How to Buy Real Estate with Your IRA Part III

In Part I we discussed how Wall Street has clearly dominated IRA funds for thirty years evidenced by its continued control over 97% of five trillion IRA dollars.

Read Article 1: http://www.escapefromamerica.com/2010/10/self-directed-ira-international-real-estate/

In Part II we learned about the three major IRA options that will allow your Retirement Plan to purchase real estate. And we learned that Wall Street offers none of these:

Self Directed IRA

Self Directed IRA Check Book Control

Individual 401(k)

Read Article 2: http://www.escapefromamerica.com/2010/11/how-to-avoid-ira-fees/

IRA Mistake #3

Understanding the operational differences among the Self-Directed IRA, the Check Book Control Self-Directed IRA and the Individual 401(k), the benefits and burdens of each, and the bottom line cost to establish each and yet you still have not changed from your current Wall Street IRA where a Stock Broker controls your financial future.

Part III   How to Buy Real Estate with Your IRA

Maybe a little encouragement is needed and examples of how real estate in your IRA can truly “Diversify” your retirement portfolio might encourage you to move forward.

First  I would like to emphasize that investing 100% of your IRA funds in real estate is probably not a good idea just as having 100% of your IRA invested in Wall Street products isn’t a good idea. Yet incredibly that is exactly what 97% of IRA Owners do, they place 100% of their retirement funds in Wall Street.

A Great Time To Buy Real Estate

Most of us are aware that the prices of housing, including rentals properties, crested a few years back and are now at bargain basement prices, in many cities rental properties are at the lowest prices in decades.

Your IRA and Real Estate

Before we get into the mechanics of “How to buy rental properties with your IRA” with illustrated examples, maybe we should first discuss …

“Why buy rental real estate at all?”

This is a good question and a valid one. Just because an investment (rental property) is priced at an all time low doesn’t automatically equate to, “you should buy it”.

But the question, “Why buy rental real estate at all?” should not automatically snap shut an open mind either.

Let’s cover some of the basic facts about rental real estate that will allow you to make a better informed decision whether or not you might want to involve your IRA with the purchasing of rental property.

When I suggest IRA owned real estate it doesn’t have to be a single family home “rental property,” it could be commercial (medical building) or industrial property (warehouse), but typically these types of property require large sums of money and therefore eliminate most IRA Owners from buying them.

Raw land or a building lot are also real estate candidates, however, neither generate income. Because we are interested in your IRA held assets creating income streams we will focus on rental income property, primarily single family homes.

You can’t live in a Mutual Fund.

The majority of people with IRAs continue to allow their Stock Broker or Financial Planner to place their IRA dollars into Mutual Funds. But, no matter how valuable the Mutual Fund shares become you cannot live in a Mutual Fund. And, if you sell Mutual Fund shares to generate income, unless the share value increases the same as or more than your withdrawals, you will deplete the principal and your principal will begin to decrease, possibly quite rapidly and to zero, i.e. you will run out of money.

Most Mutual Funds will increase over a long period of time and so too will the value of a rental property and also the rents it generates. But in contrast to a Mutual Fund, you can use all of the rental income without chipping away at the principal.

With a rental property it is possible to have your cake and eat it too, i.e. as the value of the rental unit grows so will the rents. During the recent real estate debacle many cities across the USA experienced property value declines of 50% of more yet the rentals did not decline as severely.

Replacement Costs

Many recently constructed (2000 – 2010) rental properties today come with prices so low you cannot buy the materials to rebuild the property let alone buy the land. This phenomenon is why many major home builders have ceased building new homes and are scooping up recently constructed homes at fire sale prices far below the replacement costs. Why would a builder construct a new home for $200,000 when it can buy one down the street for $85,000?

The Returns on Buying a Rental Property

Example A (all cash purchase):

Single Family Home – Constructed 2004 – 3 bed 2 bath – 1,365 sq. ft., 1 car garage

Ten Homes Purchased at one time for $350,000 total or $35,000 each.
Cost: $350,000 (replacement cost $700,000)
Combined Rental Income: $7,500 ($750 each)

Monthly Costs:

1. Zero Mortgage:  $    -0-
2. Property Management (10%):  $   750
3. Vacancy Factor (10%):  $   750
4. Reserves (5%):  $   600

Expenses:

5. Taxes:  $   1,250
6. Insurance:  $   1,000

$4,350 Total x 12 months = $52,200

7. Net Income:  $3,150 Total x 12 months = $37,800
8. Cash On Cash Return:  10.80%   ($37,800/$350,000)

This example it is quite realistic because of items #2, 3 and 4. Many rental properties are represented minus items #2, 3 and 4 and based on the erroneous assumptions that:
1.      You don’t need a Property Management Company (you’ll do it yourself)
2.      There will never be a vacancy (our example of 10% was taken from a Census)
3.      You will never need to replace a defunct water heater, worn carpet or leaky roof.

Fool’s Gold

By eliminating items #2, 3 and 4 you artificially pump up the net cash flow by $2,100 a month thus changing the Cash On Cash factor accordingly:

18.00%   ($63,000/$350,000)

Example B (50% cash 50% financing purchase):

Single Family Home – Constructed 2004 – 3 bed 2 bath – 1,365 sq. ft., 1 car garage

Ten Homes Purchased at one time for $350,000 total or $35,000 each.

Cost:  $350,000 (replacement cost $700,000)
Combined Rental Income:  $7,500 ($750 each)

Monthly Costs:

1. 50% Mortgage: $1,050   ($175,000 @ 6% 30 year amortization)
2. Property Management (10%):  $   750
3. Vacancy Factor (10%):$   750
4. Reserves (5%):  $   600

Expenses:

5. Taxes:  $   1,250 ($125 per month per home)
6. Insurance:  $   1,000 ($100 per month per home)

$5,400 Total x 12 months = $64,800

7. Net Income: $2,100 Total x 12 months = $25,200
8. Cash On Cash Return:  14.40%   ($25,200/$175,000)

You can see that your Cash On Cash Return jumped from 10.80% to over 14.40% because your IRA used 50% financing. Even in the toughest of times few economists would consider a 50% mortgage (50% LTV) for a single family home purchased at a bargain price risky.

Imagine thirty years from now leaving your children ten fully paid for cash flow producing homes?

Don’t forget U.B.I.T. (Unrelated Business Tax)

Ah, remember U.B.I.T.? If you use debt financing with your IRA you can trigger U.B.I.T.

If you use debt financing with your Individual 401(k) you do not encounter U.B.I.T.

Here’s how U.B.I.T. would impact Example B above.

7. Net Income after subtracting mortgage payments and all expenses:  $25,200 annually

U.B.I.T. requires you to apportion that part of your net rental income derived from financing percentage, i.e. you financed 50% of the purchase price ergo 50% of the net income or $12,600 is subject to U.B.I.T.

U.B.I.T. allows an annual $1,000 exemption from the apportioned net rental income.

$12,600 (50% of net rental income)
$1,000 exemption

$11,600 subject to U.B.I.T.
x 35%  U.B.I.T. tax rate

$4,060 U.B.I.T. tax

$25,200 Total Net Cash Flow
$  4,060 U.B.I.T. tax

$21,140 Net Income after U.B.I.T.

Adjusted Cash On Cash = 12.08% ($21,140/$175,000)

All Cash v. 50% Financing

$37,800 Net Income without Financing

$21,140 Net Income with 50% Financing

At first glance one might jump at the all cash purchase scenario but you should take into consideration that under Example B you used only half of your cash, $175,000 v. $350,000 and that the tenants over time are paying you mortgage off. Also, your cash On Cash Return is greater with 50% financing even after paying U.B.I.T.

All Cash: Cash On Cash Return:   10.80% ($37,800/$350,000)
50% Financing: Cash On Cash Return:  12.08% ($21,140/$175,000)

How About No U.B.I.T.?

The above Example B with 50% financing triggers U.B.I.T. whether you use an IRA, Self Directed IRA or Check Book Control Self Directed IRA.

With an Individual 401(k) U.B.I.T. does not come into play thus your Cash On Cash Return increases to 14.40% ($25,200/$175,000).

There will probably not be a more opportune time to purchase American real estate now as evidenced by the flood of foreign investors pouring Euros and Pounds into good old USA real estate. It wasn’t that long ago that a modest rental home in England Ireland fetched US$600,000. When these foreigners see quality, recently constructed US homes for under $40,000 they are snapping them up.

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