Self Directed IRA Investing

For my first book review I decided to read Patrick Rice’s “IRA Wealth: Revolutionary IRA Strategies for Real Estate Investment”.   I had heard about the book from some friends and wanted to add it to my RE book collection. 

The begining of the book starts out with 7 Rules that are easy to follow.  Some are common sense but nevertheless it’s good to remember them.   They are:

1. Set -up Self Directed IRA
2. Transfer 401k money if possible to it.   
3. Learn the IRS rules that govern IRA’s
4. Learn all you can about RE Investments
5. Do your Homework
6. Be Prepared to Act
7. Invest new money into your IRA every year.

I followed them before I knew them all as rules and I’d argue there needs to be 1 more.  Number 8. Use a Roth IRA whenever possible for tax free distributions. 

Rice’s analogy of an investor being the Captain of your own ship really hits home with me.  I can completely identify with that by having my own “Crew” help me navigate the RE Investment waters.  He keeps this theme through out the book and to me that helps make the book easy to read and not become a tired and boring book of IRS regulations.

He describes when to use the different people in your team, which is helpful to remember that it’s easier to do this with the help of others than by yourself.  One Team member I think he may have left out is a good “Note Servicing Company”.  They help collect payments and send it directly to my IRA which makes this more of an automated process.  When a payment is late they tell me.

Rice goes in to some decent details about how you can work with family members while investing the funds of your self directed IRA.  His descriptions of what makes a true Prohibited transaction is very helpful in figuring out who in your family is eligible to invest with.  I think that part of the book is the best explanation I’ve read to date and one of the most useful parts of his book.  The chart is on page 132 fig 7.1.

Another technique that I am actively seeking to use with my next few Note purchases is T-I-C or Tenancy in Common.  On page 71 Rice describes how this could help get bigger deals done by partnering up with others.  With this the partners are in the same Position in the Note but hold a percentage of it based on how much they contributed to buy the Note.  You could then split the cash flow based on the percentage of ownership or in the case of buying a Rental Property on the sale the profit would be split in the % each T-I-C has.   

To me the single most important reason I like this book is that it opened my eyes a little wider.  I have to confess I buy Notes for my Self Directed IRA for the cash flow they provide because I’m building up reserves right now.  However Mr. Rice describes a way for someone to Buy a piece of property for retirement not just cash flow.  You buy a piece of property that you will want in your retirement years, like someplace in Sanibel Island Florida, Jackson Hole Wy, Seattle, WA with your IRA funds.  Rent it out until you retire for the cash flow and then on retirement take the property as a distribution.  Now you have your vacation home paid for and can use it as you like without any worry of prohibited transactions. 

To me understanding this and reading it is worth the price of the book and why I think everyone should get Patrick Rice’s IRA Wealth: Revolutionary IRA Strategies for Real Estate Investment.  Today!

 

When I am investing my Self Directed IRA money I make extra sure I know what the Face Value is of the Note I’m interested in buying.  

Face Value of a Note is a pretty simple idea.  It’s basically the value of the Note when it was originated or in very simple terms the amount printed on it.  On the Top of the Note it will say FOR VALUE RECIEVED _________.  It’s the Number printed in the line that is the Face Value. 

However if the Note has been paid for a while the Face Value and the Actual Value can be way different.   You certianly want to know the amount of money you are buying the Note for, and generally it won’t be for Face Value.  This is where you can lose serious money if your not sure of what you are buying.  Here’s an example:

I sell you a car for $10,000 at 6% interest and payments of $200.00 a month for 58 months.  I keep the Note for my Self Directed IRA.  In the very beginning (month 1) the Face Value is $10,000 because you haven’t paid 1 month yet.  

After paying for 55 months the balance or Actual Value of the Note is $531.13.  That’s how much there is  left to pay to the Note Holder but the Face Value on the Note still says $10,000.

Using your Financial Calculator  you can figure out what the difference is between the Face Value and the Actual Value of any Note you are considering buying for your Self Directed IRA.

Will

Loan to Value or LTV is very important to understand when buying Notes for or loaning money out of your Self Directed IRA.  Simply put LTV is the % debt to value for a specific property. 

The reason it’s important is you want to make sure your total cash investment is less than what the property will sell for at the Foreclosure auction.   A good figure of thumb for that is around 70% or less.  So in the case of a SFR property valued at 100,000 you want to make sure you are into it less than 70,000.   So the lower the LTV the safer your investment is.

Loan Position also needs to be taken into account as well in this equation.   In the above example if  the house was free and clear, meaning that there was no mortgages on it.  You could loan up to 70,000 and feel safe if the borrower didn’t pay, you could foreclose and get your money back at the auction.  

However if you did the same thing and there was a first mortgage already for 30,000 then your combined LTV would be at 100% in second position and you would be really risking 30,000 of your money if the borrower defaults.  Not a good investment in my mind. 

For different types of property the LTV is different. 

1. For example on Raw Land, meaning not improved, I will not go any higher than 50%. 
2. For a mobile home in a park I feel most comfortable no more than 60% LTV. 
3. For Single Family homes I’ll go as high as 70% and in the rare case depending on the borrower, location, age of home, I’ll go as high as 80%.

My best investments so far have been really low LTV, like less than 20% in first position on SFR.  I’ll buy notes like this all day and I have several in my Self Directed IRA.  I sleep just fine even though the property and borrowers are a few thousand miles away from my home, because the LTV is so low.

Lastly LTV is one of those things that will help you determine if your make a safe or risky investment.

There are a 2 basic types of IRA accounts and both are complicated enough in their restrictions and benefits. They are the Standard or Traditional and the ROTH IRA.  There are plenty of other retirement accounts like the 401K, Solo401K, Roth401k, SEP, Simple IRA, Keough, but to make this a little easier to understand and to make my point I’m just illustrating the scenario with the Traditional and ROTH IRA’s.

The Traditional IRA is nice because you can take deductions on your taxes when you contribute as long as you qualify with the rules.  You then invest the money and because of the compound interest effect you can amass great sums of money.  The problem with the Traditional IRA that hardly anyone focuses on is that on withdrawal at retirement you will PAY TAXES on any GAINS you have made!  In effect reducing the size of your golden egg significantly.  To me that is defeating the purpose.

Now don’t get me wrong I have a Self Directed Traditional IRA account.  I even invest it’s money into Notes.  The difference for me is that is not my Main Retirement account.

 My Main Self Directed Retirement account is a ROTH IRA, for 1 reason and 1 reason only and that is GAINS and WITHDRAWLS at retirement are TAX FREE.  Of course that is unless Congress decides to amend the rules someday, but if that happens there will be so many folks complaining and making a fuss so I don’t think that will happen. 

The benefit of the ROTH IRA is that you pay taxes on the money you put in first, then invest it and compounding will create that large Golden Egg for retirement.  I would rather pay taxes up front and then be able to use that money tax free for 30 years to invest at 15% interest or better than do the reverse.

I think unless you are real close to retirement right now there is only 1 account to use and that is a ROTH IRA. 

You can of course invest in Notes in a Taxabale account but that defeats the purpose for retirement funds.  What I do is keep my IRA money working first and if I still find good Note opportunities I use my cash or borrow money to invest. 

Besides your Brain, Financial knowledge, and some Common Sense, the most important tool is a Financial Calculator. 

To know how to use one, understand what it does, and how it can help you, a financial calculator will be the single most important thing you can have in your Toolbox.  My calculator has made me more money than any other thing I use to Find and Buy Notes for my self directed IRA.  A financial calculator can save you money once you have mastered it’s use.

There are many different kinds of Financial Calculators out there.  I have an HP 10bII like this one.

This calculator is very easy to learn how to use. It comes with a good manual to learn more than just the basics as well.  I recommend it to anyone who needs a financial calculator and it will pay for itself over and over again. 

I’ll write another post soon on how to use it to calculate Yield, Monthly payments, etc.

Hands down my favorite type of Investment for my Self Directed IRA (SDIRA) are Notes.   I like Notes for 3 reasons mainly.

1. Cash Flow
2. Safety
3. Less Management problems 

Cash Flow is King for me because I can take the cash and buy another Note to make my monthly total cash flow grow bigger. 

Safety to me is having a first position Note, however if the LTV is right for me I’ll invest in any position.  The word Safety to me means that I can, at the minimum get my original invested money back.  I’d rather be in the position of having someone owe a payment to me than owing the payment to someone else as in owning a property.

Managementof Notes for me is usually less time consuming that finding renters and fixing and painting the property so I choose to own the Note on a property.  A lot of the problems can be avoided by screening what Notes you buy.

Will

A Note is short for Promissory Note.  

A Promissory Note is nothing more than a document between parties describing a payment obligation that someone signs because they received financing for something.  Here’s and example, I go out and buy a new Gas Stove from a store and I don’t have all the money.  They offer to finance it for me and I sign a document that says I now owe the Store X amount of dollars for Y term at Z Interest rate.  It also describes what will happen if I pay early, stop paying, etc. 

Here’s another defininiton from en.wikipedia.org/wiki/Promissory_note

“A promissory note is a contract detailing the terms of a promise by one party (the maker) to pay a sum of money to the other (the payee). The obligation may arise from the repayment of a loan or from another form of debt. For example, in the sale of a business, the purchase price might be a combination of an immediate cash payment and one or more promissory notes for the balance. “

Notes are created for just about any service or thing that is sold today:

Real Estate, Mechanic Liens, Yachts, Airplanes, Motorcycles, Cars, Appliances, Businesses, Mobile Homes, Private education companies, etc. 

Will

When I look at an opportunity to invest in something the first thing I want to know is.  What is my Yield going to be?

  I want to know for X amount of dollars I put in I will get back Y amount in return.  It’s not hard to figure out but you do need a tool like the HP 10bII.  The Yield on your investment is not the same as the Interest Rate.  I normally invest in Notes for my Self Directed IRA because they return a cash flow that I can collect and then re-invest it again.    When a bank loans out money, they do this to gain an interest rate in return, or their rent on their money.  To the borrower, it’s the cost of borrowing the money from the bank.  The banks return is the Interest Rate they charge. 

Here’s an Example:

You borrow $10,000 at 10 % interest.  The payment will be $200/mo for 65 months. The Lender or bank gets $13,000.00 in total by the 65th month.  A $3,000.00 gain in profit.

Yield is different, it’s the Return on Investement or ROI. 

When I buy a Note, I buy it at a discount to the Face Interest Rate and Face Value.  The Face Interest Rate is the same thing the bank charges, but when I buy that Note for less than Face Value I’m creating a higher Yield.  The Seller of the Note will sell to me for  a discount because they need cash today instead of next year. 

 Here’s an example using the same numbers as above to help illustrate my point.

You pay $7,000  for the $10,000.00 Note with a Face interest Rate of 10 % interest.  The payment will be the same $200/mo payment for 65 months.   The Yield is 25% because you paid less than the $10,000.00.  The Lender or bank gets same $13,000.00 in total by the 65th month but now you have a $6,000.00 gain in profit because you invest only $7,000.00 not $10,000.00.

I’ll make a post soon on how to use a Financial Calculator to plug these numbers in so you can do this for yourself.

 Will

The words “Self Directed IRA” to me has many different meanings.  On a purely Functional level Self Directed means that after you have identified and done your due diligence for an investment.  You “Direct” your IRA custodian to send money or “buy” it from person X.  Most often using an Escrow company or something like it.  Then in return you get the Documents and either wait for appreciation as in the case for a stock or get monthly payments in the case of a Note or Loan.  Another meaning for “Self Directed IRA” would be that you have the Choice of the types of things you can invest your money in.  As long as it’s not a Prohibited Investment or Investment in Collectibles like these:

• Artworks
• Rugs
• Antiques
• Metals
• Gems
• Stamps
• Coins
• Alcoholic beverages
• Certain other tangible personal property

You can invest in it.  The pool of available investment options just became almost limitless, but most definitely larger than stocks, bonds, mutual funds, stock options, etc.    The best part is that you can use your own creativity to find things that you already know about to invest in your retirement.  I’ll bet that some of those ideas could be pretty cheap to start with and even if you only had $4,000.00 or less to start with you get started right away. “Self Directed IRA” can also mean Freedom.  Not only is it the Freedom of choice as I mentioned just above but also it could mean freedom from fees or at least making sure the fees you are charged are less than traditional investment options.  For me one of the biggest draws was reducing management fees to a yearly fee based on the amount in my account and ultimately capped at what I think is reasonable.  No more 1-2% per year plus transaction based fees, etc.  This is not the biggest cost but every little thing helps and I want IRA funds compounding tax free as much as possible.  If I can save a little now and put it to work at a good interest rate, like 10-12% or more, I know I’m getting ahead.   Another way this is Freedom is of course at the end when you’re in harvest phase.  The work now will be Freedom later.  Compared with just a Savings account below, see what $4,000.00 IRA could be if you added that much to it every year for 35 years.  I’ll let you figure out how much $4,000.00 is per month or even daily.

Years

1

10

20

30

35

Savings

0.0%

$8,000.00

$44,000.00

$84,000.00

$124,000.00

$144,000.00

SDIRA

10.0%

$8,800.00

$80,499.64

$278,920.00

$793,571.31

$1,304,916.97

SDIRA

12.0%

$8,960.00

$91,041.73

$361,380.11

$1,201,010.11

$2,145,050.94

Lastly, “Self Directed” to me means, that after doing all the diligence in looking at an investment and making sure that it’s good for me, that I reap the rewards of it.    I’m responsible for it and I also get the benefits of that work.  The Yield, on the type of investments I have in my Self Diredcted IRA, above 15% are common and it can be even more.  Will

A lot of people contribute blindly to their IRA’s hoping that the 8-10% in interest they earn from a mutual fund over 30-35 years will make their retirement years golden.  To me there is too much chance in that idea. Why give someone else the responsibility and control over your retirement funds?   Don’t get me wrong, I really think folks that are saving in IRA’s and other qualified plans, for their retirement are on the right track.  However I’ve learned first hand over the past few years that there is a better way.  My view is to take the control back and open a self directed IRA and invest in the things that you already know about and or are willing to learn.  That way if you have specific knowledge about a certain sector or busieness you can leverage that.  In a self directed IRA you can invest in just about anything that you want.  Here’s is a short list but not limited to:

1. Real Estate 
2. Real Estate Notes 
3. Private Placements
4. Private Loans to individuals 
5. Of course Stocks, Bonds, and Mutual Funds.  

There is a list of “Prohibited Investments” but that list is quite short and most I wouldn’t consider all that great anyway. 

Prohibited Transactions

Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person. Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).

There is more detail in the IRS 590 publication that you may want to read.  I would expect that your IRA custodian would also have more info.  Will