Quincy Long

By: H. Quincy Long, Certified IRA Services Phone: 281-492-3434

Professional (CISP), Attorney and President of Fax: 281-646-9701

Entrust Retirement Services, Inc. Toll-Free: 800-320-5950

17171 Park Row, Suite 100 Email: QLong@EntrustTexas.com

Houston, Texas 77084

I have a philosophy, which is that if you can create win-win situations you should always do so. My daughter, Briana, is 12 years old and has been invited to travel to Europe next summer to be a Student Ambassador through the People to People program (www.studentambassadors.org). One of the requirements I am making for Briana to go is that she must raise one-half of the finds for the trip. Since Briana needs funds for her trip, and my company, Entrust Retirement Services, Inc. needed help stuffing envelopes to send out our quarterly statements, Briana came to work for us to help stuff envelopes. This earned her money for her trip and at the same time reduced my taxable income – a definite win-win scenario.

You may be asking, “What does this have to do with IRAs?” As her father and as a professional in the area of self-directed IRAs, of course it immediately struck me that Briana now has earned income and is therefore eligible for a Roth IRA, even at age 12. This got me thinking about how long a Roth IRA could last under a certain set of circumstances.

The original owner of a Roth IRA never has to take distributions from that Roth IRA. This is one of the benefits of a Roth IRA over a traditional IRA. With a traditional IRA distributions must begin no later than April 1 of the year following the year the IRA owner reaches age 70 1/2. Briana can therefore accumulate funds in her Roth IRA for her entire life without ever having to take a distribution. When she dies, Briana can leave the Roth IRA to anyone she wants (although she may need her spouse’s consent in certain circumstances if she lives in a community property state). Leaving her Roth IRA to someone very young is sometimes referred to as leaving that person a “Stretch IRA” or a “Beneficiary IRA.”

Unlike Briana, who never has to take distributions during her lifetime, if a non-spouse beneficiary inherits her Roth IRA they must take required minimum distributions (RMDs) based on the beneficiary’s life expectancy as determined by the IRS. The good news is that if Briana has had a Roth IRA for at least 5 tax years when she dies, required minimum distributions from the inherited Stretch Roth IRA to the beneficiary who inherits the account will be tax free, even if they are under age 59 1/2 at the time of the distributions.

So how might this work out in Briana’s situation? Let’s assume Briana makes exactly $1,000 in earned income for tax year 2008. Roth IRA contributions can be made based on the amount of her earned income (her investment income, if any, doesn’t count), up to a maximum of $5,000 for people under age 50 by the end of the year for 2008. In Briana’s case, since she earned less than the $5,000 contribution limit, she can only contribute $1,000.

If we assume that Briana will live to age 87, and she never makes another contribution to that Roth IRA, the value of the Roth IRA upon her death (75 years from the start of the Roth IRA) would be as follows:

Initial Contribution Annualized Yield Result After 75 Years

$1,000 6% $ 89,013.00

$1,000 12% $ 7,748,834.00

$1,000 18% $659,839,065.00

For purposes of our discussion, I will assume an annualized yield of 12%. Some may argue that this isn’t realistic, but in fact at Entrust we see much higher yields in self-directed IRAs than just 12%. For example, my Mom’s self-directed IRA has achieved a yield of more than 13% per year over the last couple of years by simply doing hard money lending (but that is the topic of a different article). If your calculator holds enough numbers, multiply the appropriate amount from the above chart times 5 or 6 for a full single year contribution depending on the age of the contributor (ie. $5,000 for those under age 50, and $6,000 for those age 50 or older). Of course the results on the chart above do not even account for continuous contributions during Briana’s lifetime, which she will almost certainly make based on the financial education she is going to get from me!

If Briana has a daughter at age 31 (although how she is going to have a child before she’s ever allowed to date I’m not sure), and her daughter delivers her granddaughter at age 31, who in turn gives birth to her great granddaughter at age 31, Briana will be age 81 when her great granddaughter is born (we’ll call her Samantha). If Briana updates her beneficiary designation to leave Samantha her huge Roth IRA, Samantha will be age 6 when Briana dies at age 87. By December 31 of the following year, when Samantha is age 7, required minimum distributions must begin from the inherited Stretch Roth IRA.

To calculate Samantha’s required minimum distributions, her life expectancy must be determined from the IRS Single Life Expectancy Table (Table 1 in the back of IRS Publication 590). Once the appropriate Life Expectancy Factor is found on the table, Samantha must take the value of the account as of December 31 of the prior year and divide it by the factor. For a beneficiary who must begin distributions from an inherited IRA at age 7 the Life Expectancy Factor from the IRS table is 75.8. Samantha’s first year distribution is calculated as follows:

Prior Year End Balance ($7,748,834)

Life Expectancy Factor (75.8) = Required Minimum Distribution ($102,227.36)

In subsequent years the factor is reduced by 1, and in each year the balance on December 31 of the prior year is divided by the new factor (ie. the Life Expectancy Factor is 74.8 in year 2, 73.8 in year 3, etc.). Since the original Life Expectancy Factor was 75.8, after a total of 76 years the inherited Stretch Roth IRA must be completely distributed, either to Samantha or to Samantha’s heirs if she doesn’t live that long.

The best part is that Samantha is not required to just let the money sit there earning nothing for the 76 years of required minimum distributions. As long as there is sufficient funds in the account to meet the annual required minimum distributions, the account can continue to be invested in real estate, notes, private company stock and limited partnerships, among many other choices, so that it continues to grow. In Samantha’s inherited Stretch Roth IRA, for example, during the first year of distributions if the account earns a 12% annualized yield, the income will be $929,860, while Samantha’s required minimum distribution would only be $102,227, resulting in an increase in the account balance of $827,633.

The following chart shows how powerful an inherited Stretch Roth IRA of just $100,000 can be if distributed over a long period of time:

Starting Principal Beginning Life Expectancy Factor Yield Total Distributions

$100,000.00 75.8 6% $ 2,033,743

$100,000.00 75.8 12% $ 80,496,367

$100,000.00 75.8 18% $3,420,454,810

If an annualized yield of 12% can be maintained for the entire life of Briana and Samantha so that the beginning balance of Samantha’s inherited Stretch Roth IRA is $7,748,834.00, total distributions from the account for Samantha and her heirs would be a staggering $6,237,497,033 – and under current law it is all TAX FREE! This is obviously an incredible estate planning tool. A lifetime of tax free income is quite a gift to leave to your heirs.

It should be noted that I have ignored for the purposes of this article the estate tax and generation skipping tax issues in order to illustrate the power of an inherited Stretch Roth IRA. No one can predict what tax law changes will take place over the next 75 years, or what the estate tax and generation skipping tax limitations will be if they continue to exist for that long. However, you should never avoid estate and tax planning simply because the law might change. We can only plan based on what we know right now. One thing is for sure – to fail to plan is to plan to fail.

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

Many people find it very easy to see the benefits of self-directing their Roth and Traditional IRAs, SEP IRAs, SIMPLE IRAs, Individual 401(k)s, Coverdell Education Savings Accounts (ESAs) and Health Savings Accounts (HSAs) into something other than the same old boring stocks, bonds, annuities and mutual funds. The central idea of a self-directed IRA is that it gives you total control of your retirement assets. With a self-directed account you can invest your IRA funds in whatever you know best.

When I spoke recently at John Schaub’s Real Estate All Stars conference in Las Vegas, Nevada, I outlined some of the top strategies our clients have actually used to build their retirement wealth. A brief description of these strategies is included in this article. This shows the tremendous flexibility of investing through a self-directed account.

Strategy #1 – Purchasing Rental Real Estate for Cash. Even the IRS acknowledges on its website that real estate is an acceptable investment for an IRA. In answering the question “Are there any restrictions on the things I can invest my IRA in?” the IRS includes in its response that “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.” One of our clients purchased a 10 unit apartment complex for $330,000 cash. In April, 2008 his total rent collection was $5,235. Even after payment of taxes and insurance, his cash on cash return is excellent, and the client believes that the value of the property will increase significantly over time. A discussion of the relative benefits and disadvantages of owning real estate directly in an IRA is beyond the scope of this article, but for those who know how to successfully invest in real estate it is great to know that real estate is an option for your self-directed account.

Strategy #2 – Purchase, Rehab and Resale of Real Estate. In this case study, our client decided not to hold onto the real estate purchased with his IRA. The client received a phone call one evening from an elderly gentleman who said he needed to sell his home quickly because he wanted to move to Dallas with his son. After a quick phone conversation, it was clear that the price the seller wanted was a bargain even considering the needed repairs. Our client dropped what he was doing and immediately headed over to the seller’s house with a contract. The buyer on the contract was our client’s IRA, and of course the earnest money came from the IRA after the client read and approved the contract and submitted it with a buy direction letter to Entrust. They agreed on a sales price of $101,000. Approximately $30,000 was spent rehabbing the property with all funds coming from the IRA. The property was sold 6 months later for $239,000, with a net profit after sales and holding expenses of $94,000!

Strategy #3 – Purchase and Immediate Resale of Real Estate (Flipping). The previous two examples show the tremendous power of buying real estate for cash with a self-directed IRA. However, both of these strategies require a significant amount of cash in your account. How else can you invest in real estate if you have little cash? One of our clients was able to put a commercial piece of vacant land under contract in his Roth IRA. The sales price was $503,553.60 after acreage adjustments. Using his knowledge of what was attractive for a building site, our client was able to negotiate a sales price to a major home improvement store chain for $650,000. On the day of closing Entrust received two sets of documents, one for the purchase of the property for $503,553.60 and the other for the sale of the same property for $650,000. After sales expenses, the IRA netted $146,281.40 from the sale with only the earnest money coming from the account! A word of caution in this case is that if property is flipped inside of an IRA the IRS may consider this to be Unrelated Business Taxable Income (UBTI), causing the IRA (not the IRA owner) to owe some taxes on the gain. Even if taxes had to be paid, it is hard to argue that this transaction was not beneficial to the IRA and ultimately the client! It should also be noted that in this situation everyone involved in the transaction was aware of what everyone else was doing, so there was no “under the table” dealings.

Strategy #4 – Assignments and Options – Getting Paid NOT to Buy! Another favorite strategy for building tremendous wealth without a significant amount of cash is the use of options and assignments. One of our clients put a property under contract in his daughter’s Coverdell Education Savings Account for $100. The sales price was a total of $5,500 because the house had burned down. The seller was just getting rid of the property for its lot value since he had already received a settlement from the insurance company and had purchased another house. Our client then used his contacts to find a person who specialized in rehabbing burned out houses. The new buyer was willing to purchase the property for $14,000 cash. At closing one month after the contract was signed, the seller received his $5,500 and the Coverdell ESA received an assignment fee of $8,500 right on the settlement statement. That is an astounding 8,400% return on the $100 investment in only 30 days! Even better, our client was then able to take a TAX FREE distribution from the account of $3,300 to pay for his 10 year old daughter’s private school tuition. In a similar transaction, another client’s Roth IRA recently received an assignment fee of $21,000 plus reimbursement of earnest money for a contract.

Strategy #5 – Using the Power of Debt Leveraging. One of my favorite true stories of building wealth in a Roth IRA involves purchasing property subject to a debt. If an IRA owns debt-financed property either directly or indirectly through a non-taxed entity such as a partnership or LLC taxed as a partnership, profits from that investment are taxable to the same extent there is debt on the property. One of our clients used her knowledge of real estate investing and what she learned from a free Entrust educational seminar to tremendously boost her retirement savings. After noticing a large house in downtown Houston which was in bad shape but in a great location, our client tracked down the owner in California who was being sued for approximately $97,000 in delinquent taxes on the property. She negotiated a deal with the seller for her Roth IRA to purchase the property for $75 cash subject to the delinquent taxes. With closing costs her Roth IRA’s total cash in the transaction was only around $3,000. Within 4 months she was able to sell the property for a profit to her Roth IRA of $43,500! Because the property had debt on it and because her Roth IRA sold the property for a short term capital gain, the taxes on the profit were approximately $13,500. Still, using the power of debt leveraging her Roth IRA was able to achieve a 1,000% return in less than 4 months even after paying Uncle Sam his share of the profits!

Strategy #6 – Hard Money Lending. Another excellent strategy for building your retirement wealth is through lending. Loans from IRAs can be made secured by real estate, mobile homes or anything else. Some people even choose to loan money from their IRAs on an unsecured basis. As long as the borrower is not a disqualified person to the lending IRA, almost any terms agreed to by the parties are acceptable. In many states there are limits to the amount of interest that can be charged, and loans must be properly documented, but IRA law does not impose any limits other than the prohibited transaction rules. For those wanting to avoid the direct ownership of real estate within their IRA, a loan with an equity participation agreement is often used. Several of my own self-directed accounts combined together recently to make a $25,000, 7 1/2 year, 12% first lien loan against real estate with 6% in points up front. True, this is not exactly setting the world on fire as far as return on investment goes, but I was very pleased with a safe return on a relatively small amount of cash. If I get to foreclose on the collateral my accounts should be able to make a substantial profit, since the land securing the loan was appraised at $45,000. At my office we routinely see hard money loans secured by first liens against real estate with interest at 12%-18% for terms ranging from 3 months to 3 years.

Strategy #7 – Private Placements. Many of the best opportunities for passive growth of IRAs include the purchase of private limited partnership shares, LLC membership units and private stock which does not trade on the stock market. Let me give you two examples from my own retirement account investments. In one case my 401(k) plan invested in a limited partnership which purchased a shopping center in northern Louisiana. The initial investment was $50,000, and in a little over 2 years the partnership has returned $59,321. The plan’s remaining equity is estimated as of 12/31/2007 at $31,598 and the return on investment will be around 82%. Even though the property is debt-financed the taxes on the profit have been almost nothing since the plan has taken advantage of depreciation and all of the normal deductions. Once your IRA or other plan owes taxes due to debt financing, it gets to deduct a pro rata share of all normal expenses. Another of my 401(k) plan investments is bank stock of a community bank in Houston, Texas. The initial shares were sold at $10 per share in February, 2007. The book value after less than 1 year of operations was $11 per share, and shares have recently been selling to other private investors for as much as $14.25 per share! That is a great return for a completely passive investment, and when the bank finally sells the shares are expected to sell for well above these amounts.

Strategy #8 – Owning a Business in Your IRA. One of the most innovative strategies we have seen is the ownership of a business by an IRA. Although neither you nor any other disqualified person may provide services to or get paid for working at a business owned by your IRA or other self-directed account, this does not mean that your IRA cannot own a business. Some companies do market the ability for you to start a C corporation, adopt a 401(k) plan, roll your IRA into the plan, and purchase “qualifying employer securities,” but this is different than an IRA owning a business directly. For example, my Health Savings Account invested $500 for 100% of the shares of a corporation which arranges for hard money loans to investors. The company is fully licensed as a Texas mortgage broker. The structure of the company is a C corporation. Since being a mortgage broker is a business operation, profits from the venture would have been taxable to my HSA if the entity formed to own the business was not taxable itself, and the tax rates for trusts such as IRAs and HSAs are much higher than for corporations. While normally dividends from C corporations are taxable a second time to the shareholder, dividends paid to an IRA or HSA are tax free as investment income. The corporation is run by non-disqualified persons who handle the due diligence on the loans and the legal work, as well as by a licensed Texas mortgage broker who sponsors the corporation’s mortgage broker license.

Strategy #9 – Using OPI (Other People’s IRAs) to Make Money Now. Even if you have not found the investment strategy of your dreams among the strategies discussed in this article, or if you have no IRA or if you are more focused on making money now to live on, your time spent reading this article can still be of great use to you. For each of the above strategies I have focused on the possibility that your IRA could be the investor. But what if you are the recipient of the IRA’s investment money? Are you a real estate investor having a hard time finding funding for your transactions? If you know people with self-directed IRAs or people who would move their money to a self-directed account, you can borrow their IRA money and virtually create your own private bank! You can also partner with OPI where the IRA puts up the money and you share in the equity for finding the deal and managing the project. Simply by explaining to people that they can own real estate in their IRAs you may be able to sell more property, either as a real estate broker or as the seller. You can even provide financing for your sales by having OPI make loans to your buyers. Finally, OPI can be a great way to raise capital for your business venture, although you must be aware of and comply with all securities laws. One bank I know of told me that 42% of their initial capital came from retirement accounts! Although you cannot use your own retirement account to benefit yourself at present unless you are over age 59 1/2, these are just some of the ways you can use OPI to make money for yourself right now. A good network is the key to your success.

What I have discussed in this article have been some of the more common investment strategies actually used by our clients. The only restrictions contained in the Internal Revenue Code are that IRAs cannot invest in life insurance contracts or collectibles. Almost any other investment that can be documented can be held in a self-directed IRA. As long as you follow the rules and do not invest in prohibited investments, your only real limitation is your imagination!

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

There is a lot of confusion over self-directed IRAs and what is and is not possible. In this article we will disprove some of the more common self-directed IRA myths.

Myth #1. Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

Truth:

The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles”, which are defined to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the United States or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

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.

Myth #2. Only Roth IRAs can be self-directed.

Truth:

Because of the power of tax free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments. As a result, it is a surprisingly common misconception that a Roth IRA is the only account which can be self-directed. In fact, 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 in Myth #1, but they can be combined together to purchase a single investment.
Myth #3. I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

Truth:

Almost anyone can have a self-directed account of some type. Although there are income limits for contributing to a Roth IRA (in 2008 the income limits are $169,000 for a married couple filing jointly and $116,000 for a single person or head of household), having a 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, you or your spouse having a retirement plan at work does 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. Also, a Traditional IRA can 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! It’s the best of both worlds. All of this is in addition to any retirement plan you have at your job or for your self-employed business.

Myth #4. I can’t have a self-directed 401(k) plan for my business because I am self-employed and file a Schedule C for my income.

Truth:

You can have a self-directed SEP IRA, a SIMPLE IRA or a 401(k) plan even if you are self-employed and file your income on Schedule C of your personal tax return. With a SEP IRA, you can contribute up to 20% of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C) or 25% of your wages from an employer, up to a maximum of $46,000 for 2008. With the SIMPLE IRA, you can defer up to the first $10,500 of your net earnings from self-employment (calculated by multiplying your net Schedule C income by 0.9235% for SIMPLE IRA purposes), plus an additional $2,500 of your net earnings if you are age 50 by the end of the year, plus you can contribute an additional 3% of your net earnings as an employer contribution. Beginning in 2002 even self-employed persons are entitled to have their own 401(k) plan. Better yet, in 2006 the Roth 401(k) was added, allowing even high income earners to contribute after tax dollars into an account where qualified distributions are tax free forever! With an Individual 401(k) you can defer up to $15,500 (for 2007 and 2008) of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C), plus an additional $5,000 of your net earnings if you reach age 50 by the end of the year, plus you can contribute as much as an additional $30,500 based on up to 20% of your net earnings for 2008 (or 25% of your wages from an employer). This means that a 50 plus year old self-employed person can contribute up to $51,000 for 2008!
Myth #5. Because I have a small IRA and can only contribute $5,000, it’s not worth having a self-directed IRA.

Truth:

Even small balance accounts can participate in non-traditional investing. Small balance accounts can be co-invested with larger accounts owned by you or even other people. 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! 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, this profit is tax-free forever! 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, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.

Myth # 6. If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

Truth:

A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC. Effectively you have “checkbook control” of your IRA funds. Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments. This is simply not true. Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Entrust Retirement Services, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary. Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties. This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes. Nonetheless, you must educate yourself completely as to the rules before deciding on this route. Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!
Myth #7. I can borrow money from my IRA to purchase a vacation home for myself.

Truth:

Although 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 disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. 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.

As a result of these legal restrictions, a loan from your IRA or staying at a vacation home owned by your IRA, even if fair market rates are paid for interest or rent, would be prohibited.

Myth #8. With a self-directed IRA, I can borrow my IRA funds to purchase real estate and then put all the profits back into the IRA.

Truth:

When real estate or any other asset is purchased within a self-directed IRA, the money never leaves the IRA at all. Instead, the IRA exchanges cash for the asset, in the same way that an IRA at a brokerage house exchanges cash for shares of stock or a mutual fund. Therefore, the asset must be held in the name of the IRA. For example, if Max N. Vestor were to purchase an investment house in his self-directed IRA, the title would be held as “Entrust Retirement Services, Inc. FBO Max N. Vestor IRA #12345-11.” Since the IRA owns the asset, all expenses associated with the asset must be paid by the IRA and all profit resulting from that investment belongs to the IRA, including rents received and gains from the sale of the asset.

Myth #9. If my IRA buys real estate, it must pay all cash for the property. An IRA cannot buy real estate with debt.

Truth:

An IRA can own debt-financed property, either directly or indirectly through a non-taxed entity such as an LLC or partnership. Any debt must be non-recourse to the IRA and to any disqualified person. An IRA may have to pay Unrelated Debt Financed Income Tax (UDFIT) on its profits from debt-financed property. In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt. For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable. Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth. The same leverage principle applies inside or outside of your IRA – you can do more with debt-financing than you can without it. One client was able to build her Roth IRA from $3,000 to over $33,000 in less than 4 months even after paying the taxes due by taking over a property subject to a debt and selling the property to another investor!

Myth #10. An IRA cannot own a business.

Truth:

A self-directed IRA is an amazingly flexible wealth building tool and can own almost anything, including a business. However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid. Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up. Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business. A solution to this problem may be to have the business owned by a C corporation or another taxable entity.

Many people would like to buy real estate in their IRAs but have a mistaken belief that they do not have enough money to do so. Nothing could be further from the truth! You may invest in real estate with your IRA without a lot of money in several ways, including partnering with other IRAs or non-IRA money, buying property with debt, or by using one of the most powerful and under utilized tools in real estate investing today – the option.

In this article we will focus on some option basics. First, what is an option? Once consideration for the option is paid, it is the owner’s irrevocable offer to sell the property to a buyer under the terms of the option for a certain period of time. The buyer has the right but not the obligation to buy.

You might wonder why an owner would agree to tie up his property with an option. Advantages to a property owner include: 1) the owner may be able to time his income for tax purposes, since option fees are generally taxable when the option is either exercised or expires (always check with your tax advisor); 2) if the owner needs money, an option may be a way to get money that he doesn’t have to repay, unlike a loan; 3) options are very flexible, and the owner may be able to negotiate an option which allows him to keep the property until a more opportune time – this is especially true of an owner in a pre-foreclosure situation.

Do the paperwork right! Options are extremely powerful and very easy to mess up. Be very specific, clear and complete about all the details. Remember, with options, you have to negotiate for both the option and for the purchase of the property. With a well written option, the following must be, as my old law professor was fond of saying, “patently obvious to the most casual observer”:

a)       Who is granting the option? Does it include heirs, successors and assigns?
b)       Who is receiving the option? Does it include assignees of the buyer, or is it an exclusive option to purchase by the buyer only?
c)       What property is being optioned? Property can be anything, including real estate, a beneficial interest in a land trust, a real estate note or nearly anything else.
d)       What is the consideration for the option? Remember, there must be some consideration for the option in the form of money, services or other obligations.
e)       How is the option exercised by the buyer? This is one of the easiest things to mess up in an option. If the procedure is not clear for exercising the option, it is an invitation to litigation!
f)       What will be the purchase price of the property if the option is exercised?
g)       How will the purchase price be paid when the option is exercised? Will it be for cash? Seller financing? Subject to the owner’s existing mortgage?
h)       Will the option consideration be credited to the option price or not?
i)       When can the option be exercised? For example, does the option holder have the right to exercise the option at any time during the option period, or can the option only be exercised after a specified amount of time?
j)       When will the option expire, and under what circumstances? The option should have a definite termination date, but might also include other circumstances under which the option terminates, such as a default under a lease.
k)       When it comes time to close, what are each party’s obligations? For example, who pays for title insurance, closing costs, etc? Are taxes prorated?

So what forms do you use? The answer is my favorite as a lawyer - it depends! There is not and cannot be a “standard” option for all purposes. They are simply too flexible. You must decide on a specific use for the option and then, as Shakespeare said, “Get thee to a lawyer!” (Okay, it was “Get thee to a nunnery” but I like it better as revised!).

When you have negotiated an option agreement for your IRA, you have several choices. First, you can let the option expire on its own terms. Sometimes this is the best course of action if the deal is not what you expected, especially if you only paid a small amount for the option.

Another choice is that your IRA could exercise the option and buy the property. Since there are ways to finance property being purchased by your IRA, including seller financing, bank financing, private party financing or even taking over property subject to a loan, this may be a good strategy for your IRA, even if the IRA does not have the cash to complete the purchase. Be aware that if your IRA owns debt financed property, either directly or indirectly through an LLC or partnership, its profits from that investment will be subject to Unrelated Business Income Tax (UBIT). This is not necessarily a bad way to build your retirement wealth, but it does require some understanding of the tax implications.

A third choice which is often employed in the context of self directed retirement accounts is to assign your option to a third party for a fee. Your option agreement should specifically allow for an assignment to make sure that there are no problems with the property owner. This is a great technique for building a small IRA into a large IRA quickly. I had one client who put a contract on a burned house for $100 earnest money in his daughter’s Coverdell Education Savings Account, then sold his contract to a third party who specialized in repairing burned houses for $8,500. In under 1 month the account made a profit of 8,400%, and all parties were happy with the deal! The account holder then immediately took a TAX FREE distribution to pay for his daughter’s private school tuition.

A fourth choice that sometimes is overlooked is the ability to release the option back to the property owner for a cancellation fee. In other words, this is a way for your IRA to get paid not to buy! Let me give you an example of how this might work. Suppose you want to offer the seller what he would consider to be a ridiculously low offer. When the seller balks, you say “I’ll tell you what. You sign this option agreement for my IRA to purchase this property at my price, and we’ll put in the option agreement that I cannot exercise my option for 30 days. If you find a buyer willing to offer you more money within that 30 day period, just reimburse my IRA the option fee plus a cancellation fee of $2,500.” Either way, your IRA wins!

The creative use of options can make your IRA grow astronomically if done correctly. In future articles I will be discussing different types of option strategies.

H. Quincy Long is an attorney and is President of Entrust Retirement Services, Inc., with offices in Houston and San Antonio, Texas. He may be reached by email at QLong@TheEntrustGroup.com. Nothing in this article is intended as tax, legal or investment advice.