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Real estate and self-directed IRAs

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Due diligence essential
Most people use their IRAs to buy income-producing investment properties, and that takes a lot of homework, says Thomas Musil, Ph.D., director of the Shenehon Center for Real Estate at St. Thomas University in Minneapolis.

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"The astute investor knows if the market fundamentals are there, the rental demand is there, the condition of the property warrants the investment, the terms and the price are right. There's a great deal of due diligence that the investor has to perform on a piece of property to put in a self-directed IRA."

Far and away, Musil says, the biggest mistake people make is failure to understand the market and competitive forces.

"You buy a four-unit building in a market that has a great deal of new construction taking place after you acquired the building, and the newly constructed properties are very competitive and rent for what you're charging."

Outside assistance and financing
If you want someone to find properties and do all the homework, there are companies that can assist you.

Patrick Rice, owner of one such company, IRA Resource Associates, and author of "IRA Wealth: Revolutionary IRA Strategies for Real Estate Investment," says his company manages between $50 million and $60 million in IRA assets, up from approximately $2 million in 2000.

Most people open a self-directed IRA using funds from a 401(k) that they amassed while working for a previous employer. But while brokerages may require $3,000 or less to buy a mutual fund, property usually costs considerably more, so be sure you have enough money in the account to fund a real estate purchase and other associated expenses.

Nevertheless, Rice says there are ways to buy property that don't require a large sum of money.

"Let's say I'm interested in a $250,000 vacant office building; I can use my IRA to option the property. I take $10,000 out of my IRA and say, 'I'll give you $10,000 for an option to buy this property for $250,000 within the next year.' Now, the reason I did this is because I know Joe Blow down the street needs an office building. So I say to Joe Blow, 'I'll sell this to you for $350,000.' I have only $10,000 wrapped up in the deal, but I'm making $90,000."

Additional expenses to consider
Obviously, complications can arise and a potential deal might not go so smoothly, but it's something to think about. If you do need financing, you'll have to get a nonrecourse loan. If something goes wrong, you're not personally liable; lenders can only look at the asset when trying to recover their money. By the same token, you can't personally guarantee the loan. Be prepared for a down payment of at least 30 percent.

Another major consideration is having enough money for taxes, maintenance and management fees. Just as all income from the property must go into the IRA; all expenditures -- down payments, taxes, management fees, maintenance costs and the like must come from funds that are in the IRA. So, keep appropriate amounts of cash in the account to pay bills and keep your head above water should you have a problem renting the property 100 percent of the time.

Next: "... should know how much risk they're willing to tolerate."
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