By H. Quincy Long

 Many self-directed IRA clients, including me, invest in notes within their IRAs, mostly secured by real estate.  In my years of experience as a hard money lender personally and as a third party administrator for self-directed IRAs, I have seen some common mistakes made.  As a result, I have developed some guidelines for lending your IRA (and non-IRA) money out secured by liens on real estate.  I wish someone had shared these ground rules with me before I made some of the loans in my portfolio, although fortunately I have not been hurt too much by my mistakes.

1) Do not loan on something you wouldn’t be excited for your IRA to own if the borrower defaults.  Loaning money out of your IRA at relatively high interest rates secured by real estate is inherently more risky than leaving the money in a bank certificate of deposit, but it is also more profitable.  We routinely see yields from these loans at 12% and higher.  However, if you would be upset if the borrower defaulted and you had to take the property in foreclosure you probably should not make the loan.  With a properly secured hard money loan the worst thing that can happen is that the borrower pays you back!

2) Generally, do not advance money for repairs until the repairs are done, and then have the repairs inspected before advancing the money.  This is one of the biggest mistakes I see clients make with their IRAs.  They fund the full loan amount expecting the repairs to be done on the property, but the borrower just needs a little more money on another project and diverts some of the loan proceeds to that project.  When the loan goes bad, the IRA can end up with a property which has not had the repairs completed on it.

3) Do not loan money to someone you would feel uncomfortable foreclosing on.  William Shakespeare wrote in Hamlet, “Neither a lender nor a borrower be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.”  For the most part I cannot agree with this advice, because lending and borrowing money drives our economy and increases economic activity.  However, the part about a loan losing a friend is absolutely correct, in my opinion.  If foreclosing on your borrower would cause you heartache, it is best not to make the loan.  I have seen friendships destroyed over a loan gone bad.

4) If the loan goes into default, take action immediately.  No one wants to admit they have made a mistake, but delaying action can be costly.  You can always stop the foreclosure process once it has begun, but you cannot complete the process unless you start it.

5) Collect interest monthly so you will know if the borrower is getting into trouble.  Many borrowers, especially investors, would love to just pay interest at the end of the loan, but this can expose the lender to additional risk.  The purpose of collecting payments monthly is both to make sure the borrower remembers he has to do something with that property in order to avoid the pain of the payment and to let you know if the borrower is in trouble because he starts missing his payments.  Also, unless you have contracted for monthly payments, you may not be able to foreclose even if you find out through other means that the borrower is in financial trouble because the loan may not be in default.  This actually happened to some of our clients.

6) If you are unsure about how to evaluate the loan, hire a professional to help you.  Although a hallmark of the self-directed IRA is that it is “self-directed,” meaning that you make your own decisions and find your own investments, most IRA owners either do not possess sufficient knowledge or, in my case, sufficient time to properly evaluate a loan transaction.  My solution is to hire a professional to help me with the deals.  He checks out the borrower, coordinates with the title company, orders the appraisal and usually a survey, makes sure insurance is in place, and generally evaluates the loan.  Naturally he charges a fee for this service, which is passed through to the borrower, on top of any interest and fees that my retirement plan may charge.  This increases the cost of the loan, but in this case the non-Biblical version of the golden rule applies, which is “He who has the gold makes the rules.”

7) Get title insurance for the loan.  The purpose of title insurance is to shift risk away from you and to the title company.  In Texas, where my office is, the incremental cost of title insurance is very small when issued in conjunction with an owner’s title policy.  Regardless of the cost, making sure that your IRA is protected from title flaws is very important.

8) Verify that hazard and, if necessary, flood insurance is in place naming your IRA as an additional insured.  It is very easy to miss this issue when you are trying to get everything done right before a closing.  Borrowers may get insurance at the last moment and simply forget to add your IRA as an insured.  But if something goes wrong, you will want to make sure your IRA is named on the check.

9) Insist that the borrower provide you evidence of payment when property taxes and homeowners association fees become due.  The same thing would apply to hazard and flood insurance premiums, although normally you would receive notice of cancellation for non-payment of those bills.  Depending on where you live, property tax bills can increase quickly due to penalties and court costs, which reduces your equity position in the property.

10) Get a personal guarantee if lending to an entity or to an individual with some weakness.  When things are going well, you might be tempted not to insist on a personal guarantee, and indeed many borrowers will resist this.  However, as we all have discovered recently, circumstances do change, and a personal guarantee may be helpful in collecting the debt.  I collected on a note once where the property had decreased substantially in value due to vandalism and market conditions.  Instead of foreclosing, I had my lawyer send a letter explaining to the guarantor, who had a significant amount of assets, that he was personally liable on the debt and that if he was unable to satisfy the note I would pursue legal action against him and the borrower.  A week later a cashier’s check showed up satisfying the lien.

 This list of suggestions is not meant to be exclusive.  Other issues you will need to understand include your lien position (personally I only invest in first lien loans), any state usury laws that might apply to the loan, and at least a general idea of what the foreclosure process is in your state in case the loan goes into default.  Always get good legal counsel to assist you with loan documentation.  Especially since the borrower traditionally pays for all expenses including legal fees, there is no reason not to have an attorney draw up loan documents.

 Lending can be an excellent investment in an IRA.  It is relatively easy to do and if done correctly has a comparatively low risk.  Getting to know successful real estate entrepreneurs who borrow your IRA money may also lead to other, intangible benefits as well. 

 H. Quincy Long is Certified IRA Services Professional (CISP) and an attorney and is President of Entrust Retirement Services, Inc., serving clients in the State of Texas with offices in Houston and Dallas.  He may be reached by email at QLong@EntrustTexas.com.  Nothing in this article is intended as tax, legal or investment advice.

By: H. Quincy Long

 There is a lot of confusion over self-directed IRAs and what is and is not possible.  In this article I will discuss some of the most important things you need to know about self-directed IRAs. 

1)   IRAs Can Purchase Almost Anything.  A common misconception about IRAs is that purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.  This is false.  The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles.”  Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA.  A “self-directed” IRA allows any investment not expressly prohibited by law.  Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.

2) Seven Types of Accounts Can Be Self-Directed, Not Just Roth IRAs.  There are seven different types of accounts which can be self-directed.  They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA).  Not only can all of these accounts invest in non-traditional investments as indicated above, but they can be combined together to purchase a single investment.

3) Almost Anyone Can Have a Self-Directed Account of Some Type.  Although there are income limits for contributing to a Roth IRA, having a retirement plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either.  With a Traditional IRA, the fact that you or your spouse has a retirement plan at work may affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA.  There are no upper income limits for contributing to a Traditional IRA.  A Traditional IRA can also receive funds from a prior employer’s 401(k) or other qualified plan.  Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined.  If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level.  With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever!  All of this is in addition to any retirement plan you have at your job or for your self-employed business, including a SEP IRA, a SIMPLE IRA or a qualified plan such as a 401(k) plan or a 403(b) plan.

4) Even Small Balance Accounts Can Participate in Non-Traditional Investing.  There are at least 4 ways you can participate in real estate investment even with a small IRA.  First, you can wholesale property.  You simply put the contract in the name of your IRA instead of your name.  The earnest money comes from the IRA.  When you assign the contract, the assignment fee goes back into your IRA.  If using a Roth IRA, a Roth 401(k), an HSA, or a Coverdell ESA, this profit can be tax-free forever as long as you take the money out as a qualified distribution.  Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee.  Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller.  Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however.  Finally, your IRA can be a partner with other IRA or non-IRA investors.  For example, one recent hard money loan we funded had 10 different accounts participating.  The smallest account to participate was for only $1,827.00! 

5) Caution:  There Are Restrictions on What You Can Do With Your IRA.  Although as noted above in paragraph 1 the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.  If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.  Essentially, the prohibited transaction rules were made to discourage certain persons, called disqualified persons, from dealing with the income and assets of the plan in a self-dealing manner.  As a result, disqualified persons are prohibited from directly or indirectly entering into or benefitting from your IRA’s investments. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person.  Investment transactions are supposed to be on an arms-length basis.  Disqualified persons to your IRA include, among others, yourself, your spouse, your parents and other lineal ascendants, your kids and other lineal descendants and their spouses, and any corporation, partnership trust or estate which is owned or controlled by any combination of these persons.  It is essential when choosing a custodian or administrator that the company you choose is very knowledgeable in this area.  Even though no self-directed IRA custodian or administrator will give you tax, legal or investment advice, the education they provide will be critical to your success as a self-directed IRA investor.

6) Some IRA Investments May Cause Your IRA to Owe Taxes – But That May Be Okay.  Normally an IRA’s income and profits are exempt from taxation until a distribution is taken (or not at all, if it is a qualifying distribution from a Roth IRA).  However, there are three circumstances when an IRA may owe tax on its profits.  First, if the IRA is engaged in an unrelated trade or business, either directly or indirectly through a non-taxable entity such as an LLC or a limited partnership, the IRA will owe tax on its share of Unrelated Business Income (UBI).  Second, the IRA will owe taxes if it has rental income from personal property, such as a mobile home not treated as real estate under state law (but rents from real property are exempt from tax if the property is debt-free).  Finally, if the IRA owns, either directly or indirectly, property subject to debt, it will owe tax only on the portion of its income derived from the debt, which is sometimes referred to as Unrelated Debt Financed Income (UDFI).  This may sound like something you never would want to do, but a more careful analysis may lead you to the conclusion that paying tax now in your IRA may be the way to financial freedom in your retirement.  For example, one client made a net gain of over 1,000% in less than four months after her IRA paid this tax.  This is definitely a topic you will want to learn more about, but it is not something you should shut your mind to before investigating whether the after tax returns on your investment would exceed the return you might otherwise be able to achieve in your IRA.

7) An Inherited Roth IRA Can Give You Tax Free Income Now No Matter What Your Age.  Many people know that a qualified distribution from a Roth IRA is tax free.  To make the distribution qualify as tax free, it must be distributed after the IRA owner has had a Roth IRA for at least 5 tax years and after one of four events occurs – 1) the IRA owner is over age 59 ½, 2) the IRA owner becomes disabled, 3) the IRA owner dies and the distribution is to his or her beneficiary, or 4) the distribution is for a first-time home purchase, either for the IRA owner or certain close family members.  Although the neither the original Roth IRA owner nor his or her spouse has to take a distribution (assuming the spouse elects to treat the IRA as their own), non-spouse beneficiaries of a Roth IRA do have to take distributions, normally over their expected lifetimes.  However, once the five year test is met, those distributions are tax free, regardless of the age of the IRA beneficiary!  Even a $100,000 Roth IRA left to a 6 year old beneficiary may generate as much as $80,496,367 in lifetime tax free distributions if the IRA can sustain a yield of 12%, which is very possible with a self-directed IRA.

2010 Brings an Incredible Gift From Your Government.  Most people who understand the benefits of a Roth IRA really want one, but many people have not been able to qualify for this incredible wealth building tool because of income limitations which restrict the eligibility of a person to contribute to a Roth IRA or to convert pre-tax accounts like Traditional IRAs into a Roth IRA.  In 2010 the rules for conversions will change so that anyone, regardless of income level, will be eligible to do a Roth conversion.  Beginning in 2010 anyone who has a Traditional IRA (including a SEP IRA), a SIMPLE IRA which has been in existence for at least two years, or a former employer retirement plan such as a 401(k) or a 403(b) can convert those into a Roth IRA and can then begin to create tax free wealth for their retirement.  Even if you do not currently have an IRA but are eligible to contribute to a Traditional IRA, the contribution can be made and immediately converted into a Roth IRA.  This truly is one of the most exciting tax planning opportunities to come along in a very long time!

9) There Are Millions of Dollars Available to Finance Your Real Estate Deals Right Now.  We are in a very exciting time for wise real estate investors.  There are a lot of super real estate bargains out there right now, but it can be very difficult for investors to get financing – unless they know the secret of private financing.  There are billions of dollars of lazy IRA money sitting on the sidelines waiting for the right investment, because many people are very afraid of the stock market.  Included among the many things people can invest in with a self-directed IRA are real estate secured loans or even unsecured loans.  Shakespeare wrote in his play Hamlet, “Neither a lender nor a borrower be, for a loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.”  I believe Shakespeare was wrong, but he might be forgiven since he did not have the advantage of knowing about self-directed IRAs.  You can benefit from your knowledge of self-directed IRAs either by having your IRA be a private lender or by borrowing OPI – Other People’s IRAs – for your real estate transactions.  Networking is the key to success in the area of private lending or borrowing, but there are things you must know to do it properly.

10) Use Options to Dramatically Boost Your Small IRA.  Options are one of the most powerful and under-utilized tools in real estate investing today, and they work beautifully within a self-directed IRA.  The consideration for the option and the property being optioned can be almost anything, not just real estate.  Once an IRA owns an option, it can 1) let the option lapse (which at times is the right answer), 2) exercise the option and acquire the property, 3) assign the option for a fee (assuming the option agreement allows for assignment) or 4) agree to cancel the option for a fee with the property owner, thereby getting paid not to buy the property!  Options are very flexible and can be designed to fit almost any situation.  One client paid $5,000 from his Roth IRA for an option which he later canceled for a fee of over $35,000.   Then he took that money, bought a property at a foreclosure auction for cash, and later sold the property for $70,000 with $5,000 down and a $65,000 seller-financed note.  By using the option he was able to take his $5,000 Roth IRA and turn it into a $70,000 Roth in less than a year!

 Truthfully there are many more things that you should know about self-directed IRAs.  To learn more, attend one or more of Entrust’s many free networking and educational events.  You can get the entire schedule of events in addition to playing pre-recorded webinars by going to our website at www.EntrustTexas.com.  Happy investing!

 H. Quincy Long is an attorney who holds the designation of Certified IRA Services Professional (CISP) and is President of Entrust Retirement Services, Inc., a third party administrator of self-directed IRAs serving clients in the State of Texas and throughout the nation with offices in Houston and Dallas.  He may be reached by email at QLong@EntrustTexas.com.  Nothing in this article is intended as tax, legal or investment advice.
© Copyright 2009 H. Quincy Long.  All rights reserved.