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. While it is very convenient to invest in the stock market, she finds that the returns on the mutual funds in her IRA account are underperforming. As she grows older, Sunny is faced with the reality that her gray hairs are not her advantage, but could be a disadvantage in the field of high technology. She is also concerned about the volatility of the stock market. On a good market day, 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 them have been placed in the stock market.

After learning that he can use the money from a self-directed IRA to invest in real estate, he is motivated as he has been successful in real estate investments where he has 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. After 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 Arrangements, or IRAs. ERISA allows you to open an IRA account and control how your money is invested. 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 good business sense for them. It’s like McDonald’s concentrating on fast food and not serving prime rib. So if you want to have more investment options besides stocks and mutual funds, you should use a service from 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, companies, 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 their fee information, 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 self-directed IRA assets. It is usually a bank.
3. Administrator: This company only 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 direct ascendants or descendants.
2. An IRA owner is not permitted to commingle 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 account. 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 guarantee. However, it is difficult to apply for a non-recourse loan. 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,” say, 8% to 12% interest on the loan. Therefore, obtaining financing at a low rate seems to be the most complicated 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 places a significant 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 something wrong 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 keeping all the profits!
4. Apply for a non-recourse loan: It is quite difficult to qualify for a non-recourse loan as lenders tend to have very strict guidelines, for example:

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

The property must have a long-term lease with a national tenant, for example, 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 collateral. 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 as they co-own 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 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 the 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 Sunny Doe, must be on the title of the property. For example, if you have a self-directed IRA with Pensco Trust, you should take the title as “Pensco Trust FBO (for the benefit of) Sunny Doe IRA.” Pensco Trust will sign all real estate and loan documents on Sunny’s behalf as trustee of her account at escrow closing. Sunny requests a tax ID from the IRS website for this entity after escrow closes for the income tax return.

Possible investment scenario

Sunny invests with her brother in a $2 million dialysis facility for a single tenant 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. With this arrangement, they borrow $1.4M (70% LTV) from 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 also meets IRS requirements.