By H. Quincy Long for the Self-Directed Source Blog
Have you wanted to buy real estate in your IRA but think you don’t have enough money? Think buying a small property for all cash is your only choice?
Nothing could be further from the truth.
You can invest in real estate using your IRA without a lot of money in several ways, including buying property with debt, partnering with other investors (IRA or non-IRA money), or even utilizing seller financing. However, in this article we will discuss one of the most powerful and grossly underutilized tools in real estate investing today – the option.
Option Basics and Motivation
Let’s focus on some option basics. First, what is an option? Once consideration for the option is paid, an option is the owner’s irrevocable offer to sell the property to a buyer under the terms of the option for a certain period of time. The buyer has the right but not the obligation to buy. The terms of the purchase are binding on the seller at the discretion of the buyer.
Why would an owner agree to tie up his property with an option? Advantages to a property owner are many, and include: 1) the owner may be able to time his income for tax purposes, since option fees are generally taxable when the option is either exercised or expires (always check with your tax advisor); 2) if the owner needs money (for taxes, for example), an option may be a way to get money that he doesn’t have to repay, unlike a loan; 3) options are very flexible, and the owner may be able to negotiate an option which allows him to keep the property until a more opportune time – this is especially true of an owner in a pre-foreclosure situation.
Paperwork is Everything!
Options are extremely powerful and very easy to mess up. Get the paperwork right up front! So what forms do you use? The answer is my favorite as a lawyer – it depends! There is not and cannot be a “standard” option for all purposes. They are simply too flexible. You must decide on a specific use for the option and then be very specific, clear and complete about all the details. Remember, with options, you have to negotiate for both the terms of the option and for the terms of the purchase of the property.
Crucial Terms to be Negotiated and Documented
With a well written option, there is a fairly length list of terms to be negotiated and documented in the contract, including:
a) Who is granting the option? Does it include heirs, successors and assigns?
b) Who is receiving the option? Does it include assignees of the buyer, or is it an exclusive option to purchase by the buyer only?
c) What property is being optioned? Property can be anything, including real estate, a beneficial interest in a land trust, a real estate note or nearly anything else.
d) What is the consideration for the option? Remember, there must be some consideration for the option in the form of money, services or other obligations.
e) How is the option exercised by the buyer? This is one of the easiest things to mess up in an option. If the procedure is not clear for exercising the option, it is an invitation to litigation!
f) What will be the purchase price of the property if the option is exercised?
g) How will the purchase price be paid when the option is exercised? Will it be for cash? Seller financing? Subject to the owner’s existing mortgage?
h) Will the option consideration be credited to the option price or not?
i) When can the option be exercised? For example, does the option holder have the right to exercise the option at any time during the option period, or can the option only be exercised after a specified amount of time?
j) When will the option expire, and under what circumstances? The option should have a definite termination date, but might also include other circumstances under which the option terminates, such as a default under a lease.
k) When it comes time to close, what are each party’s obligations? For example, who pays for title insurance, closing costs, etc? Are taxes prorated?
Five potential outcomes exist once an option is created. They are:
Expiration. When you have negotiated and executed an option agreement for your IRA, the first of several choices is to let the option expire on its own terms. Sometimes this is the best course of action if the deal is not what you expected, especially if you only paid a small amount for the option. The consideration paid for the option is retained by the seller.
Extension. If closing within the originally agreed upon timeframe in neither possible or practical, but you still desire to exercise the option, you may wish to negotiate an extension, either by paying additional option consideration, changing the price, or altering some other terms. Be sure to document this extension as carefully as you did the original option.
Exercise. Another choice is that your IRA could exercise the option and buy the property. Since there are ways to finance property being purchased by your IRA, including seller financing, bank financing, private party financing or even taking over property subject to a loan, this may be a good strategy for your IRA, even if the IRA does not have the cash to complete the purchase. Be aware that if your IRA owns debt financed property, either directly or indirectly through an LLC or partnership, its profits from that investment will be subject to Unrelated Business Income Tax (UBIT). This is not necessarily a bad way to build your retirement wealth, but it does require some understanding of the tax implications.
Assignment. A fourth choice is to assign your option to a third party for a fee. Your option agreement should specifically allow for an assignment to make sure that there are no problems with the property owner. This is a great technique for building a small IRA into a large IRA quickly. I had one client who put a contract on a burned house for $100 earnest money in his daughter’s Coverdell Education Savings Account, then sold his contract to a third party who specialized in repairing burned houses for $8,500. In under one month the account made a profit of 8,400%, and all parties were happy with the deal! The account holder then immediately took a TAX FREE distribution to pay for his daughter’s private school tuition.
Cancellation. A fifth choice that sometimes is overlooked but ideal in the context of self directed retirement accounts (for capital preservation) is the ability to release the option back to the property owner for a cancellation fee. In other words, this is a way for your IRA to get paid not to buy! Let me give you an example of how this might work. Suppose you want to offer the seller what he would consider to be a ridiculously low offer. When the seller balks, you say “I’ll tell you what. You sign this option agreement for my IRA to purchase this property at my price, and we’ll put in the option agreement that I cannot exercise my option for 30 days. If you find a buyer willing to offer you more money within that 30 day period, just reimburse my IRA the option fee plus a cancellation fee of $2,500.” Either way, your IRA wins!
The creative use of options is one of the most powerful ways to make your IRA or 401K grow astronomically. If used correctly, options maximize the leverage of a small account and offer significant flexibility for the option holder.