Guest writer: Dan Summers – Chief Executive Officer at IHT
Real estate has historically been a favorite investment vehicle for those looking to diversify their portfolios and grow wealth. Lower than stock market volatility, higher than government bonds and saving accounts rates of return, combined with tax advantages, have made it an essential part of any smart investment strategy.
Until recently, however, the most lucrative deals were only available to institutional investors and affluent families. Now, thanks to innovations in technology and the democratization of the legal system, millions of Americans have an access to the wealth-building tools and information.
The JOBS (Jumpstart Our Business Startups) Act signed by President Obama in April of 2012 has made it possible for everyday citizens to participate in private placements, including real estate offerings, with as little as $1,000 – $5,000, and mitigate risks by co- investing alongside hundreds of other stakeholders.
The legal framework has changed significantly over last four years. The latest legislation, Title III of the JOBS Act, has given non-accredited investors access to private deal flow for the first time since 1933. The document will take force in May of 2016.
Learn more about the laws ruling real estate crowdfunding and investment options available in this white paper.
An investor can choose among various property types, geographies, debt or equity deals, while enjoying the freedom of passive investments, straightforward process, transparency and fast information flow, and employing the expertise of professionals to vet properties, administer the deals, and handle the day-to-day operations.
Those who consider investing in new real estate crowdfunding offerings, can improve their rate of return by using tax efficient strategies involving individual retirement accounts (IRA). They’ve been around since 1974, and now, there are over 50 million IRAs in the US worth $7.3 Trillion, the largest category in the $23 Trillion retirement industry.
There are four most common types of Individual Retirement Accounts:
- Traditional IRA – a tax-deferred retirement savings account, allowing the money to be reinvested and taxes paid only on withdrawals in retirement.
- Roth IRA – a retirement savings account funded with after-tax dollars that allows your money to grow and withdrawals at retirement tax-free.
- Simplified Employee Pension Plan (SEP) – a version of a traditional IRA for self-employed individuals and small business owners.
- Savings Incentive Match Plan for Employees (SIMPLE) – a similar to SEP type which allows employees to participate and requires employers to make contributions on the employee’s behalf.
Over 98% of these IRAs are held in brokerage firms that invest in publicly traded securities such as stocks, bonds, mutual funds and exchange traded funds (ETF)s. Those who want to be more in control of their financial future and enjoy more flexibility in the investment types, use self-directed IRAs.
A Self-Directed IRA (SDIRA) can be structured as either Roth IRA or traditional IRA and allows the owner to invest in alternative assets such as real estate, private companies, promissory notes, precious metals, green energy, etc. As an investor, you can have a considerably more diversified portfolio than those who deal with publicly traded securities alone. SDIRA is further protected under federal bankruptcy laws, plus, real estate investments are insurable, which means they cannot disappear into thin air like some traditional Wall Street investments. According to the industry estimates, there are more than 2.5 million of self-directed IRAs in the U.S., accumulating over $146 billion.
Investing with self-directed IRA is not overly complicated. The IRS regulations require that your account assets are held by a qualified trustee, or custodian. So, you need to do your due diligence to find a reliable custodian, open and fund the account and choose among the investment options allowed by your custodian while following some basic rules which are generally outlined in the custodian’s documents.
There are two primary ways to fund your account:
- Roll Over Funds from a 401(k), other IRA or retirement account.
- Make Annual Contributions.
There are, however, limits on annual contributions: $5,500, if you are 50 and under, and $6,500 for older folks. Self-employed individuals can open a Roth SOLO-401k to increase the limit. In this case, those who are 50 and under, can contribute up to $34,000 tax-deferred & $18,000 tax-free. Individuals over 50 are limited by $34,000 tax-deferred & $24,000 tax-free.
There are also limitations on the use of the funds. You cannot “self-deal”, meaning the IRA owner, lineal family, spouse, or other disqualified persons cannot use IRA money for their direct benefit in the present, but rather build up IRA funds for the future. Investments in life insurance and in collectibles (artwork, rugs, antiques, gems, stamps, coins, alcoholic beverages) are not allowed. An IRA cannot be a general partner in an LP or LLP, or invest in S-corporation.
Another important issue to consider is possible taxation on your gains. Unrelated Business Income Tax (“UBIT”) applies to an IRA if it receives an ordinary income or if the offering company leverages its property acquisition with debt. UBIT is a hefty tax ranging from 15% to 39.6%.
An ordinary income includes investing in an LLC or LP that conducts new construction, real estate developments held for sale, or other business activities. Typical real estate offerings where UBIT can be due include: fix and flip properties or real estate developments with an immediate sale.
Passive income investments, on the other hand, include rental, capital gain, interest, and dividend income from a C-corporation. Most self-directed IRA holders find that there is a great benefit in working closely with a Certified Public Accountant ( CPA )that is familiar with real estate tax matters inside of self directed IRA or similar pension plan.
I therefore strongly encourage anyone consult with their CPA or tax advisor prior to establishing the account.
Fortunately, IRAs are allowed to use property related expenses and depreciation to offset UBIT. Just remember: the property is owned by the IRA, not you; all expenses must be paid by the IRA, not you, and all income therefore must go to the IRA.
The Self-directed IRA, by definition, involves more of a hands-on approach; but if you do your due-diligence and partner with a reputable company, the rewards can significantly outweigh the risks. By using your retirement savings to diversify your portfolio and boost your real estate investments, you can enjoy a much higher return in the long run so that you have more disposable income in your retirement years.
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