*** Disclaimer: I am not an accountant, lawyer, or financial advisor! You should consult with a qualified professional before acting on any of the opinions shared in this post!!! ***
Self directed IRAs have become very hot among investors with the rise in popularity in alternative investments such as real estate, gold, and cryptocurrency. They allow retirement account owners to invest money in assets that your traditional IRA or 401k would not. Typically they have been restricted to Wall Street type products like stocks, bonds, and mutual funds. Typically around this time of year, investors are looking at maximize their retirement account contributions before the April 15th tax filing deadline.
Something really stupid I have seen people doing is buying real estate using their Self Directed IRA. It's stupid for a multitude of reasons, here's why:
1.) Real estate is illiquid. Retirement accounts are illiquid (at least until you reach an age to start taking distributions.) Why would you want to double down on the biggest risk involved with real estate, liquidity risk? Besides, I am not even a fan of tax advantaged accounts like IRAs and 401ks because you cannot do what you want with your OWN money. I value being nimble and having options. This scenario is very restrictive.
2.) Lack of leveragability. One of the best parts of the real estate asset class is that it is a hard asset. Banks love hard assets as collateral and therefore allow you to leverage them. Which means you can buy and control a $100k for $20k essentially or whatever your bank will allow you to do. This allows you to scale multiples on your net worth over time. For example. Let's say you buy a property for $100,000, all cash, no leverage. Let's say that property appreciates 3%, pretty average for Rochester, NY in good locations. Let's say you sell that property for $103,000. That $3000 return on investment yielded you 3% return on your money. Now, lets say you buy that same building and put bank financing on it. So you put $20,000 down and have your bank put a $80,000 mortgage on it. The property appreciates 3% or by $3,000. $3,000/$20,000 = 15% return on investment. Plus you can buy 5 properties using that same type of leverage; much better for building your long term wealth! With Self Directed IRAs (SIDRA), you cannot use bank financing in this way. Why not? Because most bank financing requires personal guarantees, something strictly prohibited by the IRS in Internal Revenue Code Section 4975, therefore precluding you from using leverage. There might be come convoluted ways in which to get around this but at the end of the day usually doesn't make sense.
3.) Lack of tax benefits. Yes, SIDRAs and other tax advantaged retirement vehicles have tax advantages in their own right but it ends up stripping out one of the greatest part of owning investment real estate, depreciation! Depreciation is an expense that you take "on paper" each year you own a piece of investment property. When you own desirable real estate assets in great locations, you pay for it. You usually have a higher cost basis when you buy great property. You can take a certain portion of that basis as an expense each year. Often times that expense synthetically wipes out positive cash flow while you own the property. Assuming a dollar today is worth more than a dollar tomorrow (it's a fact, look up "Time Value Of Money"), the less you pay in tax today, reinvest those tax savings, it's quite simply explosive to building your net worth over time.
So now that I've thoroughly trashed buying real estate with your SIDRA, you should know some tactics on how to use your SIDRA to grow your real estate business. One tactic that is my favorite is making loans out of my SIDRA. Loans that are backed by real estate. You can make loans out of your SIDRA with interest rates and terms more attractive than typical private or hard money. Why would you do this?
If you have a reciprocal relationship with another investor with a SIDRA, you can loan them money to help them grow their real estate business and they can lend you money to help you grow yours, without the crushingly brutal rates of some hard money lenders.
Another way to invest is by investing in an LLC or special purpose vehicle as a limited partner (silent partner) and partnering with the managing person of that LLC in exchange for an equity stake. Again, it would still be best to do this not using your retirement accounts for reasons stated above, but if it's the only way for you, it's the only way! The only caveat is to make sure that whatever bank financing that investor is using will allow your IRA to own membership interest in that deal without having to sign a personal guarantee. Usually you can avoid personal guarantees by having your IRAs membership interest at 19% or less in that LLC. What are your thoughts on this? Do you invest in real estate with your SIDRA?
This blog serves an an outlet for all of our invaluable team members to share their insight on development, property management, and all things affecting real estate in our community.