Entrust Learning Center > Case Studies > Options Can Be Great for Self-Directed Investors

Options Can Be Great for Self-Directed Investors

If you are a real estate investor, you probably make the majority of your profits by being creative. Utilizing a truly self-directed IRA allows you to maximize this creativity by making the profits that you earn become tax-deferred or tax-free.

By: By: Dave Owens, CES and Erica Dorrance

IRA Insights

One creative method for many real estate investors is the use of an option contract. If you are among the many individuals who purchase options on land or property, you will be happy to know that you can make tax-deferred or tax-free the profits from these transactions by purchasing them with your Self-Directed IRA dollars.

An option is a unilateral contract that allows a buyer (optionee) the right to buy property from an owner/seller (optionor) at a fixed price within a specified time. There are many ways an option contract can be used, most of which are permissible in an IR (assuming that the IRA isn’t engaging in anything prohibited).

Example: Mary Mortgagor is paying on a first and second mortgage. She is able to make the 1st mortgage payments comfortably but has a $30,000.00 balloon payment due at the end of the month for her second mortgage.

She cannot come up with the money. Joe Investor can choose to loan $30,000.00 to her to cover the balloon if she will give him an option to purchase the property in 5 years at today’s market value (which I $395,000.00) for $1,000.00. Note: The $30,000.00 loan will have to be structured in a way that would allow the IRA to purchase the option without being prohibited.

The contract is structured so that Mary gets to keep her house for at least 4 years provided that her mortgage payments are current. After that point, Joe Investor can ultimately have the house sold for $445,000.00. This would earn him a $50,000.00 return on a $1,000 option. If this was done in a Roth IRA, imagine the tax-free possibilities.

The terms and conditions of any option contract rely heavily on the seller’s situation/motivation to accept an option contract offer. Many option contracts are the result of a distressed seller. You should be familiar with your state laws as they pertain to lending to distressed homeowners.
Profits are commonly earned when an optionee sells and assigns their option to someone else for a fee rather than actually exercising the option by purchasing the property for themselves (or their IRA). This can be done by having the option recorded after it is purchased, finding a buyer and having a simultaneous closing between the optionor, optionee, and the new buyer. An option fee can be included in the closing statement.

In summary, the general purpose of an option is to offer consideration to purchase property at a fixed price over a certain period of time and within that time, find a buyer who will purchase at a price greater than the fixed price listed in the option contract. If the consideration comes from IRA funds, the difference/profit can flow back to the IRA. This is a unique investment strategy but should only be used by the experienced or skilled real estate investor. If this strategy is properly executed and all parties’ best interests are concerned, this can be very lucrative for an IRA.

Dave Owens is the Managing Member and Erica Dorrance is an IRA Specialist at 1031 Tax-Free Strategies, LLC a company that specializes in 1031 Exchanges and Self- Directed Retirement Accounts in SW-Florida. www.taxfreestrategies.com.

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