New Investor seeking advice on SDIRAs: How do they work? How do you pick a custodian?

Question

Hello! I am new to the real estate investing game. Looking to purchase my first property for a long-term rental. I've heard about using your 401k to invest, but I am having trouble figuring out how this works. I currently have a Roth IRA through my W2 with a custodian that does not do SDIRA. (Honestly not even sure if I am using the term custodian correctly.) Here are the things I am stuck on:

- Seems like there are a lot of different custodians out there who do SDIRAs. What questions should I be asking and what things should I be looking for when switching my Roth IRA to an SDIRA?

- Can I use the SDIRA for the down payment and closing costs? Can I use it for these things in seller-financing deals?

- How does it actually work? Is there a timeline for when it has to be paid back? What is the interest rate? Do those things all depend on the custodian? Can those terms be negotiated?

Thank you all in advanced! I appreciate the community here!

Brett Synicky · Answer

Here are several BP blog posts that explain much of what you’d want to know in short succinct explanations.

Non-recourse lenders

https://www.biggerpockets.com/member-blogs/2810/50272-list-of-non-recourse-lenders-for-self-directged-ira-and-401k

Solo 401k

https://www.biggerpockets.com/member-blogs/2810/21298-solo-401k-advantages

Sdira self directed ira

https://www.biggerpockets.com/member-blogs/2810/blog_posts/28450-real-estate-ira

Prohibited Transactions

https://www.biggerpockets.com/member-blogs/2810/44738-prohibited-transactions-for-a-self-directed-solo-401k-or-checkbook-ira

Disqualified Person

https://www.biggerpockets.com/member-blogs/2810/47960-disqualified-person-in-a-self-directed-ira-or-401k

Jeffrey Dixon · Answer

The IRA should be already set up and funded. If you wait to open the account until you find a property, that can cause delays. It can often take 2-6 weeks for the funds from another retirement account to be moved to the new account with us. finds the property the IRA will be purchasing? Answer is – You! Be sure to follow the rules and avoid prohibited transactions. Don’t choose a property that you or a prohibited party already own. You will negotiate the purchase price.

Your IRA will have a name that is listed as the buyer on the sales contactYou cannot assign a contract that you have entered into personally. If you do that, that contract will need to be voided and any personal money you have provided must be returned to you.

If you have to give the seller a deposit or earnest money, that comes from the Self-Directed IRA. The custodian sends the money. You cannot write a personal check for anything related to the house purchase.

The IRA can use financing. Just as the IRA is the buyer, the IRA borrows and repays the money to the lender. The only loan the IRS allows is a non-recourse loan. Non-recourse means that the lender can only foreclose on the property if the IRA is in default. You cannot give a personal guarantee for the loan. Most lenders will not agree to make a loan to an IRA.

There is a tax called Unrelated Debt Financed Income (UDFI) that your Self-Directed IRA will be subject to when financing is used. The Solo 401k is generally exempt to this tax.

The closing agent will draw up a settlement statement. This will list all the costs of the purchase.

The IRA must pay for any cost the property incurs. To make sure the IRA is sufficiently funded, we require the IRA have a 10% cash cushion left after closing. You can never pay any of these costs yourself.

So who does the repairs on IRA-Owned properties? The work must be done by a third party. You or a prohibited party cannot do any work on the property. You can decide who will do the work.

Rents are made to the IRA. The money can be sent by check or wire. The money can never be made payable to you. You could pick up a check made payable to the IRA and mail it to your account. If the tenant wanted to pay using cash, they would need to get a cashiers check made payable to the IRA.

Kevin Sobilo · Answer

@Christiana Scheevel, a few thoughts:

1. Yes, you are using the word custodian correctly. When you are investing in non-traditional investments there needs to be someone responsible for ensuring you are following all the IRS rules aka "the custodian".

2. You can use the funds for the down payment and closing costs.

3. HOWEVER! Your IRA is the entity taking the loan and that complicates things a bit. It is not you in your personal name. My understanding is that you would need a non-recourse loan and those have a lower LTV. I think something like 60% LTV. That means you would need to put down 40%.

4. The custodian has NOTHING to do with the investments you make. They are only there to ensure you comply with IRS rules. So, they don't determine interest rate or anything like that. You work through a lender.

5. You can't actively work on the rental. You can't be painting walls etc. I don't even think you can do the property management. You probably have to hire that out. Everything you do with an SDIRA investment needs to be passive where you are not doing "work". A custodian could better explain exactly what these rules are and what is and isn't allowed.

6. A typical SDIRA custodian may charge you fees for each transaction you ask them to make. So, if you need to pay a utility bill on the property the custodian may charge you a fee to initiate that transaction. This could be cost prohibitive for a typical small time rental investment.

7. There is another option. You will see the term "Checkbook IRA". That is a type of self directed IRA, BUT the only asset the SDIRA owns is an LLC you create and operate.

Since you operate the LLC, you are working around the fees. There is more cost setting up but less transaction costs running investments requiring more transaction.

HOWEVER! YOU bare more responsibility for not running afoul of IRS rules because the custodian isn't aware of every action you take.

8. A standard SDIRA is probably most idea for investing in VERY passive things like syndications where you as a limited partner do not work actively on the investment. You only contribute money to the deal.

Todd Goedeke · Answer

@Greg Scott Yes, you can invest in individually owned rental properties in an IRA. Passive management allows for hiring people to do property management jobs. With STVRs you can triple net lease a property to a management company to maintain passive management.

Nicholas L. · Answer

@Christiana Scheevel

hello. I would recommend that you not try to do this for your first property. it just adds complexity and risk.

the market is very, very difficult for new investors right now, and if you don't have actual cash... i'd wait. too many people are trying to get in with HELOC money, or retirement money, or sub-to... it just takes actual cash, or you will just lose money.

hope this helps - happy to dialogue further

Greg Scott · Answer

You can't invest actively in real estate with a SDIRA. In most cases it would be considered a prohibited transaction. (Google IRA Prohibited Transactions.) You can invest passively through an SDIRA in deals that other people manage..

On the other hand, should you do that at all? Investing in real estate through an SDIRA can actually increase the total tax you would pay, compared with withdrawing the money, paying ordinary income tax and then investing. Read Tom Wheelwright's book on Tax Free Wealth for a very good explanation. A Roth SDIRA is slightly different, but you still can't actively invest with it.

If you have the ability to create a Solo 401K, then you can avoid the excess taxes, but you still can't actively invest in real estate. You can only invest passively.

New Investor seeking advice on SDIRAs: How do they work? How do you pick a custodian?

New Investor seeking advice on SDIRAs: How do they work? How do you pick a custodian?

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