In our previous blogs in this series, we introduced the basics of investing your self-directed IRA or 401(k) in flipping property and discussed the first of three options for doing so, using your plan to flip property. In this post, we will get into the second option: lending through a self-directed retirement plan.
The Other Side of the Counter
With this option, rather than having your self-directed IRA or 401(k) take an equity stake in a flipping business, you would use your plan to lend capital to investors and/or contractors who have expertise in flipping properties. This places you on the other side of the counter, so to speak, by making you the lender. While your plan is still able to take advantage of the flip opportunity in your market, doing so as a lender makes this a passive investment. Lending is less demanding of your time than direct involvement in a flip, and is generally less complex in nature.
The Pros and Cons
One of the major benefits of this strategy is that the points or interest on your lending notes will not be subject to UBIT, because this is a passive investment strategy.
In addition, while there is a requirement for research and diligence on the front end, once a loan is in place there is not a lot of work to be done other than ensuring your payments are received on time.
Often times the capital requirements for lending are lower than those to acquire and rehab properties. This creates the ability for investors with smaller accounts to participate, or provides those with larger accounts a means to diversify.
One challenge with short-term lending on property flips is keeping your money actively deployed. There will certainly be periods of idle capital between one note maturing and being able to invest in the next deal. This is a challenge with most any real estate related investment strategy, however.
Some important aspects of this type of lending to keep in mind are that the terms of your notes may include points/fees and interest, and must be in conformance with state lending law.
Your IRA-funded note may not contain a share of the profits; otherwise it becomes an equity stake in the flip and subject to UBIT.
The key consideration – as with all IRA or 401k transactions – is to avoid disqualified parties. The borrower may not be a disqualified party to the IRA or 401(k). Disqualified parties include the IRA/401(k) plan participant, those providing services to the plan (e.g., the trustee or custodian), an employer whose employees are covered by the plan, a lineal family member of the plan participant including spouse, parents, grandparents, children, grandchildren, and spouses of lineal descendants. Entities such as businesses or trusts in which the plan participant or lineal family member(s) hold a controlling equity, beneficial or management interest are also disqualified
How it Works
In this type of transaction, your self-directed IRA or 401(k) plan would hold a trust deed secured by the property in question. Depending on the loan-to-value ratio (as well as other variables, such as the risk involved, amount of rehab required, and time for repayment), your plan might charge two to three points up front and 12 to 15 percent interest, with a minimum of 6 months interest owed even if the project is completed prior to that time.
If you are working with a turnkey provider that has a substantial track record and a steady supply of lenders, the rates may be somewhat lower.
If your plan lent an investor $150,000 with a two-point fee and a minimum of six months interest at 12 percent (interest only), your net gain after six months would be $12,000. If you did two such loans in a year, your total return would be $24,000, resulting in an annualized ROI of 16 percent.
While this option may not be as lucrative as acting as the property flipper, it still offers quite favorable returns compared with most other options for investing with your self-directed IRA or 401(k) plan. Most significantly, it shields your profits from liability to the UBIT and it does not carry quite as much risk or complexity as flipping property with your plan.
If you find that both of the options we have discussed so far appeal to you, stay tuned for our next blog, Real Estate Flipping 201: The Hybrid Flip Approach, in which we will cover the third option for investing in flipping property with your self-directed IRA or 401(k) plan – a model that allows you to capitalize on the equity potential of flips without the burden of UBIT.