With the erratic nature of returns in standard stock market investments, American workers have started moving to platforms that provide them with more asset choices. One of these platforms – the Self-Directed IRA – has received quite a bit of publicity lately, largely due to the cryptocurrency craze. For the average investor, however, a more common destination for Self-Directed IRA investing is real estate. Although the plans are usually straight forward, there are a few pitfalls that even the savviest real estate investors should keep in mind.
Pitfall #1: Not reserving funds for maintenance and other payments
Real estate can be an expensive investment, and investors often fully utilize their funds when buying a property. This can be a mistake. Almost any property needs at least a minimal amount of maintenance, and the funds used to make those transactions need to come from the retirement account itself. If the investor lays out cash from his/her own pocket, that would be considered a Prohibited Transaction and could have negative repercussions for the IRA. The easiest way to avoid this problem is to calculate the property-related outlay for the upcoming year and make sure that there is an equivalent cash amount in the IRA account.
Pitfall #2: Choosing the wrong Self-Directed platform
Self-Directed IRAs come in two basic platforms: the Custodian model and the Checkbook Control model. In the Custodian model, the IRA funds are held by a third-party custodian and all transactions must go through the custodian. This involves filling out a form, waiting for authorization and execution, and paying a transaction fee for the custodian’s involvement. This model is most appropriate for properties that will have little to no investor involvement. However, if the property will require maintenance, business-related involvement, or a quick fix-and-flip, then the Custodian model is not the right choice. The execution will be time-intensive, and the transaction fees will quickly add up. Rather, the real estate investor should consider the Checkbook Control model. The Checkbook Control model works by establishing a dedicated LLC for the IRA, and then using that LLC to open a checking account at a bank of the investor’s choosing. The investor will receive a checkbook for the account, and use that checkbook to place all investments. This process puts transactional and investment control solely in the hands of the account holder. By doing so, it eliminates transaction fees and allows for instantaneous execution. This model is quickly growing in popularity amongst real estate investors as it offers a speed and economy not found in previous platforms.
Pitfall #3: Taking out the wrong kind of mortgage
Many investors wish to purchase properties by using their retirement funds to make a down payment and then finance the rest with a loan or bank mortgage. This is a permissible transaction as long as one important rule is followed. The loan must be a non-recourse loan. This means that the loan will be guaranteed solely by the property itself. A standard loan or mortgage usually requires some kind of personal guarantee and thus would constitute a Prohibited Transaction. With a non-recourse loan, the account holder has no personal responsibility to the lending institution. Most Self-Directed IRA facilitators will be able to provide an investor with a list of available non-recourse lenders.
All in all, real estate is an excellent addition to a retirement portfolio. When done properly, it can be easy, hassle-free, and, most importantly, profitable. For those looking to get away from the stock market and wall street with their retirement funds, real estate investing is the most common use for Self-Directed IRAs.
Learn more about the advantages of investing in real estate with your retirement accounts.