Use your 401K or IRA to invest in Real Estate without Tax or Distribution penalty!

Happy New Year everybody! 2009 will be a great year to buy real estate. It’s likely to get a little worse before it gets better and that means Deals! Deals! Deals! Things have been a little rough in the industry, although my activity and some other Realtors activity that I have talked with have been outstanding in the early stages of 2009! It is desperately needed everywhere including the Spokane and North Idaho markets! December 2008 numbers are not out yet but there were only 252 sales in November 2008 in Spokane County. December projections are to be similar. Median home prices in our local area are staying strong which is very good. Spokane county median home price is actually up from 2006 and 2007 to $179,950! Both ’06 and 07 were right about $176,000.
So let’s get to the real estate investment info. that you have come to read! Investing with your 401K or your IRA is a huge topic. Especially with the brutal fall of the stock market in 2008. Before we talk strategy I want to talk a little real estate investment versus a stock. How many publicly traded companies went bankrupt in 2008? I don’t know the exact number but it was A LOT! What happened to their stock? In most cases it lost 90+% of its value! Are you kidding me? That will wipe your retirement account out pretty quick. How many real estate properties went bankrupt? Zero. Yes the last couple years have taken its toll on real estate values, but some of the WORST cases (LasVegas, parts of California and most of Florida) were 50%. Most markets did not lose more than 25% of value. As you can see above some markets like Spokane have actually been pretty static, which is a good thing! So should you diversify some of your 401K or IRA into real estate? If you don’t need the money in the next 10 years the answer is absolutely! Real Estate even comes with very nice tax benefits!
Okay time for the strategy part. How do you invest in real estate with your retirement account without taking any tax hits or distribution penalties? Well there are a couple ways to do it. One is to do something called a hedge loan. This is basically a loan against your retirement account. Depending on your portfolio some hedge lenders will lend up to 80-90% of your account value. Problem here is you pay interest on the money. These loans are typically expensive and of course could put you in a very tough position if the value of the account drops below what you borrowed. Now you are in the negatives and that is not good. The benefit is you can “double dip”. Your funds stay in your account and do their thing, good or bad and you have a loan against them. This would be a good strategy if you really like the returns you’re getting in the stock market.
The method I typically recommend for my investors is different. I recommend actually using your funds and buying the real estate. No interest to pay and no risk of being upside down. Sounds good but what about the taxes or distribution issues? No tax penalties because you put all the profits back into your account! Here is how it works……. Let’s say you have a $200,000 401K that is not quite giving you the returns you would like. You find a nice apartment building in an emerging real estate market that puts off some nice cash flow and will likely increase in value. You and two partners are going to use your 401k funds to purchase the building for $600,000. After you have done your due diligence and consulted with an expert like me J and decide you are going to move forward on the building you are going to move your funds from your 401K to a self directed IRA. You are then going to give instructions to yourself directed IRA to fund the deal at escrow at the appropriate time. Your IRA will wire funds to escrow and you and your partners are commercial property real estate investors! Here is the catch….. all profits and cash flow go back to the IRA to avoid any tax penalty (so you are not taking a disbursement). Of course if you keep any of it you will pay the taxes. Okay so same group of 3 owns a building that makes a net profit of $75,000 per year just in cash flow. That will be $25,000 each that will go into your retirement account. That is a 13% return on your $200,000 investment. Each year the property is owned the returns go up. Why? Because rents go up increasing the net operating income of the property. A good property management company will help you reduce expenses in a lot of cases as well, again increasing the net profit. For this example let’s just sit at the 13% return every year. After 5 years you guys decide to sell. Because you have a great broker who put you in a solid property and your NOI is better than when you purchased it (that is what apartment building values are figured) the property is now worth $760,000. After ALL fees and taxes to sell, your group nets $700,000. So each of you will put your original $200,000 back in your account plus the end profit $33,000 each on top of the $25,000 per year. So now after 5 years you $200,000 investment has a value of $358,000! That is an annualized return of 16%. Not making you jump out of your chair? I don’t blame you, but we are being very realistic here! Also a 16% average return every year for 5 years secured by real estate is also a much lower risk than a company’s stock. Plus there is a lot of upside as the market takes off you greatly increase your NOI you could push the number closer to 20%. Those figures are nothing to sneeze at. If you could show me a portfolio with a sustained 16% per year return or heck even an 11% I would say that is extremely well done. Oh, I forgot to mention …… you will be depreciating the building each year you own it that will give you great tax benefits. That is not calculated into the above returns.
So in a small nutshell that is how it is done. Yes you would need an LLC among a grocery list of other things but a good advisor will handle all of that for you. Those costs are built in. Another thing you should know is that it is actually your IRA that is the member of the LLC and has the interest in the real estate.
I put deals like this together and can help you make solid returns using your retirement account. Let’s say we will give your retirement account some growth hormones. So if it is not sitting where you want it to be or not getting the returns you like, think about using it tax free to buy some solid properties and take advantage of today’s buyers market. Feel free to contact me with any additional questions on the subject. There is, as you may expect more detail to it but I can guide you through or answer questions you may have. Oh by the way, this same self directed IRA and process can be used for single family property, commercial property, mortgages, hard money loans, private money, etc. So get that account working a little smarter for you!