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

Sunny Doe has worked as an engineer in the Bay Area for over 15 years. Over the years, she contributed to her company’s 401K plan and accumulated over $350K in her IRA rollover account. Although it is very convenient to invest in the stock market, she finds that the returns on the mutual funds in her IRA account are below the returns. As she gets older, Sunny is faced with the reality that her gray hair isn’t her asset, but could be a handicap in the high-tech field. She is also concerned about the volatility of the stock market. On a day when the market is doing well, Sunny enjoys checking her account balance several times. On a bad day, she feels discouraged and questions the investment choices made. In addition, Sunny also wants to diversify her investments since most of it has been placed in the stock market.

After learning that you can use money from a self-directed IRA to invest in real estate, you are motivated as you have had success in real estate investments where you have more comfort and control. Learning that 44% of net worth per capita in the US is in real estate, he knows he’s headed in the right direction. Upon further investigation, 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 enacted the Employee Retirement Income Security Act (ERISA) that established IRAs to give us the freedom to make our own Individual Retirement Agreement, or IRA. ERISA allows you to open an IRA account and control the investment of your money. It didn’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 focuses on fast food and doesn’t serve prime rib. So if you want to have more investment options than just stocks and mutual funds, you should use a service of a self-directed IRA company. Once 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 of the companies that offer self-directed IRAs. The author does not endorse any company.

1. Capital 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 on their fees, they typically 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-directed IRA companies. You need to know this to understand how they work.

1. Custodian– This company holds the assets on your behalf and executes your instructions. This is typically a bank or entity approved by the IRS to hold self-directed IRA assets.
2. Trustee: This company only owns the assets of self-directed IRAs. Usually it is a bank.
3. Administrator: this company just does the paperwork. He usually works with a trustee or a division of a bank.

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

1. You are not allowed to buy or sell property between your IRA and you, your spouse, or your immediate ascendants or descendants.

2. An IRA owner is not allowed to mix Self-Directed IRA funds with their personal funds. However, the IRS allows an IRA owner to use personal funds to pay incidental charges, such as closing costs.

3. The IRS excludes any personal collateral for the loan and treats the violation as a withdrawal from an IRA. Most business loans require personal guarantees. Therefore, financing is the main challenge. Non-recourse business loans where the property itself is the only collateral do not require this personal collateral. However, it is difficult to apply for a loan without recourse. Also, most commercial non-recourse lenders are not familiar with lending money to a self-directed IRA as a borrowing entity. Therefore, they are somewhat hesitant to lend money, especially when the self-directed IRA is the only borrowing entity on the property. So-called self-directed IRAs and hard money lenders that don’t require personal guarantees literally charge “an arm and a leg,” for example, 8% to 12% interest on the loan. Therefore, obtaining financing at a low rate seems to be the most difficult part.

Financing for Properties with Self-Directed IRA Funds

Sunny has several financing options:

1. buy cash: This is the easiest and most direct way to invest with funds from a Self-Directed IRA. However, this puts a major restriction on the size of your investment properties. Also, Sunny loves the idea of ​​using someone else’s money to make money.
2. Get the seller to finance: This may work. However, most sellers prefer to get cash for their properties. The seller who agreed to provide financing probably had trouble selling the property. If so, there may be a problem with the property.
3. Borrow money from a “self-directed IRA” or hard money lender: These lenders charge very high interest rates, from 8% to 12%. Sunny has a big problem with this type of interest rate. The banks will end up pocketing all the profits!
4. Request a loan without recourse: It is quite difficult to qualify for a non-recourse loan as lenders tend to have very strict guidelines, for example:

Borrower must be an experienced commercial real estate investor with high net worth and stellar credit history. So Sunny wants to work with a local lender who knows him well.

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

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

The loan amount must be large, for example, at least $1 million.

5. Invest together with other investors: Sunny buys a commercial retail property along with other investors. All co-owners apply for a loan. As long as you own less than 20% of the property (this limit is set by the individual lender), the lender does not require you to submit a loan application and sign any guarantees. This will comply with the IRS restriction on personal guarantees. Sunny pays the lowest interest rate and can maximize leverage on the best properties. This is the best option for self-directed IRA investors, since they are co-owners of a better property at the lower interest rate.

income tax: Assuming Sunny deposits 30% and borrows 70% of the money to purchase the property, 30% of the income will be taxed deferred. This cash flow will go back into your Self-Directed IRA. The other 70% of the income attributable to debt is subject to income tax called Unrelated Business Income Tax or UBIT tax at the fiduciary rate. All rental and depreciation expenses are deductible from income. Also, the first $1,000 of income is exempt from UBIT tax. When property is sold, the IRA can avoid UBIT and capital gains tax if the debt was paid off with principal at least one year before the sale.

property title

Your self-directed IRA, not the Sunny Doe, must be on the title to the property. For example, if you have a self-directed IRA with Pensco Trust, you would take the title as “Pensco Trust IRA FBO (for the benefit of) Sunny Doe.” Pensco Trust will sign all real estate and loan documents on behalf of Sunny as trustee of your account at closing of escrow. Sunny requests a tax ID from the IRS website for this entity after the income tax escrow closes.

Possible investment scenario

Sunny invests with her brother in a $2 million single-tenant dialysis facility 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 title to the property. The LLC operating agreement specifies that her brother owns 80% and the Pensco Trust FBO Sunny Doe IRA owns 20% ownership. Under this arrangement, they take out a $1.4M (70% LTV) loan with a national lender and use a total of $600,000 for a down payment. $120,000 of this $600,000 comes from Sunny’s IRA, since she owns 20%. Since Sunny’s share is 20% initially, only Sunny’s brother has to apply for the loan and provide the lender with financial documents. The bank also requires Sunny’s brother to sign a personal guarantee; therefore, Sunny is not required to sign a personal guarantee that meets IRS requirements.