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IRAs and real estate – expand your investment horizons

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“Oh, give me land, lots of land under starry skies above, don’t fence me in.” Cole Porter

If you’ve got an urge to sock away something in your IRA besides stocks, bonds and mutual funds, you may want to consider real estate. Raw land, houses, condos, commercial properties and even mortgage notes — you can use an IRA to broaden your portfolio.

Ruby Barnett, an insurance company office manager in Oakland, Calif., says she always wanted to invest in property.

“I read a book a few years ago, and it mentioned you could use an IRA to invest in real estate. My goal was to buy properties and flip them — rehab and sell them,” says Barnett. “But I ended up buying income property, so I have tenants. The rent goes into the IRA.”

You can use an IRA for real estate investments whether you’re a hands-on person like Barnett or an investor who prefers relying on someone else’s expertise. But many people who do this seem to like being in the driver’s seat — they’re willing to learn.

“We recommend it be an individual who knows the kind of assets they want to purchase. Know the subject matter reasonably well. If you’ve never bought real estate before you want to do a lot of homework,” says Hugh Bromma, CEO of Oakland, Calif.,-based Entrust Administration Inc.

It takes self-direction
You can’t buy real estate with your basic IRA; you need to open a self-directed IRA. Banks, insurance companies and brokerages will help you open a self-directed IRA, but, generally, they limit your investment options to the products they sell. To buy real estate you may have to find an independent administrator to serve as a trustee or custodian.

IRA Resource Associates, Inc in Camas, Wash., helps people find the right administrator for their self-directed IRAs.

“We help match the client with the administrator that’s capable of handling the type of transactions the client wants,” says president Patrick Rice. “We also match them geographically, and we match them up with price. You’ll pay between 40 and 150 basis points of your asset value in the IRA annually to have it serviced. It makes a big difference which one you choose because that can be a big chunk of change.”

Fee-based administrators charge each time they do something. For instance, if they have to make weekly payments for your account they might charge $10 per payment.

An asset-based administrator charges a percentage of the total asset value annually. According to Rice, if you have a $40,000 portfolio you might pay from 1 percent to 1.5 percent in fees. If you have a million dollar portfolio you might pay .03 percent.

A hybrid-based administrator charges a little of both, and Rice says that’s the way most administrators are going.

If you opt for finding an administrator on your own, say, through an Internet search, talk to several before choosing one. The most expensive may not be the best, and the cheapest may not be a bargain.

Rice advises avoiding a company that just opened its doors.

“This isn’t necessarily to disqualify the administrator; but I’ve seen a lot of them come and go. It doesn’t mean the client will lose his money, but it probably means it will be tied up while it all gets sorted out,” says Rice. “Know their asset base; how much is under their control? How many years of experience do they have?

“Talk to the reps, and make sure they understand what you’re doing and that they know how to do it. Look at their flexibility; a lot of administrators won’t take a real estate contract because they don’t understand it. Ask hard questions. Ask for an annual statement. What are their geographic areas? Ask about fees.”

Once you find an administrator, they’ll walk you through the steps needed to set up a self-directed IRA. You can set up an account with new money, but then you’d only be able to fund it with the maximum IRA contribution each year. Or you could transfer some or all of the assets from your traditional IRA.

Hugh Bromma of Entrust Administration says that for people who qualify, a self-directed Roth IRA is often best for real estate investments.

“For those who make a lot of money in their investment portfolio, it has the best advantage. The earnings are tax-free at distribution compared to a traditional IRA where the distribution is taxed. If you take a small amount, say $10,000 and parlay that into a half-million or a million, in a traditional IRA you’d have to pay taxes on a million dollars.”

Some administrators, such as Entrust, don’t give investment advice. If you’re not a do-it-yourself type you may need to rely on a firm that specializes in finding real estate that’s suitable for your portfolio.

Bruce Bishop’s company, Secured Assets Funding in Vacaville, Calif., specializes in real estate notes.

“Our clients are making a loan on a property. They’re not looking for building appreciation. We recommend loans only on property we know and limit our geographic area to northern California.”

Bishop says many of his clients are retiring or leaving a company, and they’re ready to rollover a 401(k) into an IRA. But they want to do something different from stocks and mutual funds.

Beware the IRS red tape

One reason you probably shouldn’t tackle an IRA real estate investment on your own is the IRS. The money-grabbing branch of the government has a lot of rules when it comes to using retirement funds for real estate.

“Probably the most common question I hear is, ‘I’ve found a really neat time share and I want to buy it with my IRA, can I do that?’ Yes, you can,” says Patrick Rice of IRA Resource Associates. “Then they say, ‘I want to use it for a couple weeks a year.’ Well, no, you can’t do that. Most calls I get, people want to buy products for their own

Rice says the IRS allows you to use the land or building, but not while it’s in your IRA. For instance, you could buy a retirement home, rent it to someone else, put the rental income in your IRA, and, when you retire, take the house as a distribution. Then you can move in.

Just to show how complicated this can get: You cannot rent the house to your spouse or your ascendants or descendants — grandparents, parents, children, grandchildren, etc., but you could rent it to your brother or sister while it’s in your IRA.

Entrust’s Bromma says he sees very few people who want to use their IRA to buy a retirement home. He says the IRA is best when used for true investment property.

Whether you want to use an IRA for a retirement home or commercial property, the IRS doesn’t really tell you what you can do with assets in your IRA — it tells you what you can’t do. Entrust has an extensive section dealing with prohibited transactions on its Web site.

Consider your options
You don’t necessarily need a lot of money to make money on property with your IRA if you know what you’re doing. Hugh Bromma of Entrust says people who use options sometimes have just a few thousand dollars. An option gives you the exclusive right to buy a piece of property within a set period.

“Suppose I like your house and would like an option to buy it in 60 days at $100,000. If I don’t, you get my option money — $1,000,” explains Bromma. “I hunt down a buyer who will pay $150,000. On day 59 I say I’m going to exercise this option and I give you $100,000. The next day I sell the property for $150,000. With $1,000 (option money) from the IRA, I made $50,000 on the deal.”

Patrick Rice believes investing in real estate gives you more control than investing in the stock market.

“You can drive by and look at a neighborhood, control the value of the property through maintenance, good tenants and foresee changes in the market a lot easier. When [Federal Reserve Chairman Alan] Greenspan drops basis points, that’s a good market for real estate. When he raises, you see it coming. It happens today but doesn’t hit the hometown market for three months; it gives you time to maneuver.”

If you use an investment-locator company you’ll have the benefit of experts who can check out hundreds of properties and cherry pick the best

“We do the appraisals, get opinions; you get a couple inches of research to review,” says Rice.

Ruby Barnett, the insurance office manager, who does her own research, says do as much homework as you can.

“Last year, there were multiple offers on the property I bought. The seller takes a look and decides what they’ll accept. They don’t always take the highest price. What worked for me was I had cash and could close the deal sooner. I looked at the property, had inspectors check it out. I went with them. I got up on the roof with the inspector.”

Barnett is in the minority, according to Hugh Bromma.

“There are people who say they want to get into real estate, but when they find out it’s really work, they don’t. When I do seminars, probably 10 percent of the people I talk to will follow through on doing these types of investments. They don’t have enough knowledge in their investment arena. I discourage them from doing anything until they do their homework.”

Figuring out if real estate is the right way for you to broaden your portfolio choices will take some work, but you may be like Ruby Barnett and find it interesting and profitable.