Durfee West PC

P.O. Box 203
Wynnewood, PA 19096
Philadelphia 610.642.1586 Denver 303.831.9500
Fax Toll Free 866.383.4874

1. What kinds of investments can an IRA make?
2. How can an IRA owner take advantage of these “unconventional” investments?
3. What are the drawbacks of investing IRA money in real estate?
4. What’s the problem with leverage?
5. What is a “Prohibited Transaction”?
6. Some IRA custodians offer “check book control” over the investments. How does that work?
7. If I buy property, can I get around the due on sale provision in a mortgage by putting it in a Land Trust?
8. Do I need a lawyer when I buy real estate?
9. Give some examples of people who needed a real estate lawyer.
10. How can I evaluate my “real estate investment guru”?
11. Besides not getting competent legal advice, what’s the biggest mistake real estate investors make?
12. Wait, I thought you were a full-time student. When do you have time to practice law?
13. How can you practice law in Colorado when you’re living in Pennsylvania now?

What kinds of investments can an IRA make?

An IRA can invest in almost anything except life insurance, collectibles (art, stamps, most coins, antiques) foreign investments, and stock in Subchapter S corporations. That means it can own gold bullion, race horses, timber, stock in private corporations, real estate, and other investments.

How can an IRA owner take advantage of these “unconventional” investments?

The IRA has to be in the name of a qualified custodian, which must be a bank or similar financial institution. To invest in things other than stocks or bonds, you need to have the account with a truly self-directed custodian. You can find them on the web. There are only a handful right now, but as this becomes more popular there will most likely be more.

What are the drawbacks of investing IRA money in real estate?

There are some significant drawbacks:

• The IRA can’t deduct property taxes or mortgage interest, or take depreciation.
• When you sell, the profit is ordinary income, not capital gain (which doesn’t really matter, because it’s tax-exempt or tax-deferred anyway).
• If you mortgage the property, it has to be in the name of the IRA, and you can’t guaranty the debt.
• The IRA must have enough liquid assets (either standing alone or in connection with allowable annual contributions from the owner) to pay all the expenses and service any debt, plus make any required distributions if the IRA owner is at or near retirement age.
• Income attributable to leverage may incur “unrelated business income tax” liability (a rule that allows the IRS to collect tax from an entity that otherwise doesn’t have to pay).
• If the owner performs personal services (i.e. “sweat equity”) to improve the property there can be all kinds of adverse consequences, including disqualification of the plan, penalties, and tax evasion charges.
• If you commingle funds or otherwise fail to respect the “separate” status of the IRA trust, the plan can be disqualified or there can be other tax problems.
• If you engage in a “prohibited transaction,” the plan can be disqualified.
• All income must flow into the IRA, and all expenses must be paid out of it. Keep in mind that the IRA is a separate legal entity, and the assets must be kept separate. You can’t manage the property yourself.

Despite these issues, many people still want to do it, because they have a bunch of money locked up in retirement accounts, and their stocks aren’t doing that well, and they think they can still do better with real estate.

Here’s a simple, safe example: Your IRA pays cash for a vacant lot. It is purchased from an unrelated party, and you don’t use it for any personal purposes. Your annual contributions are sufficient to pay taxes on it. The IRA holds it for a period of time, then sells it. The profit is tax-deferred, for a traditional IRA, and tax free, for a Roth IRA.

What’s the problem with leverage?

There are two problems with leverage. A big one is that the IRA owner can’t be liable on the debt. Not many banks are willing to lend on a nonrecourse basis to an IRA Trust. There are some, however. The other problem is that income attributable to the leveraged portion of the asset is subject to additional tax. In evaluating a leveraged investment in your IRA, you have to include that cost in order to decide whether your rate of return is acceptable.

What is a “Prohibited Transaction”?

Some advisors say that as long as your IRA doesn’t deal with a “disqualified person,” you’re OK. A “disqualified person” is: (a) the IRA Owner; (b) the IRA Owner’s spouse, ancestor, or descendent; (c) the spouse of the IRA owner’s child; (d) a fiduciary of the IRA or a person providing services to the IRA (such as the IRA custodian); (e) an Entity that is at least 50% owned (or a 50% beneficial interest is held) by any of the foregoing parties; or (f) a 10% owner, officer, director, or highly compensated employee of such an entity.

But there’s more to it. For example, if the IRA investment is found to be essential to accomplishing a transaction in which both the IRA owner and the IRA invest, then the entire transaction will be prohibited. Section 4975(c)(1)(E) prohibits any “act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account.” The person or entity on the other side of one of these transactions doesn’t have to be a “disqualified person” for it to be prohibited. Broadly, it’s a conflict of interest if the IRA does something that benefits your personal situation, and if there’s a conflict of interest, then that’s a prohibited transaction.

Here’s a simplified statement of what not to do with your IRA money. If you stay within this rule, you won’t get into a “prohibited transaction:”

“Never allow your IRA, or any entity it invests in where you have any say in the matter, to rent or sell to, or rent or buy from, or hire, or allow to use the IRA property in any way with or without consideration, (1) yourself or any person who is related to you by blood or marriage, or with whom you have any personal or business relationship outside the IRA, or (2) any entity that is owned in whole or in part or that employs or engages anyone in category (1)”.

There are still real estate investments you can make within these rules. Just be careful.

Some IRA custodians offer “check book control” over the investments. How does that work?

All of the client’s retirement plan funds are contributed to a limited liability company. The custodian owns all the shares of the LLC (but no other assets). The IRA owner is the manager of the LLC. The LLC can then invest in what it wants. The risks of commingling funds go up substantially in this kind of arrangement. Someday the LLC Manager might need money, and he might take it out of the LLC’s bank account. If he does, he’s just made a taxable distribution to himself, and if he’s not of retirement age, he’ll also have to pay a penalty. Or maybe he won’t have the LLC checkbook with him, and he pays an expense of the LLC. Oops, excess IRA contribution. So far, this structure is OK from a tax law standpoint. But if it begins to lead to widespread commingling of funds or other abuses, the IRS or Congress might step in to put a stop to it.

If I buy property, can I get around the due on sale provision in a mortgage by putting it in a Land Trust?

The short answer is no. The “trust” exception for the due on sale provision only applies to a grantor trust where the borrower continues to be the beneficiary of the trust. It’s also not true that doing this will give you “greater privacy.” In Colorado, you can’t find out from public records who owns or manages any entity, but to buy, sell, or encumber real estate, a trust will have to record a statement of authority which says who is authorized to act (i.e., the trustee). There is no way around the due on sale clause. If you rent with option to buy, do an installment land contract, or put it in a trust which then changes the beneficiary, you have violated the provision and the lender can call the loan due. And they have ways of finding out. And you have no defense except, perhaps, estoppel or laches, because when you did the transfer you sent them a letter telling them about it and they did nothing. I tell my clients to do that, but not to rely on it. They have to be willing to take the risk of having to refinance the debt on short notice if the bank calls the loan due for breach of the due on sale provision.

Do I need a lawyer when I buy real estate?

You may be assuming that the broker, or the lender, or the title company, is looking out for you. To some extent that’s true, and to some extent you and the lender have common concerns and interests. But if you don’t have a lawyer, there is no one in the transaction who is advocating just for you. You also will not have anyone who is knowledgeable about title and who will read all the documents and will explain to you what you’re getting into.

Give some examples of people who needed a real estate lawyer.

• The couple who bought a dude ranch from someone who had not used a lawyer, or gotten title insurance or a survey, when he bought the ranch. It turned out he didn’t own about one-third of it.
• The couple who bought a house and found out later that the driveway easement that ran next to their lot permitted the beneficiary of the easement to change the grade, resulting in too steep a slope for them to get into their own garage
• The couple who bought a property with 5 townhouses on it, and the covenants did not provide for adequate party wall, damage and destruction, or common maintenance provisions
• The people who thought they were getting access to their property over a private road by getting an easement from only one of the beneficiaries of the private road
• The many people who bought houses with neighboring fences, garages, walls, or driveways that encroach onto their property (shown by the survey, if they’d just look at it) and didn’t realize that could cause a subsequent buyer to decide not to buy
• The woman who wanted to open a hair salon in her home, which was legal under the zoning, but prohibited by the covenants on her property

How can I evaluate my “real estate investment guru”?

Ask for specific information about his own portfolio. Have him show you what he’s done.

Ask for references.

Be wary if he says you don’t need to hire experts. Of course you need to hire experts.

Be skeptical of “sure fire” schemes or “get rich quick” formulas. The only way to make money in real estate is to add value. Many, many people have gone broke on the “greater fool” theory. If it sounds too good to be true, then it isn’t true.

Here’s a link to a site by John T. Reed, who, among other things, “rates” gurus.

Besides not getting competent legal advice, what’s the biggest mistake real estate investors make?

Excessive optimism. You need to damp down all your projections, pump up all your projected expenses, and plan for it to take a lot longer than you expected. You need contingency plans (and funds) for unexpected issues. The plan needs to “work” for you with your “worst case” outcome. You also need at least one exit strategy. Remember that real estate is illiquid. Plan accordingly.

Wait, I thought you were a full time student. When do you have time to practice law?

Yes, I am a full time student. I think of school as one major “client,” but I have time for others. My classes are mostly at night, with a couple of them starting at 3 p.m., giving me blocks of time during the day to allocate to important and urgent matters. I have a BlackBerry, so clients can always reach me by email. For most of my career I was raising five children. They are grown now, leaving me plenty of time to concentrate on learning and law.

How can you practice law in Colorado when you’re living in Pennsylvania now?

My practice is entirely transactional, so there are no court appearances. When I was in Denver I rarely met face to face with anyone. Almost everything was done by phone, email, fax and overnight delivery. I have people in Denver who can take care of any in-person work, and I can do video conferencing, or hop on a plane, if necessary.