January 2020

In the January Issue

  • Benefits of a Self-Directed IRA
  • How to Start Investing with a Self-Directed IRA
  • How Options Work

Benefits of a Self-Directed IRA

Benefits of a Self-Directed IRA

It’s a common misconception among investors out there today that the best way to prepare for retirement is by growing a portfolio of assets through passive Wall Street investments like mutual funds, stocks, and bonds.

As such, it may come as a surprise to learn that there is another option of which you can take charge. These funds, self-directed IRAs (Individual Retirement Accounts) and 401k funds, are set up to allow you to actively manage your investments.

This strategy is an attractive alternative to the passive approach in that it enables you to grow both your retirement portfolio and diversify your real estate holdings at the same time.

If this is news to you, read on. We’ll show you how to get started with a self-directed IRA and also take a look at how to invest funds into real estate deals with mortgage leverage in a way that avoids burdensome taxes.

How to Start Investing With a Self-Directed IRA

The first step in investing with a self-directed IRA is setting up an account with a self-directed IRA custodian.

Your custodian will guide 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 January 1 and April 15.

Buying Property With a Self-Directed IRA

Once your account is established, 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 $50,000 toward it, you’re left with a $50,000 mortgage. This is common in the traditional space.

In this scenario, you buy the property with 50% leverage and 50% equity, so your IRA gets the leverage of a mortgage. This, however, is where things can get tricky because the self-directed IRA is now subject to UBIT, or “Unrelated Business Income Tax,” an especially burdensome tax which can result in a lot of pain if you haven’t structured your IRA prudently.

Just like trust rates which are among the highest in the code, UBIT tax rates can be very high and onerous.

How to Avoid the Pain of UBIT

To start with, let’s define “Unrelated Business Income Tax,” so we can understand how it applies to self-directed IRAs. In simple terms, UBIT is a tax imposed on nonprofits and professional organizations that don’t pay taxes as regular businesses do in addition to retirement funds such as IRAs and 401Ks which might in some scenarios receive business income as opposed to investment income.

Let’s look at an example as it relates to businesses. Imagine if a nonprofit starts operating a McDonald’s and makes a ton of money in the process. Since nonprofits don’t pay taxes, it would be unfair competition to the McDonald’s operators who do pay income taxes.

To level the playing field, the IRS Tax Code concept would tax the unrelated business income in this hypothetical. Just as the charitable organization running the McDonald’s would be taxed on unrelated business income, so too would a retirement fund be required to pay UBIT in the “50%-50%” mortgage scenario described above in which the self-directed IRA leverages its purchasing power with debt.

Technically speaking, this income is known as “unrelated debt financed income” (UDFI) and it causes UBIT. In the mortgage example above, if $5,000 was generated from the rental of the property, then 50% or $2,500, would be considered UDFI and subject to UBIT.

In short, if an IRA leverages debt to purchase any investment, then the investment income that results from the debt is taxed.

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.

  1. Find a “Financial Friend”
  2. 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.

  3. 1st Lien, 2nd Lien Loan
  4. 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.

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.

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.

Wrap-Up

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.

As always, if you’re interested in learning more about how you can invest in the Tempo Opportunity Fund LLC, please visit https://tempofunding.com/fund/ or contact me, Mike Zlotnik, at mike@tempofunding.com or by phone (917-806-5029). I’ll be happy to forward you the PPM, term sheets, and subscription paperwork or answer any questions you might have.

Please don’t miss the latest Episodes on Big Mike Fund Podcast:

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Thanks for reading,


Mike Zlotnik
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.