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By: David Cline
IRA Insights
By: David Cline
Perhaps you like the idea of using your self-directed IRA or 401(k) to buy and rehab real estate, but worry you don't have enough money saved. Maybe, like many, you haven't even started saving for retirement yet but plan to make this your New Year's Resolution.
It turns out, you don't need a lot of money in your IRA to start investing in real estate. Your IRA can borrow money. That's right! There are a few lenders that understand your special needs and can make a "non-recourse" loan to leverage the money available in your IRA. Because the IRS requires that loans made to IRAs be "non-recourse" (meaning the lender has no recourse to you personally, or your IRA—the only recourse is the asset itself), most lenders tend to shy away from making these types of loans.
Why would a lender want to issue a non-recourse loan to a self-directed IRA? The answer is actually quite simple. A lender would make a non-recourse loan as long as they have reasonable insulation from risk. The insulation from risk usually comes in the form of a down payment.
The more money a borrower has down on a loan, the more protected the lender is. This formula fits perfectly with the IRS requirements of tax free profits using the self-directed IRA. Most rehab lenders require at least 30% to 40% of the loan amount as a down payment, but you can put more if you wish. This could allow you to buy up to 3 times as many rehab properties as you could without this type of leverage.
When looking at financing for your rehabs, you would generally expect to have a year to complete the project, preferably without prepayment penalties. The goal is to get in and get out; you shouldn't be penalized for your efficiency. Second, expect to pay points to secure this type of financing. Once you have identified your investment property, the finance company will likely have a "subject to repairs" appraisal done. This type of appraisal is used to determine what the property would potentially be worth if all required repairs were complete. A rehab lender will usually base their loan as a percentage of the after value (ARV).
When seeking out a non-recourse loan, be prepared to submit your self-directed IRA statements, a credit application and recent credit report. The lender will generally pull the credit. Once you submit this information, the file is underwritten and "decisioned" within a few business days.
First, you need to have your self-directed IRA account open and funded. You will want to see the folks at EntrustCAMA for this. Next, you need to put a property under contract.
You may be thinking, "Well, how do I know how much to offer for a property?" This is an often-asked question, and I'll outline a specific deal we did recently for you.
There were homes on a specific block selling for $120,000. Knowing this, our borrower wanted to sell the property quickly so he planned to sell the house for around $110,000. Time is money, and the quicker you are able to sell a rehabbed property, the better. He needed to build in a spread to allow for carrying costs, any cost overruns, unforeseen delays, selling expenses and, oh yeah, profit.
We usually recommend 35% of the ARV as your starting point. (You should use whatever number is comfortable for you, keeping in mind the aforementioned items.) This means he had $78,000 to work with ($120,000 - 35%). Now he needed to budget for repairs.
Remember, in a like for like comparison, he wanted to have the nicest and lowest priced home in the neighborhood, so he had to budget accordingly. It was determined that the property needed $22,000 in repairs. (We recommend you factor in miscellaneous expenses, usually 10% of the total repairs.) He subtracted the $22,000 from the $78,000. This left him with $56,000 for the purchase price and any closing costs. If he wanted to wrap closing costs he would have wanted to subtract them too. For a rehab loan, the closing costs generally run up to 10% of the loan amount.
The total amount of the loan was $78,000, with a 30% down payment being required. This would require that the self-directed IRA had to put down $23,400. The remainder of the deal was financed, allowing the borrower to leverage the funds he had available in his self-directed IRA, which, in turn, allowed him to do a larger deal (tax free or deferred) than he otherwise could have.
As we discussed earlier, one of the most important tips to remember as you lock up properties is to make sure your rehab loan does not have a pre-payment penalty.
You will have to meet with your accountant to discuss Unrelated Business Income Tax (UBIT/UDFI) which is a tax on the gains you receive from the borrowed portion of the investment. Many investors choose to use investment gains to pay off the loan as soon as possible to avoid paying UBIT. Depending on your situation, UBIT/UDFI isn’t necessarily a bad thing. We recommend that you talk with your tax advisors about it.
As you can see, using a rehab lender in conjunction with your IRA will allow you to buy a higher priced property or more properties than you could have otherwise with your regular income or IRA alone.
David Cline, VP of Marketing for Rehab Funding, has been a real estate investor since 1999. He has bought and sold homes through-out the Delaware Valley. If you are interested to learn more about non-recourse loans for your rehab projects, contact the Sr. Account Executive, Corey Baumann at the Wynnewood offices of Rehab Funding. He can be contacted at (610) 645-9939 ext 310 or via e-mail.
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