Entrust Learning Center > Investments > Investing in a Pre-Construction Project

Investing in a Pre-Construction Project

Sam is looking for a good short-term investment return for cash in his traditional IRA. He doesnt have a lot to invest, but hes not impressed with the returns in the equity and bond markets. Sam,

Sam is looking for a good short-term investment return for cash in his traditional IRA. He doesn’t have a lot to invest, but he’s not impressed with the returns in the equity and bond markets. Sam, who is 50 years old, is comfortable with taking some risk, so when Harold, a builder he knows, approaches him with an intriguing preconstruction opportunity, he expresses interest. Harold needs $23,500 in cash, with the balance of the project (about $185,000) to be covered by a loan from a hard money lender.

Once the property is built, Sam will have two options:

• He can buy the property from Harold for a total price of $228,500. This represents his initial investment of $23,500, plus the $185,000 property completion cost, plus a profit of $20,000 for Harold. In this scenario Sam would use the property for long term rental income.
• Alternatively, he can have Harold sell the completed property to a third party for more than $228,500, and be repaid a fixed amount from the net profit. Harold and Sam have agreed that in this scenario Sam would receive $33,500. That represents repayment of his initial $23,500 investment, plus a $10,000 profit.

More attracted to the idea of long-term cash flow to his IRA, Sam decides that he would have his IRA invest the original up front money of $23,500 in Harold’s house construction project, and on completion, Sam will have his IRA purchase the property for $205,000 (This includes the $185,000 to pay off Harold’s completion cost, and the profit of $20,000 that Sam and Harold negotiated as part of the transaction.

Sam’s only remaining issue is whether or not to borrow the initial $23,500 so he can use his current cash for other investment opportunities. If he borrows, his IRA will have to obtain a non-recourse loan through his mortgage broker, Renee.

In a scenario Sam ultimately did not choose, he could have had his IRA lend Harold $23,500 on an unsecured basis. The loan would have been repaid from the net proceeds of the sale of the completed building. The division of the profits would have been 25 percent to Sam and the rest to Harold. Let’s assume the home sold for $285,000. After loan expense of $14,535, construction and closing costs, the profit was $68,815. Sam would have realized 25 percent of that, or $17,204 on $23,500, invested in a nine-month period. But instead he chose the long term cash flow scenario.

Traditional or Roth IRA?

When Sam loaned Harold money for the construction project, he used funds from his traditional IRA. What if Sam had tapped a Roth IRA rather than a traditional IRA for his preconstruction investment? To keep the comparison straightforward, let’s assume the amount invested is the same: $23,500. The rate of return from the construction loan is 6 percent over the next 20 years, and Sam doesn’t make additional contributions to his Roth.

First, let’s look at the upfront tax consequences. In contrast to traditional IRA contributions, which are tax deductible in the year that they are made, Roth IRA contributions are not tax deductible but the distributions are tax free.

Assuming that Sam’s tax rate is 35 percent, he has paid $8,225 in tax on $23,500 in Roth contributions; in other words, he has $8,225 less to invest. In contrast, Sam didn’t have to pay tax on his traditional IRA, and he wisely invested the $8,225 in a 7 percent Certificate of Deposit.
Whether the funds for the loan came from a Roth or traditional IRA, Sam’s preconstruction investment profit of $17,204 is the same.

After adding the profit to the repaid principal of $23,500, both IRAs would have $40,704.
But in Sam’s Roth IRA, that $40,704 and any additional profits from it would not be taxed upon distribution at or after age 59-1/2. In a traditional IRA, the same amount and additional profits would be taxed at the tax rate Sam would pay for distributions.

So let’s see how this works:

For the sake of this example, Sam invests the $40,704 in a CD earning 7 percent.

After 20 years, his investment has grown to $168,537. Since Sam is now 59 ½ years old, he decides to take a lump sum distribution of the full amount. From his traditional IRA, assuming a tax rate of 20 percent, Sam receives $134,830. But he also has the $8,225 he saved in taxes that he invested in a 7 percent certificate of deposit compounding annually.

Despite annual tax payments on that investment income at Sam’s tax rate of 35 percent, it has grown to $21,429.

So he now has an after-tax total of $156,259.

In contrast, the Roth IRA produces a tax-free distribution of $168,537—that’s a $12,279 difference in Sam’s favor! If Sam doesn’t choose to take a lump sum distribution, he would be required to take a distribution from his traditional IRA at 70-1/2, but he’s not required to take one from his Roth IRA, which is something that is very important to consider.

IRS statistics show that a 70-year-old will live an additional 21 years. In addition, about 27 percent of individuals continue to work and earn income after reaching the legal retirement age, although at age 70 1/2, a person is no longer permitted to contribute to an IRA. In this scenario, if Sam were to continue to work, his tax rate could be higher than 20 percent, thereby further reducing his earnings from his traditional IRA.

The Roth IRA investment option is quite appealing and provides Sam a gain on a longer term basis.
We always recommend that every person do the long term planning and analysis for their situation. As seen above, Sam was able to take advantage of the tax laws to add additional cash in his pocket over a long term. Due diligence complemented by planning and the long view pays dividends.

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