With the current downturn in the stock market and the likelihood that interest rates will remain low in the long term, there has been considerable interest in investing self directed 401(k) or IRA funds in real estate.
Ironically, there seems to be a direct correlation between the surge of interest in this area and the lack of accurate information about it. There are several fallacies promoted as fact about this kind of investment. I would like to address each of them in turn.
Fallacy #1 – This kind of investment is not considered appropriate by the IRS
This is flatly untrue. It has been perfectly legal to purchase real estate with your IRA funds since 1974 and to direct any profits, whether rental or capital, back to your IRA. You can also use your IRA funds to pay for the maintenance fees and development, decorative and other upgrade or modernization work on your real estate holdings.
Where the confusion lies is that any real estate investments you make may not be used by yourself or your immediate family, otherwise the ‘profit’ you make from their use would be regarded as a withdrawal from your IRA and subjected to the usual taxes and penalties.
While the IRS is sometimes accused of not reading its own code, what this actually means is that your parents, grandparents, children and grandchildren may not use the property for any purpose. Yet your brother or sister and their family may. So, if, for example, you invested in a holiday property in Mexico, your brother, sister in law and their children can use it for their holidays and pay you the rental but you couldn’t go and stay with them during their vacation.
Fallacy #2 – If it’s legal, why haven’t I heard of it until now?
Who would tell you, your current financial advisor? They will only let you invest your IRA in investments that their firm offers because they earn a commission off what they sell you. At a bank you will be limited to CDs. At a brokerage firm you will be limited to stocks and bonds.
There are any number of companies that help investors take their IRA cash and use it to purchase real estate for investment purposes or for any other legal investment purpose. The company’s representatives who do this are called ‘IRA Custodians’ or ‘Self Directed IRA Custodians’ – depending on the exact financial arrangements you have made.
Third-party IRA custodians look after your investments and will advise you on the kinds of choices – stocks, shares, bonds, mutual funds, CDs, business opportunities or real estate – you can make. They retain a degree of control over the disposition of funds and over the writing of checks.
Self directed IRA custodians are not allowed to advise you on your investment choices. They are mainly there to help you properly and legally administer your funds and to avoid accidentally making withdrawals or incurring penalties and taxes.
Both types of custodian take fees – and there is considerable variation in the rates charged and the services offered. So it pays to shop around.
This contrasts with the behavior of traditional investment community which has control over 97% of retirement accounts and has been making considerable profit from it for over 30 years. They have no motivation to inform you of alternatives that would be of no benefit to them.
As investors become ever more depressed and disappointed with poor investment returns in traditional funds, they want to take control of their own investments and to make more tangible investments such as real estate or more profitable ones such as business ventures.
But the response of their current custodians is that such investments are either illegal, over complex, too expensive or simply un-doable – advice which is neither objective, impartial or factual.
So in order to take advantage of these opportunities, investors have to take their business elsewhere.
Fallacy #3 – It is prohibitively expensive to invest in real estate
In Publication 590, ” Traditional IRAs”, you are prohibited from taking the following actions with your IRA -
* borrowing money from it
* selling property to it
* receiving unreasonable compensation for managing it
* using your IRA as security for a loan
* buying property for personal use (present or future)
These regulations do not prevent you from using your IRA funds to purchase investment property outright. Nor does it prevent you borrowing money (through a non-recourse loan) or using other people’s IRA in partnership in order to part fund the investment.
(An alternative route is to take a low-cost option to buy a property within 60 days and, if you manage to find a buyer at a higher price, you can make an immediate profit for with little up-front cash.)
Neither of these routes makes it prohibitive to procure real estate. Real estate investments should not eat up all your cash, particularly if you partner with others.
Not being permitted to receive unreasonable compensation for managing your IRA is not the same as not being permitted to receive reasonable compensation. If you check out the fees charged for administration as long as you stay within the current price range available on the market you cannot be accused of being ‘unreasonable’.
I have already covered the restrictions on buying property. But it should clarified that ‘future’ use does not preclude you taking your property out of your IRA after you have reached 70 ½ when you are forced to take distributions and using it as a retirement home or vacation property.
Fallacy #4 – Real estate investment is trouble with a capital T
Real estate prices have been undergoing a considerable boom in prices over the past few years, but, despite the obvious gains, it is often considered a risky and troublesome form of investment with at least as many headaches as owning your own home. You may have to find tenants, or improve the property before selling it, or just maintain it.
All of this is true, but there are people and companies who will do this for you. Arguments that this will eat away at your profit leading to a poor final return on your investment are also fallacious as fees are charged for all investments you make. The difference is that you can see where the fees are applied and what you are getting for your money.
In addition, you gain some advantages over the stock market – lower risks, less market volatility, property insurance. While mutual funds and corporate stock have both been subjected to sudden and sharp nosedives over the past few years and slow and uninspiring recoveries. Nobody insures you against the loss of investment funds in the stock market. Ask Enron’s investors!
Fallacy #5 – Real estate funds are not liquid investments
It’s difficult to see why this argument is put forward in what has been a seller’s market for several years. Besides when has liquidity been the only benefit on a losing proposition in the stock market? And, at least until IRA funds are available for withdrawal, liquidity is not going to benefit most investors.
Fallacy #6 – Real estate investment is riskier than the stock market
It is difficult to comprehend how anyone could believe that real estate is more risky than the stock market. While it is true that in the long run the stock market returns a solid 10% per year overall, the danger in the short term is that any gains can be wiped out by a sudden drop in the market or in individual stock. Companies can afford this risk, individuals on the other hand cannot.
It is true that real estate prices can also drop, but this normally happens only in very unusual circumstances. Prices do not fluctuate the same way they do on the stock market.
So when given the choice be it owning and managing investment property or taking the cash from your IRA and investing it in an S&P 500 index fund, you are being given the choice between sticking all your eggs in one shaky basket or properly diversifying your holdings and increasing your money earning opportunities. The choice is obvious. Nor is the advice ever to put all your funds into real estate either. About 25 to 40 % of your portfolio should go into real estate and the rest into other more traditional investments. The percentage will depend of course on the level of risk, the investment’s profit potential, and on your individual financial position.
Nor are property returns less than those in the stock market. On average the stock market returns 10%; property returns in recent years have been as high as 23 % a year. Ideally, when you self direct your IRA if you can locate pre-construction projects, lend your IRA funds and participate in an equity position you can compound the rate of return. Your return on investment therefore can be much higher without turning a wrench, fixing a leaky faucet or swinging a hammer. Best of all, all the gain goes into the IRA either tax free or tax deferred.
By diversifying your holdings you can invest in several different kinds of assets so that you can weather any investment climate from a bear market to a real estate crash.
Real estate deals are therefore no more and can be a lot less risky than other forms of investment. However, as with any financial deal, you should do your homework first and run the numbers with your financial advisor.
Fallacy #7 – My CPA, my financial planner and Family Lawyer understand all there is to know about self directed IRAs
Your family attorney, financial planner, and CPA are unlikely to be experts in self directed IRA regulations and self directed IRA investing market. For specialized expert advice, you should add a self directed IRA advisor to your advisory team, in the end their advice will save you both time and money. Of course, you should check out the company the Better Business Bureau, your state’s Attorney General’s office and make sure they comply with any state licensing requirements.
* With poor stock market performance likely to continue now is the time to think about diversifying your holdings
* Real estate IRA investment is legal and need not be overly expensive, complicated or inconvenient
* You should take the time to thoroughly investigate the process, the self directed IRA custodian and his or her company before you sign any documents
* You should run the numbers with an independent financial advisor
* Remember signing with a self directed IRA custodian does not oblige you to buy real estate – you can make any of the traditional investment choices as well as considering other lucrative business or property ventures
* You don’t have to buy real estate solely from cash in your funds you can borrow money or work in partnership with others
* All investments carry risk but using real estate to diversify your holdings can also give you protection against stock market vagaries
To find out more, simply go to Google.com and type in “use IRA cash to invest in real estate.”