Last week, in Part 1 of this article, I emphasized the fact that not all IRAs are created equal. Most people have a stockbroker, mutual fund salesperson, or financial planner set one up for them — and then sit back and allow these people to steer their retirement ship. You are given a menu of financial products to choose from — but your choice is generally limited to products that they sell (and earn a commission on).
In other words, most IRA money is in the stock market. If you want to maximize your yields and returns, this may not be in your best interest. Proof of this is the 2000 stock market debacle, when hundreds of thousands of Americans lost substantial equity in their IRA portfolios. As stocks fell, many people watched their retirement dreams being crushed, while others were set back decades. As I said last week, if I had my IRA holdings in the stock market, I would begin to liquidate and convert my portfolio into non-financial market products like real estate.
You can do this with your IRA . . . if it’s the right kind of IRA. Most Americans have a Traditional or Roth IRA that grants control over the IRA funds to a “custodian” or “trustee.” Usually, these custodians are banks, federally insured credit unions, and savings & loans. More often, they are other entities that have been approved by the IRS, such as stock brokerage firms, mutual funds, financial planners, or insurance companies. The people employed by these entities may understand the financial markets, but they don’t understand real estate.
What’s more, they’re usually not even willing to make a real estate purchase for your IRA, because they wouldn’t make a commission by doing so. So if you want your IRA to buy real estate, you will probably have to change your IRA custodian. There are two types of IRAs that I think you should consider: the Self-Directed IRA and the Check Book Control Self-Directed IRA. Both have the ability to purchase real estate.
The major difference is how the purchase is conducted. A Self-Directed IRA custodian requires you to submit a “Letter of Intent to Purchase” before it approves the purchase of a piece of real estate. The Check Book Control Self-Directed IRA allows you to simply write a check from an LLC (Limited Liability Company) that your IRA creates and elects you manager of. This way, you avoid all of the traditional “red tape” that IRA custodians are notorious for putting people through before approving and funding a real estate purchase.
One caution: A Check Book Control Self-Directed IRA does not give you free rein to buy anything at all for your IRA. You are limited to products that are allowed by the IRS. Okay. So let’s say you have set up a Self-Directed IRA and you are ready to purchase real estate. Now what? The first thing to understand is that an IRA cannot sign a Recourse Note, which is something that 99.99% of all banks require for any real estate purchase.
A Recourse Note is a mortgage that requires the borrower to agree in advance that the lender may seek action against him if the property goes into default and is subsequently sold at a loss (for less than is owed to the lender). You can sign a Recourse Note if you are buying property as an individual — but you CANNOT sign a Recourse Note per a side agreement with the lender for property held by your IRA. Conversely, a NON Recourse Note is a mortgage that does NOT require the borrower to agree in advance that the lender may seek action if the property goes into default and is subsequently sold at a loss. In this case, your IRA CAN sign the note. However, as I said, you can’t get this kind of mortgage from most banks.
This gives you two basic options when buying real estate with your IRA:
(1) You can pay all cash, or
(2) you can pay some cash and use a Non Recourse mortgage for the balance.
There are advantages to both methods. Your age and personal situation will determine which one is best for you. If, for example, you are on the verge of retiring, you should probably pay cash for any rental income real estate you buy. You wouldn’t want the worry of mortgage payments if you ever run into a period of high vacancy. On the other hand, if you are younger, you might want to assume a little risk and incur a mortgage.
In that case, I would suggest a Non Recourse mortgage for 50% – 70% of the purchase. Here is an example of how doing that can greatly increase your yield. Two sisters, Jane and Fern, decide to buy identical side-by-side duplexes. Jane buys hers with $200,000 cash from her IRA funds. She lives in one unit and rents the other one out. Jane receives monthly rental income from her tenant — and, at the same time, the property appreciates in value by 5% per year, or $10,000 the first year. That makes her return on her $200,000 IRA investment 5%. (Because $10,000 is 5% of $200,000.)
Fern also pays $200,000 for her duplex. But because she uses only $50,000 of her IRA funds as a down payment and mortgages the rest, she enjoys a much higher yield. Fern doesn’t wind up with as much monthly income from her rental unit as Jane does, because she has to use most of it to make her mortgage payments. However, her property, too, appreciates by $10,000 the first year. That makes her return on her $50,000 IRA investment 20%. (Because $10,000 is 20% of $50,000.)
Imagine what would happen if Fern were to invest the $200,000 in her IRA in four duplexes, putting $50,000 down on each. She would have $800,000 worth of real estate in her IRA — all of it appreciating every year. And if she were to hold those properties until the mortgages were paid off (maybe 15 or 20 years), she (and some day her heirs) would enjoy a tremendous monthly income generated by rents that also increased over the years. This is the kind of income and security you could look forward to in retirement — if, that is, you get most of your IRA money out of the financial markets and into real estate with a Self-Directed IRA or a Check Book Control Self-Directed IRA.
(Ed. Note: Thomas Phelan is a financial author, an active real estate investor, and a contributing editor to Main Street Millionaire, ETR’s real estate investment education program. He also counsels investors on setting up Self-Directed IRAs and assists real estate investors with setting up tax-deferred real estate sales through 1031 Like-Kind Exchanges. Mr. Phelan was a guest speaker at last year’s ETR Wealthbuilding Bootcamp. You can contact him at Phelany@aol.com.)