other qualified plans in certain circumstances.

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Q.        Where can I find out more information?

A.        Visit our website at www.QuestIRA.com for more information.  Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered inIRS

Publication 598, which is freely available on the IRSwebsite at www.irs.gov.  The actual statutes may be found in Internal Revenue Code §511-514.

There is one general truth that applies both inside and outside of an IRA – you can do more with debt than you can without it.  Despite the increased risk from debt and the taxes due on income from debt financed property, a careful analysis may lead to the conclusion that having your IRA pay taxes now may be the way to financial freedom in your retirement.  Be sure to have your IRA pay the tax if it owes it, though.  As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!”

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Buying Real Estate in Your IRA

1.  Who is H. Quincy Long and why do I care?

H. Quincy Long, who holds the designation of CISP (Certified IRA Services Professional), is CEO/President of Quest IRA, Inc., a self-directed IRA third party administrator with offices in Houston, Dallas, and Austin, Texas as well as Mason, Michigan.  Mr. Long has been a licensed Texas attorney since 1991 who specializes in real estate, and has been a fee attorney for American Title Company.  He has sat on the board of directors of the Realty Investment Club of Houston (RICH), the second largest real estate club in the country.  Mr. Long received his Doctor of Jurisprudence law degree in 1990 from the University of Houston.  He received his Master of Laws, also from the University of Houston, in 1997.

Mr. Long is also the author of numerous articles on self-directed IRAs and other real estate related topics, and is editor and co-author of the book Real Estate Investment Using Self-Directed IRAs and Other Retirement Plans by Dyches Boddiford and George Yeiter, CPA.

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Mr. Long knows real estate and real estate investing. This can be critical to you when choosing a self-directed IRA custodian or administrator, especially if you want to buy real estate or real estate related products in your IRA.

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2.         What does Quest IRA, Inc. do?

Quest IRA, Inc. (www.QuestIRA.com) is a third party administrator of self-directed IRAs in Houston, Dallas, and Austin,Texas, as well as Mason, Michigan. Quest IRA, Inc. is the leading provider of self-directed retirement account administration services.  Quest IRA has been in business since 2003 with over $400MM in assets under management.  As a neutral party, Quest IRA does not offer any investments and therefore has no conflicts of interest with what our clients want to do with their IRAs.  Quest allows you to be in total control of your retirement wealth.

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3.         As a real estate professional, how can knowledge about self-directed IRAs put money in my pocket now?

For those of you who are investors, you can make other people aware that they actually have more money to invest in real estate than they thought since they can use their IRAs to buy real estate.  In other words, your knowledge of self-directed IRAs can increase your pool of eligible buyers for your properties.  Also, you can help others transfer their retirement funds into a self-directed IRA, then you can borrow those funds to make your own investments – in other words, you can create your own private bank!  Finally, you can make your own retirement wealth grow with your knowledge and experience in real estate by buying and selling through your own self-directed IRA.

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4.         What is the difference between a “self-directed IRA” and a regular IRA?

There is no legal distinction between a “self-directed IRA” and any other IRA.  The difference is simply this:  Quest lets you take control of your retirement by letting you invest your IRA in what you know best.  There are 2 different sets of rules that govern what you can do with your IRA.  First, there is the Internal Revenue Code, which has surprisingly few restrictions.  Second, there is your account agreement with the custodian.  With most custodians you are restricted in the type of investments you can buy in your IRA.  Quest allows you the maximum amount of control and flexibility.  Almost anything that can be documented can be held in your Quest self-directed IRA.

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5.         Which types of IRAs does Quest IRA offer?

  • Quest offers almost all types of retirement plans, including:
  • Traditional IRAs
  • Roth IRAs
  • SEP IRAs
  • SIMPLE IRAs
  • Individual 401(k)s, including the NEW Roth 401(k)
  • Coverdell Education Savings Accounts (formerly Education IRAs)
  • Health Savings Accounts (HSAs)

All of our plans are self-directed, and all of them can hold the same type of non-traditional assets, such as real estate.

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6.         How much can I contribute to my IRA?

Roth and Traditional IRAs -   $4,000 for 2007 (increased to $5,000 for 2008) plus $1,000 catch-up if you are age 50 or over by the end of the year.

SEP IRAs – 25% of your wages (or up to 20% of your net earnings from self-employment) up to a maximum of $45,000 for 2007 and $46,000 for 2008.  Contributions can be made up to the employer’s tax filing deadline, including extensions (if you are self-employed, you are the employer).

SIMPLE IRAs – $10,500 salary deferral plus $2,500 catch-up if you are 50 or over for 2008 plus up to 3% of your salary matched by your employer.

Profit Sharing/401(k)s – $15,500 in salary deferral for 2007 and 2008, plus catch-up deferral of $5,000 if you are age 50 or older by the end of the year plus 25% of your wages (or 20% of your net earnings from self-employment) up to a maximum of $45,000 for 2007 and $46,000 for 2008 (excluding the catch up contribution of $5,000).

Coverdell ESAs (formerly Education IRAs) – $2,000 per year until the child is age 18.

Health Savings Accounts (HSAs) – $2,850 for individual coverage in 2007 ($2,900 for 2008) and $5,650 for family coverage in 2007 ($5,800 for 2008) plus $800 catch-up for 2007 ($900 for 2008) if you are over age 55.

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7.         What kinds of investments can be made in an Quest IRA self-directed IRA?

  • You have the broadest possible choice of investments, including:
  • Real Estate, including debt-financed and foreign real estate
  • Deeds of Trust
  • Real Estate Options
  • Lease Options
  • Unsecured Notes
  • Oil and Gas Interests
  • Small, non-publicly traded corporate stock
  • Limited Liability Companies
  • Limited Partnerships
  • Factored Invoices
  • Discounted Commissions
  • Security Agreements and Notes
  • Tax Lien Certificates
  • Foreclosure Property
  • Joint Ventures
  • Race Horses
  • Publicly traded stocks and mutual funds
  • and a whole lot more…

It should be made clear that you are not taking a distribution to purchase these assets.  All assets are purchased within the IRA, and all profits stay in the IRA!

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8.         Is it really legal to buy real estate in your IRA?

Yes, absolutely!  The Internal Revenue Code does not tell you what you can do with your IRA, only what you cannot do.  Besides restrictions on purchasing life insurance and most collectibles in your IRA, nearly everything else is fair game.  Unless your IRA is self-directed, however, your custodian may not allow investments in real estate.

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9.         Can I partner with my IRA or with other peoples IRAs?

Your IRA can always partner with other people individually or with other people’s IRAs.  Under certain circumstances you personally may be able to partner with your IRA.  However, the burden of proving that you received no impermissible benefit from your IRA’s participation in the investment will be on you if the IRS ever questions the transaction.  The transaction still must be an arms-length transaction, and the investment remains subject to the same restrictions as if the entire investment were in your IRA.  In general it is better to separate your IRA’s investments from your own investments.

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10.       I only have a small IRA.  How can I buy real estate?

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, this profit is tax-free forever!  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, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.

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11.       Can an IRA buy debt-financed property?

Yes.  Any debt must be non-recourse to the IRA and to any disqualified person.  An IRA may have to pay UBIT on its profits from debt-financed property.  In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt.  For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable.  Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth.  The same leverage principle applies inside or outside of your IRA.  You can do more with debt-financing than you can without it.

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12.       Could my IRA be classified as a “dealer?”

It is possible that an IRA could be classified as a dealer.  The same principles for determining whether you are a dealer personally also apply to your IRA.  If the IRA is classified as a dealer, it would be considered to be running an unrelated trade or business, and the IRA would have to pay UBIT.  Remember, it is not illegal to do things in your IRA that incur UBIT.  Your IRA just has to pay taxes.

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13.       Can I sell a property I now own to my IRA?

No.  Although the IRS has very few restrictions on the types of investments which are permissible in an IRA, there is a list of “disqualified persons” who are prohibited from dealing with your IRA or benefiting from its investments.  The list of disqualified persons includes you, your spouse, your parents, your children, their spouses, certain business partners and key employees and persons providing services to your plan, among others.  Interestingly enough, the definition of disqualified persons does NOT INCLUDE non-lineal descendants or ascendants, so if the transaction is an arms length transaction your IRA may be able to transact business with your brother or sister, aunt or uncle, cousins, etc.  However, you should be aware that there is an element of danger in transacting business with any person in whom you may have an interest which affects your best judgment as a fiduciary of your IRA, as this could be considered to be a prohibited transaction.

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14.       Can I receive a fee for managing property owned by my IRA?

No.  The prohibited transaction rules are intended to make sure that you receive no current benefit from your IRA other than as the beneficiary of the IRA.  Investments must be arms-length and exclusively for the benefit of your IRA.

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15.       If I am a Realtor, can I receive a commission for property bought or sold by my IRA?

No, for the same reasons stated in the prior answer.  Anything that creates a possible conflict of interest with your IRA is likely to be a prohibited transaction.  Why take money that is tax-free or tax-deferred and pay taxes on it now anyway?

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16.       Can I collect rents and do other management without compensation?

Most likely the answer is yes, although this has never been tested in court to our knowledge.  An interesting question is how much can you do before your service to your IRA constitutes an excess contribution?  In any event all checks must be made out directly to your IRA.

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17.       I like the sound of this, but can you give me specific, real life examples of what has been done in an Quest self-directed IRA?

Example 1 – Wise Roth Conversion.  Dapper Don has two Quest IRA self-directed IRAs a traditional IRA with money from his former employer’s retirement plan and a Roth IRA.  Don found a small piece of property in the country with a mobile home on it, which he could acquire for about $12,000. Don realizes the high profit potential of this transaction, but has insufficient funds in his Roth IRA to do the deal. Because Don will have modified adjusted gross income of less than $100,000 this year, he decided to convert $12,000 from his traditional IRA into his Roth IRA. Only seven weeks after his Roth IRA purchased the property, it was sold to the neighbor for $30,000. Although Don must pay income taxes on the $12,000 he converted from his traditional IRA to his Roth IRA, the $18,000 in profit from the transaction is TAX-FREE FOREVER!

Example 2 – Note Secured by Real Estate.  Savvy Sam borrows money from Rich Rodney’s IRA at Quest IRA.  Sam agrees to pay Rodney’s IRA 15% interest with no points and a 3 month minimum term on the loan.  Before Sam can even finish the repairs, he gets an offer on the house.  Sam accepts the offer, and they close within 6 weeks.  Sam is ecstatic because he made $20,000 with no money from his pocket.  Rich Rodney is very happy too because Sam paid his IRA 90 days of interest at 15% and only kept the money outstanding for 6 weeks!

Example 3 – Rehabbing a House.  Rehabber Rhonda buys a house needing substantial repairs for $101,000 cash in her Quest IRA.  Rhonda spends approximately $30,000 from her IRA on the rehab.  The property is sold in 6 months for $239,000.  After the cost of the purchase, rehab, closing costs, holding costs and selling costs, Rhonda’s IRA nets approximately $94,000 on the deal.

Example 4 – Co-Investing With an IRA.  Wise Wally invests $5,000 from his SEP IRA at Quest IRA and Wally’s father invests an additional $5,000 on a house purchased for $10,000 cash.  Although the house could be called a junker, the rental income is $400 per month, which of course is split equally between Wally’s IRA and Wally’s father (the tenants send separate checks).  Wally believes that eventually this neighborhood will be bought up by developers because of its location right on the lake.  In the meantime, Wally expects to recover his acquisition expenses from the rental income in less than 3 years, even after payment of property taxes.

Example 5 – Purchase and Simultaneous Resale of Real Estate.  QuickQuincy finds a commercial piece of land and puts it under contract in his Roth IRA for $500,000. Quincy’s IRA pays the earnest money. Quincy then contacts a major home improvement chain about buying the land.  After some negotiation, the store chain and Quincy’s IRA agree to a sales price of $650,000.  At closing,Quincy’s IRA buys the property from the seller and simultaneously sells the property to Barry’s retail store chain. Quincy’s Roth IRA nets approximately $146,000 after payment of closing costs.

Example 6 – Assignment of a Contract.  Awesome Annie gets a contract on a burned out house in the Coverdell ESA of her daughter, Smart Sally, for $5,500 cash with a $100 earnest money deposit.  Annie locates Investor Ingrid, who is willing to pay $14,000 for the house.  Sally’s Coverdell ESA assigns the contract to Ingrid, and at closing Sally’s Coverdell ESA gets a check for $8,500.

Example 7 – Buying Real Estate With a Loan.  Realtor Rose is a full-time real estate agent who at times purchases rental real estate for her own investment portfolio.  Rose locates 2 properties that she wants to buy in her SEP IRA at Quest IRA.  The houses Rose wants to buy cost about $210,000.  Rose has a good relationship with a local bank, and they are willing to loan Rose’s IRA the money she needs with only 10% down on a 5 year, 6.5% interest, non-recourse note.

Example 8 – Buying Property Subject to a Lien.  FantasticFlorence finds a property which is subject to nearly $100,000 in delinquent property taxes and is about to be foreclosed on by the taxing authorities.  She contacts the owner and buys the property in her Roth IRA at Quest IRA for around $3,000 (including closing costs).  The owner just wants to be rid of the headache. Florence’s IRA sells the property to an investor 3 1/2 months later and her IRA nets approximately $46,500 from the sale. Florence’s IRA will have to pay Unrelated Business Income Tax (UBIT) of about $13,500, but even after payment of taxes her IRA will be worth around $33,000 in only 3 1/2 months!

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18.       How can I find out more?

a)      Visit our website at www.QuestIRA.com.  The website has a real estate tour showing you step by step how to buy and sell real estate in your IRA.

b)      Call us at 281-492-3434 or toll-free 800-320-5950.

c)      Email Quincy Long at Quincy@QuestIRA.com.

d)     Sign up for our IRA and 401(k) Insights quarterly email newsletter.

e)      Plan on attending our next 8-hour or 3-hour MCE seminar and learn all about self-directed IRAs.

Top 10 Things You Need to Know About Self-Directed IRAs

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 “self­directed” 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 acount 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 benefiting 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 IRA’s many free networking and educational events. You can get the entire schedule of events in addition to playing pre­recorded 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 with offices in Houston and Dallas, TX and Mason, MI. 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.

Top Ten Things You Need to Know When Investing in Real Estate Notes with Your IRA

Investing in real estate notes with your IRA is one of the most popular self-directed IRA investments available. But with this popularity comes common mistakes when people lend their IRA (and non-IRA) money out, secured by liens on real estate. Follow these 10 tips to avoid potentially costly mistakes when choosing real estate as an IRA self-directed investment.

 

1) You may end up owning this piece of real estate if your borrower defaults. Never loan on something you wouldn’t want your IRA to own. The risk of loaning your IRA investments toward real estate notes is matched by the reward: I routinely see yields from these loans at 12% and higher; however, borrowers can default and you may be left with the property in foreclosure. If you would be upset by the potential of taking over this property in foreclosure, you probably should not make the loan.

 

2) Do not advance IRA money for home repairs until the repairs are finished; then have the repairs inspected before advancing the money. This is one of the biggest mistakes that I see clients make with their IRAs. They fund the full loan amount expecting that the repairs will be done on the property, but the borrower will actually need a little more money on another. If the loan goes bad, the IRA could end up with a property that hasn’t had the necessary repairs.

 

3) Do not loan money to someone you would feel uncomfortable foreclosing on. William Shakespeare wrote in Hamlet, “Neither a borrower nor a lender be/ For loan oft loses both itself and friend/ And borrowing dulls the edge of husbandry.” For the most part, I cannot agree with this advice, because lending and borrowing money drives our economy and increases economic activity. However, the part about a loan losing a friend is absolutely correct, in my opinion. If foreclosing on your borrower would cause you heartache, it is better not to make the loan. I have seen friendships destroyed over a loan gone bad.

 

4) If the loan goes into default, take action immediately. No one wants to admit that he or she has made a mistake in self-directed investing, but delaying action can be costly. You can always stop the foreclosure process once it has begun, but you cannot complete the process unless you start it.

 

5) Collect interest monthly so you will know if the borrower is getting into trouble. Many borrowers, especially investors, would prefer to pay interest at the end of the loan. But this exposes the lender to additional risk. The purpose of collecting payments monthly is both to:

 

  • Make sure the borrower remembers that he or she has to do something with that property in order to avoid the pain of the payment
  • Let you know if the borrower is in trouble because he or she starts missing payments

 

Keep in mind that unless you have contracted for monthly payments, you may not be able to foreclose, even if you do discover that the borrower is in financial trouble, because the loan may not be in default. This has actually happened to some of my clients.

 

6) If you are unsure about how to evaluate the loan, hire a professional to help you. Although a hallmark of the self-directed IRA is that it is “self-directed” — meaning that you make your own decisions and find your own investments — most IRA owners either do not possess sufficient knowledge or, in my case, sufficient time, to properly evaluate a loan transaction. My solution is to hire a professional to help me with the deals. He checks out the borrower, coordinates with the title company, orders the appraisal and usually a survey, makes sure insurance is in place and generally evaluates the loan. Naturally, he charges a fee for this service, which is passed through to the borrower on top of any interest and fees that my retirement plan may charge. This increases the cost of the loan; but in this case, the non-Biblical version of the golden rule applies, which is “He who has the gold makes the rules.”

 

7) Get title insurance for the loan. The purpose of title insurance is to shift risk away from you and to the title company. In Texas, where my office is, the incremental cost of title insurance is very small when issued in conjunction with an owner’s title policy. Regardless of the cost, making sure that your IRA is protected from title flaws is important.

 

8) Verify that hazard and, if necessary, flood insurance is in place, naming your IRA as an additional insured. It is very easy to miss this issue when you are trying to get everything completed right before a closing. Borrowers may get insurance at the last moment and simply forget to add your IRA as an insured. But if something goes wrong, you will want to make sure your IRA is named on the check.

 

9) Insist that the borrower provides you with evidence of payment when property taxes and homeowners association fees become due. The same thing would apply to hazard and flood insurance premiums, although normally you would receive notice of cancellation for non-payment of those bills. Depending on where you live, property tax bills can increase quickly due to penalties and court costs, which reduces your equity position in the property.

 

10) Get a personal guarantee if lending to an entity or to an individual with some weakness. When things are going well, you might be tempted not to insist on a personal guarantee, and indeed many borrowers will resist this. However, as we all have discovered recently, circumstances do change, and a personal guarantee may be helpful in collecting the debt. I collected on a note once where the property had decreased substantially in value due to vandalism and market conditions. Instead of foreclosing, I had my lawyer send a letter explaining to the guarantor, who had a significant amount of assets, that he was personally liable on the debt and that if he were unable to satisfy the note, I would pursue legal action against him and the borrower. A week later, a cashier’s check showed up that satisfied the lien.

 

There’s more to know when considering real estate for your self-directed IRA
This list of suggestions is not meant to be exhaustive. Other issues you will need to understand include:

 

  • Your lien position (personally, I only invest in first-lien loans)
  • Any state usury laws that might apply to the loan
  • At least a general idea of what the foreclosure process is in your state, in case the loan goes into default

 

Always get good legal counsel to assist you with loan documentation. Because the borrower traditionally pays for all expenses including legal fees, there is no reason not to have an attorney draw up loan documents.

 

Lending can be an excellent investment in an IRA. It is relatively easy to do and, if done correctly, has a comparatively low risk. Getting to know successful real estate entrepreneurs who borrow your IRA money may also lead to other, intangible benefits as well. Finally, be sure to learn the pointers for buying real estate with your self-directed IRA before you take any actions.

 

H. Quincy Long is a certified IRA services professional (CISP) and an attorney and is the president of Quest IRA, Inc., with offices in Houston and Dallas, Texas, as well as, Mason, Michigan. Email him at Quincy@QuestIRA.com.
Nothing in this article is intended as tax, legal or investment advice.