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Real Estate Investing: Using Your IRA Funds

Many real estate investors don't realize or understand how to invest their IRA funds into into real estate investment property. You can purchase nearly anything, as long as you don't use the property as a personal residence or as your place of business. You can also rent the purchased investment property to anyone who is not a disqualified person, and use the monthly payments to grow your IRA.

Buying real estate from an unrelated party (i.e., one who is not a disqualified person) with cash is the simplest way of investing in real estate with your IRA. Your IRA can buy raw land, commercial property, residential (e.g., rental) property, real estate options, as well as extend loans to unrelated parties on real estate that is secured within your IRA.

Basically, there are two ways to invest in real estate:

The Easy Way:

If you have your IRA purchase real estate investment property from an unrelated party and pay cash for it, and you do not use the real estate investment for personal reasons while it is in your IRA (i.e., you treat it strictly as an investment), there are no special issues.

The More Complex Way:

If your IRA invests in investment property through a down payment and leveraging, there are some significant issues:

1. You cannot personally guarantee a loan for your IRA;
2. Some custodians will limit the amount of debt the IRA can carry (limit is usually 50%);
3. It may be difficult to get a bank to allow an IRA to be the debtor without a personal guarantee;
4. Your IRA will pay tax on UDFI (unrelated debt financed income), which is the income and/or capital gains attributable to the leveraged portion. (UDFI is taxed at the trust tax rate because an IRA is a trust.)

As a consequence, although it is PERFECTLY LEGAL, it may not be desirable to have an IRA carry debt in a real estate investment transaction.

Once you have decided to invest your IRA money in real estate here are several types of property that continuously top the list of IRA investments:

Residential Investment Property - This includes not only single-family houses but also multi-family houses, condominiums, and mobile homes. The primary purpose of real estate investors in purchasing one- to four-family housing is to either generate income from rent or take advantage of the property's appreciation over the span of ownership. Another strategy would be to buy a handyman's special-a house that requires extensive remodeling and repair-for a low price, fix it up and resell it at a profit.

When buying an investment property with your IRA, real estate investors must keep certain rules in mind. As a real estate investor, you cannot live in the house until you retire. You cannot use it as collateral for any loan-not even a loan on the property you're buying with your IRA. But your IRA-purchased house can have many benefits. First and foremost, when rented, the investment property can provide your IRA with a steady stream of income. Moreover, when well cared for, houses tend to hold their value, so you will rarely if ever experience a loss. And in many cases, you can buy a house with relatively little money down.

Condominiums - If the thought of maintaining a house and finding tenants seems too time consuming, the purchase of a condominium might be a good alternative. Condominiums are often good investment choices simply because they can often be placed in a rental pool, managed by a single individual or a company.

Commercial Property - Real estate that is generally used by retail, wholesale, office, hotel, or service businesses are often better investments than houses because businesses can afford to pay rents of higher per-square-foot value. Also, in most cases commercial lease agreements stipulate that the tenant is responsible for the upkeep of the leased space. The downside is increased risk. As a commercial property owner, your income is dependent on the success of your tenant�s business.

Loans - It is possible to borrow money to buy property with your IRA. However, you must use the IRA-purchased property-not the IRA itself-as security for the loan (a non-recourse loan).

Tenancy-in-Common Ownership - In this form of ownership, each of two or more people has an undivided interest in the property, without the right to survivorship. With a tenancy-in-common arrangement, you can buy property with several partners, with each person putting in the amount of money he or she has available. Each will own a certain percentage of the property. Then, as time goes on, each will get a proportionate share of the annual income and, ultimately, a share of the sale profits based on ownership percentage. Tenancy-in-common ownerships also allows you to use both IRA funds and discretionary funds to buy a single investment. The possibilities are obviously endless and completely legal.

Limited Liability Companies - When an IRA doesn�t provide sufficient funds for the purchase, and neither loans nor tenancy-in-common ownership provides a solution, another excellent option is the limited liability company, or LLC.
The LLC is a combination of a corporation and a partnership in which each party buys shares or membership interests in the LLC, which holds title to the property, according to the funds he has available. The LLC limits personal liability to each of the parties involved, so that members cannot lose more money than they contributed. However, an LLC is taxed not like a corporation, but like a partnership, in that earnings are taxed only once, with the taxes being paid individually by the members.

Real Estate Notes - The purchase of notes, as well as investments in income-producing properties, is where the real money is made in real estate. Real estate notes can be an attractive investment because real estate ownership is an ongoing management concern and it can take constant work to maintain the upkeep of the property. However, when you buy a note secured with real estate, it is the responsibility of the borrower to maintain the property. Purchasing notes is a very secure investment as the borrower has made a promise to pay you a certain amount, usually monthly. If the borrower fails to meet his promise, you will have the right to foreclose on his property.

The following are county sites for tax certificate sales:
www.bidmiamidade.com
http://www.brevardtaxcollector.com/taxcol2.htm

WHAT YOU CAN'T DO IN AN IRA WITH REAL ESTATE:

1. You cannot directly or indirectly buy real estate from a "disqualified person". That begs the question, who is a disqualified person?
- The IRA owner;
- The IRA owner's spouse, descendant (e.g., son), or ascendant (e.g., mother);
- Spouse of a descendant of the IRA holder;
- A fiduciary of the IRA or person providing services to the IRA (e.g., the trustee or custodian);
- An entity at least 50% of which is owned (or at least 50% of the beneficial interests are held) by a combination of the above (e.g., if you and your spouse own 50% of an LLC, that LLC is a disqualified entity with respect to your IRA);
- A 10% owner, officer or director, or other highly compensated employee of such an entity.

2. You cannot have your IRA enable an investment for yourself or another disqualified person. In other words, if the IRA's investment is deemed essential to accomplishing a transaction in which both you and your IRA invest, then the transaction would be considered a prohibited transaction.

Your IRA funds cannot purchase a real estate asset and then have a disqualified person use it while it is in the IRA. For example, you cannot buy a vacation home and use it partly for personal use, even though you might rent it to unrelated persons the rest of the year.

WHY YOU HAVEN'T HEARD ABOUT THIS INVESTMENT OPPORTUNITY BEFORE

Now that you understand some of the basics of investing IRA money in real estate you may wonder why you haven�t heard much about this type of investment. The answer is simple, even though there aren't any rules to keep you from investing IRA funds in real estate, it is downplayed by many banks and other administrators such as stock brokerage houses and insurance companies because those banks and insurance companies only make money by selling their own products to an IRA account holder. It is not in their financial interest to have IRA money tied up in real estate as that money obviously can't be out there buying stocks, bonds, or other investment vehicles.

RISKS:
As with any investment, there are risks. However, when investing IRA funds in real estate, a minimum-risk return is about 12 percent. Such low-risk investments�low-loan-to-value first-position notes, for instance-have about zero chance of going awry. It is highly improbable that you will lose your interest much less your principal. Moreover, it is also highly possible to raise the return to 20 percent and still keep the risk relatively low, and you can even boost it to 25 percent or even 35 percent if you�re willing to take a moderate risk. It's true that moderate-risk investments, such as the purchase of real estate through LLCs, can put your profit, as well as a portion of your principal at risk, but ample due diligence can make even these investments fairly safe.

On the other hand, it is our opinion that the stock market is high-risk. Market gains and losses are not controlled by the common man. There are forces at work that are mysterious at best. More often than not, you cannot predict the rise or fall of a particular stock with any degree of certainty. Pension losses during 2001 and 2002, all tied to the stock market, are legendary.

Non-liquidity of Real Estate: We agree that real estate is not as easy to turn into cash as stocks are. However, in a rapidly moving investment vehicle such as the stock market, liquidity is extremely important because you have to be able to bail out quickly when your stock takes a nosedive. But when you are in a slower-moving product, such as real estate, you have much more time to get out if needed. The real estate market telegraphs its moves well in advance, so if you are attuned to the market, you will have ample time to liquidate.

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