In the January Issue
- How to Invest with Self-Directed IRAs
- What is UBIT?
- How to Use Options to Protect Your Appreciation
- Example of a Successful Investment
Take Control with a Self-Directed IRA
You may have been led to believe that preparing for your retirement by growing your portfolio of assets is limited to only investing passively in the likes of mutual funds, stocks, and bonds. What you may not know is with the power of a self-directed IRA (Individual Retirement Account), you can actively control the direction of your investments. In this newsletter, we’ll show you how to use this powerful tool to grow your retirement portfolio and diversify your real estate holdings at the same time.
The first step in investing with a self-directed IRA is setting up an account with a self-directed IRA custodian.
There are a few custodians we’ve worked with in the past that have excellent track records. We’re not endorsing any custodians, but here are a few we recommend:
- New Direction IRA Inc.
- Quest IRA
- Kingdom Trust
You can also ask your friends and colleagues about custodians they’ve had experience with, good or bad.
The custodians will walk you through the process of selecting which type of account to set up (Traditional vs Roth IRA, for example) and will explain ways to fund the account via a rollover or transfer.
Also, we suggest you ask your CPA about funding the IRA so that you maximize the tax benefits of doing so.
Note: you’re allowed to count allocated funds toward last year’s or this year’s taxes when you complete the transaction between Jan 1 and April 15.
Buying Property with a Self-Directed IRA
Once your account is set up, you can now direct your custodian to buy a property with cash or get the proper financing needed. For example, if a property costs $100,000 and your IRA custodian pays $40,000, you are left with a $60,000 mortgage. This is common in the traditional space.
In this scenario, you buy the property with 60% leverage and 40% equity, so your IRA gets leverage of a mortgage. The challenge is that the IRA is now subject to UBIT. Let me explain.
UBIT: The Deal Killer
UBIT stands for, “Unrelated Business Income Tax.” The IRS came up with this concept and imposes it on IRA accounts, non-profits, and professional organizations that don’t pay taxes.
The UBIT is a heavy tax that you might not know about until it hits you like a brick wall.
What does this mean for your potential self-directed IRA investment? It means that all the leftover income will be subject to the UBIT tax. But that’s not all, any appreciation that gets captured in the property resale will also be hit with the UBIT tax.
UBIT tax rates can be very high, the same level as trust rates which are some of the highest taxes. See below.
The rate at which the IRA leverage will be taxed
If your IRA bought the property in full for cash, then there’s no UBIT, but if your IRA bought the property for cash with 60% leverage, that 60% is subject to UBIT.
The Best Ways to Invest with Self-Directed IRAs
To get the most from your investment, there are two strategies we recommend when using self-directed IRAs: the power of lending money and the power of options.
Find a “Financial Friend”
When an IRA gets a loan and takes the property title directly, they are typically subject to higher interest rates from lenders because the IRA cannot guarantee the mortgage. Lenders also provide less money, so the LTV is around 50%-60%. Not a good scenario.
The more valuable route is to find a financial friend who can obtain a Fannie Mae, Freddy Mac conventional mortgage and get a 75%-80% LTV. This financial friend, however, needs good credit and cannot be a “prohibited party” meaning they cannot be a lineal ascendant or descendant (parent or offspring).
So who is eligible to be a financial friend? Brothers, sisters, aunts, uncles…. As long as they are not of your lineal line, they can help.
1st Lien, 2nd Lien Loan
Ideally, your financial friend obtains a Freddie Mac Mortgage, putting 20% or 25% down and in turn gets a 75-80% mortgage at a better rate than term in contrast to the 50%-60% LTV if the IRA obtained the first lien loan.
However, what if they are unable to provide the down payment fund? Here’s the solution. Your financial friend obtains a 1st lien mortgage in their name, and the down payment funds would come as a loan from your IRA. Meaning, your IRA comes in and makes a loan of the second lien mortgage on the property for all the funds necessary to close.
The idea is the financial friend just bridges the money for a couple of days. This way your financial friend will not be out-of-pocket any of his/her own money. The IRA will make a loan on the same property in second position, behind the first lien from Fannie Mae or Freddie Mac, and provide all the down payment funds to your financial friend.
Compare and Contrast Self-Directed IRA Strategies
A Note of Caution
While buying and selling properties in this manner is legal, there is a chance you could still get hit with UBIT if you buy and sell too often.
The IRS rules state that if an IRA is involved in a trading business, in theory, it can be subject to UBIT. We recommend no more than 2 or 3 deals a year to be on the safe side.
This scenario, however, is incredibly powerful because your IRA can now grow at an accelerated pace. But how can you capture any upsight your property may get? That’s where options come into play.
Use Options to Protect Your Property’s Appreciation
We’ve mentioned them a few times, but let’s delve deeper into how to use options to get the most out of your self-directed IRA investment.
The second lien note captures all the income of the property in the form of interest payments to the IRA custodian, but if the property appreciates, how do you catch that appreciation?
The IRA will buy an option on the property using a separate transaction for a small consideration. Let me give you an example.
How Options Work
A property is purchased with no money down and a second lien loan for $200,000. The IRA purchases a 20 year option for $2,000 at a strike price of $205,000 as a separate transaction. They now have the right to exercise the option for the next 20 years.
This option will capture virtually all the upsight above the strike price. In turn, the option combined with the second lien loan result in full control of the property.
The power of options should not be underestimated. The income derived from purchase and sale of the option is perfectly suited for IRA since capital gains are not subject to UBIT.
Example of a Self-Directed IRA Purchase
Now that we have discussed self-directed IRAs and options, let’s put these two strategies together. Our financial friend agrees to purchase a property for $100,000 with a down payment of $25,000 and a Freddie Mac mortgage of $75,000. After collecting rent of $1,000 and paying PITI, the net-operating income is $350/month.
The IRA makes a second lien loan of $30,000 (covers down payment and closing costs) to the financial friend at an interest rate of 12% a year, resulting in a $300 monthly payment. Virtually, all the cash flow is going as an interest payment to the IRA on a second lien loan. Here’s the beauty of that…. The interest collected by the second lien loan is perfectly acceptable to the IRS, meaning there is no UBIT tax.
Now, let’s add in options. The IRA buys a 20 year option on the property for $1,000 at a strike price of $105,000. After the 20 years, the property appreciates from $100,000 to $200,000, so the option captures all the upsight above the strike price, $95,000.
In summary, the second lien loan from the IRA plus the option results in full control of the property. The second lien loan provides the down payment funds and earns a high interest rate while the option controls all the upsight.
It’s a beautiful deal.
While we only discussed long-term scenarios, self-directed IRA investments can be implemented in the short term as well. There’s nothing preventing an IRA from getting a shorter term loan on a property.
Using self-directed IRAs and options to purchase properties is an incredibly powerful technique that anyone should consider. When working together they can drastically build up your retirement fund; they also provide the added benefit of expanding and diversifying your real estate portfolio.
If you have any further questions about self-directed IRAs please contact us and we’ll be happy to talk with you and answer any questions you may have.
Thanks for reading,
CEO, TF Management Group LLC
This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor.
TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.