Cash Flow To Is Interest Paid Less Net New Borrowing. How to Invest in Commercial Real Estate With Self-Directed IRA Funds

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How to Invest in Commercial Real Estate With Self-Directed IRA Funds

Sunny Doe has been working as an engineer in the Bay Area for over 15 years. Over the years, he contributed to his company’s 401k plan and accumulated more than $350,000 in his IRA rollover account. Although it is very convenient to invest in the stock market, he notices that the mutual fund returns in his IRA account are too low. As he grows up, Sunny faces the reality that his gray hair is not his asset, but could be a problem in the high-tech field. He is also concerned about the volatility of the stock market. On a day when the market is doing well, Sunny likes to check his account balance several times. On a bad day, he feels discouraged and questions his investment decisions. In addition, Sunny wants to diversify its investments, since most of them have been placed on the stock market.

After learning that he can use his self-directed IRA money to invest in real estate, he is motivated because he has been successful in real estate investing where he has more comfort and control. When he learns that 44% of net worth per capita in the US is in real estate, he knows he’s on the right track. After further research, he discovers that money from a self-directed IRA can be used as a down payment.

What is a Self-Directed IRA?

In 1974, Congress passed the Employee Retirement Income Security Act (ERISA), which established the IRA to give us the freedom to design our own Individual Retirement Agreement, or IRA. ERISA allows you to open an IRA account and control the investment of your money. It doesn’t say you have to invest in stocks, bonds or mutual funds. Most IRA companies choose to focus on stocks and mutual funds because it makes business sense for them. It’s like McDonald’s is focusing on fast food and not serving prime rib. So, if you want to have more investment choices besides stocks and mutual funds, you should use the service of a self-managed IRA company. When you open a self-directed IRA, you can use the money to invest in stocks, bonds, mutual funds, real estate, mortgage notes, businesses, precious metals, and other assets.

Self-directed IRA companies

Below are some companies that offer self-directed IRA accounts. The author does not endorse any companies.

  1. Equity Trust Company, (440) 323-5491.

  2. IRA Trust Services, (650) 593-2221.

  3. Pensco Trust, (866) 818-4472.

When you contact these companies for information about their fees, they will usually provide a menu of services and associated fees. Some are based on asset size and/or number of assets, some are based on the services you need.

There are 3 types of self-employed IRAs. You need to know this to understand how they work.

  1. Caretaker: this company holds funds on your behalf and executes your instructions. This is usually a bank or entity that has been approved by the IRS to hold self-directed IRA funds.
  2. Caregiver: this company just holds the IRA funds on its own. This is usually a bank.
  3. Administrator: this company only paper work. It usually works with an administrator or a bank department.

What are some of the prohibited transactions or limitations of a self-directed IRA?

  1. You are not allowed to buy or sell real estate between your IRA and you, your spouse, or your immediate ancestors or descendants.

  2. An IRA owner is not permitted to commingle the funds of a self-directed IRA with his personal funds. However, the IRS allows the IRA owner to use personal funds to pay for unforeseen expenses, e.g. closure costs.

  3. The IRS excludes any personal loan guarantee and treats the violation the same as a withdrawal from an IRA account. Most commercial loans require a personal guarantee. And so funding is the main challenge. Non-recourse commercial loans, where the property itself is the only security, do not require this personal guarantee. However, it is difficult to apply for a loan without recourse. Additionally, most non-recourse commercial lenders are unfamiliar with lending money to a self-directed IRA as the borrowing entity. As a result, they are somewhat hesitant to lend money, especially if the self-managed IRA account is the only entity borrowing from the property. So-called self-directed IRAs and hard money lenders that don’t require personal guarantees literally charge an “arm and a leg” e.g. 8 to 12 percent interest on the loan. Getting financing at a low rate seems to be the hardest part.

Real estate financing with self-directed IRA funds

Sunny has several financing options:

  1. Buy in cash: This is the easiest and most direct way to invest with a self-directed IRA. However, this severely limits the size of his investment properties. Plus, Sunny likes the idea of ​​using someone else’s money to make money.
  2. Get dealer financing: This can work out. However, most sellers prefer to get cash for their properties. A seller who agrees to finance has probably had trouble selling the property. If so, there may be something wrong with the property.
  3. Borrow money from a “self-directed IRA” or hard money lender: These lenders charge very high interest rates ranging from 8% to 12%. Sunny has a big problem with this type of interest rates. The banks will end up keeping all the profits!
  4. Apply for a non-recourse loan: It is quite difficult to qualify for a non-recourse loan as lenders have very strict guidelines such as:

· Borrower must be an experienced commercial real estate investor with a high net worth and stellar credit history. And so Sunny wants to work with a local lender he knows well.

· The property must be on a long-term lease with a national tenant, e.g. Walgreens.

· The property is in good condition and in a good location.

· The loan amount must be large, e.g. at least 1 million USD.

  1. Invest together with other investors: Sunny buys a commercial property together with other investors. All co-owners apply for one loan. As long as he owns less than 20% of the property (this limit is determined by the individual lender), the lender does not require him to submit a loan application and sign a guarantee. This will satisfy the IRS limitation on personal guarantees. Sunny pays the lowest interest rate and can maximize leverage in the best properties. This is the best option for self-directed IRA investors because they co-own the better property at the lowest interest rate.

Income tax: Assuming Sunny deposits 30% and borrows 70% of the money to buy the property, 30% of the income will be tax deferred. That cash flow will go back into his self-directed IRA account. The other 70% of the income attributable to the debt is subject to an income tax called the unrelated business income tax or UBIT tax at the custodial rate. All rental costs and depreciation are deducted from income. Additionally, the first $1,000 of income is exempt from UBIT tax. When the property is sold, the IRA can avoid UBIT and capital gains tax if the debt has been paid off by making principal payments at least one year before the sale.

Property ownership

His IRA account, held by himself, not Sunny Doe, must be the title to the property. For example, if she has a stand-alone IRA account with Pensco Trust, it should be addressed as “Pensco Trust FBO (for the benefit of) Sunny Doe IRA Account”. Pensco Trust will sign all real estate and loan documents on Sunny’s behalf as trustee of his account at the close of custody. Sunny applies for a tax identification number on the IRS website for this entity after completion of custody for income tax filing.

Possible investment scenario

Sunny invests with his brother in a single tenant dialysis center valued at $2 million on a 10-year NNN lease with a net operating income of $150,000 (7.5% cap rate). They form a limited liability company (LLC) to take ownership of the property. The LLC’s operating agreement states that his brother owns 80% and Pensco Trust FBO Sunny Doe’s IRA Account owns 20%. With this arrangement, they apply for a $1.4 million loan (70% LTV) from a national lender and spend a total of $600,000 for a down payment. $120,000 of that $600,000 comes from Sunny’s IRA account as he owns 20%. Since Sunny’s share is initially 20%, only Sunny’s brother needs to apply for the loan and provide financial documents to the lender. The bank also requires Sunny’s brother to sign a personal guarantee; therefore, Sunny does not need to sign a personal guarantee that complies with IRS requirements.

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