WAIT - My IRA Can Get A Mortgage And Buy Real Estate?

By: Catherine Wynne

One of the biggest roadblocks in the purchase of real estate with your IRA is the question of leverage. Leverage is one of the attributes of real estate investment that may enhance the rate of return. After all, having the bank as a partner, a large partner, allows you to buy something much larger than you could alone, without the bank. The greater leverage (the size of the loan) yields a higher rate of return. Why? This is how Rate of Return is calculated:

Net Profit

———————- = Rate of Return (%)

Total $ Invested

The smaller the investment as compared to the Net Profit, the larger the Rate of Return. This is why purchasing a larger building using a loan, thus minimizing the amount of cash you need, can increase your return on each dollar you invest. This is the concept of Leverage and how it is used to make money in real estate. Note that if using leverage, should the value of your property go down, leverage would also increase your loss. Using your IRA and debt to fund a real estate purchase is possible but there are rules that need to be observed in order to satisfy the IRS regulations on this type of investment.

Non-Recourse Loan – Not a Deal Breaker

The first issue that comes up is the IRS rule prohibiting individuals from providing credit to their IRA. This includes providing a personal guarantee on a loan secured by a property purchased by your IRA. Unfortunately, when making a loan on a property most banks require that you sign personally on the note. This is called a Recourse Loan and is not allowed by the IRS when using your IRA. If your IRA will own 100% of the property, this is equivalent to lending money to your IRA. Since most banks require BOTH a personal

guarantee AND the property as security, this creates a dilemma for IRA real estate purchases. Some banks may accept only the property as security by providing what is called a “non-recourse” loan, however; they also would require a very large down payment, likely 50% or more, if they will do it at all. In all cases a lower-leverage loan is better than no loan but there are other options to consider. The following outlines different approaches to buying real estate and using loans in the process. Our clients are constantly coming up with new ways of doing things and these are just a few.

Partnering With IRA With Cash

One couple found a rental property that was, in their estimation, an incredible deal. This property in Texas was affordable, unlike just about anything in their home state of New York. The problem was they had a total of $25,000 in their combined Roth IRAs, $25,000 short of the $50,000 purchase price of the property. What could they do? Talking with lenders revealed that there would be no Non-Recourse loan available to them. The solution? This is what they did:

1. $25,000 from the Roth IRAs

2. $25,000 cash from a refinance of their personal residence in New York

3. Property deeded to the couple, as individuals, at 25% each (total of 50%)

4. Property deeded to Roth IRAs as 50% ownership

5. Result: The couple reports 50% of the net operating income from the property; less the interest deduction for the $25,000 they borrowed with a home equity loan.

6. IRA: the IRA receives 50% of the net cash flow from the property. NOTE: IRA must pay its proportionate share of the expenses; therefore the bookkeeping must be done correctly to avoid IRS issues.

7. Upon sale, 50% of the net proceeds go back to the IRA; the 50% personally owned by the couple personally goes either to the couple or to a 1031 exchange accommodator.

What makes this a win-win situation is that the couple has 100% leverage on their 50% share of this property as well as the interest deduction and depreciation. The IRA, although not leveraged, has a real estate investment and the opportunity for both cash flow and appreciation at the sale of the property.

What are Friends For? Recourse Assumed by Third Party

One strategy that has worked well for obtaining leverage within the IRA is using an “angel”. In layman’s terms an “angel” is someone who will sign for the loan recourse by participating in the deal as a cash investor. By teaming up with someone who will sign for recourse you have access to a host of loan products. The amount of leverage possible is up to the bank and they will look at the financial strength of the person signing for recourse as well as the property value itself. Who can be the “angel” in your deal? The answer is not your wife, husband, parents, children or real estate broker or the spouses of these individuals, who are considered “disqualified persons” under IRS regulations. You can look to the following for help:

• Brother
• Sister
• Business associate (not your employer)
• Friends

Why would anyone consider signing for all the recourse of a loan and give your IRA a free ride in the event of default? Good question. People have used this strategy and have negotiated either a better equity position for the signer, or assuming the recourse for the signer’s IRA on the next purchase, or any combination of these two or other options. It’s really about the perceived risk and how the signer can best be compensated, if at all.

Owner Carry or Seller Carryback – Still the Best Deal in Town.

The “owner carry”, even with terms somewhat less than favorable than market, is still the best deal around, particularly with an IRA-funded purchase. An “owner carry” is when the person selling the property is willing to “be the bank” and fund the purchase by creating a note. This frequently happens on properties where the seller either has little debt or debt that can be paid off with your down payment. Usually there are far less closing costs than in a traditional bank-financed purchase. You would negotiate with the seller to structure the note such that the note is secured by the property only, not by your personal guarantee. The terms of the note are negotiable between you and the seller. Keep in mind that the due diligence on both the value and the title to the property are your responsibility and should be taken seriously. Banks, in protecting their interest in the property are also looking out for yours as well. It is suggested that both title insurance as well as an appraisal be purchased, although they are not required. The appraisal will ensure you are “in the ball park” price-wise and the title insurance will insure that the title passes to you free from previous claims and encumbrances.

Conclusion, but Not The End

There are many ways you can make a real estate deal work with your IRA. Leverage can be used if you decide to. It’s all up to you and what you are able to put together given the circumstances of each deal. There are many possibilities that can be examined and analyzed for their viability. I am always astonished at the creativity and ingenuity of the self-directed IRA investor. Maybe the next deal will be yours, but only if you take the first step and join the club.