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 two of the three options for doing so. With the first strategy, you act as a fund manager, making decisions, negotiating and executing contracts, selecting vendors, and conducting the financial transactions. With the second strategy, you operate as a lender, using your plan to lend capital to investors and/or contractors who have expertise in flipping properties. In this post we will talk about a third option, which captures the up-side of a flip without the down-side of UBIT.
The Pros and Cons
One of the most appealing aspects of flipping property is the opportunity to build equity through buying distressed properties at a discount and adding value through rehabilitating the property. The hybrid flip approach is a strategy that allows you to reap this equity reward, but without the cost of UBIT liability. This is accomplished by holding the property as a passive rental investment for a period of time prior to selling.
The risk of this transaction type is that the real estate market could change, and that $200,000 property might not sell as easily in the future as it could today, or fetch that kind of a price if the market turns. However, if you have good cash flow coming in, there is no requirement for you to sell. You might choose to hold the property, perhaps pulling out a bit of the equity in the form of a non-recourse loan, which you could use to make additional investments.
Another consideration is that the skills to find discount properties and rehab them are quite different from those required to be a landlord. Not everyone is good at both, and many who come from a flipping background would be well served by having their IRA hire a property manager to run the rental phase.
Slow and Steady Wins the Race
The primary thing to keep in mind about this strategy for investing with your self-directed retirement plan is that it takes a little patience. Rather than buy-fix-sell, you would buy-fix-rent-sell. By holding a property as a passive rental for a reasonable period of time (at least one year), you change the nature of the transaction from active to passive. When you sell that property in the future, your plan is simply disposing of a passive investment asset and reallocating its portfolio from holding real property to holding cash. For this type of property sale, there is no UBIT implication.
Of course, if you were to do this with six properties simultaneously and sell them all after 12 months and one day, the IRS would almost certainly consider this to be real estate sales business subject to UBIT liability. However, if you maintain a natural process of fixing and renting properties, then selling them and moving on to new properties (or other investments) down the road; this would not likely be viewed as a business activity subject to UBIT.
How it Works
In our prior posts, we illustrated each option a capital investment of $150,000. If you took that same $150,000 and put it into this type of a transaction, what would it look like? Your $150,000 investment in the flip created a property with a market value of $200,000. If we apply the standard 1 percent rule, a property of that nature should rent for around $2,000 per month. For the sake of simplicity, we will ignore potential appreciation, since any such gain in the short-term would probably be nullified by the cost of freshening up the property for sale after renting it for a period of time.
Since the property was recently rehabilitated, we can expect minimal repair expenses and, after allowing for holding costs like property taxes, insurance, maintenance, etc.; we might project $18,000 in net income. Though you may very well choose to hold the property longer, the one-year performance would be a net return of $68,000, representing a 45 percent ROI. If we compare that with other investment options, this is a very strong prospective return for your efforts.
The bottom line is that there is no single way to approach every opportunity, but any good opportunity can provide you with several ways to generate good returns. Additionally, since the average annualized return in the stock market for the ten years beginning in 2005 was 7.65 percent, each of the three strategies we have outlined in this series represents a significant step forward on the path to building your retirement future. If you familiarize yourself with the processes, requirements, and tax rules that apply to real estate investing with your self-directed IRA or 401(k) plan, you can find a way to take advantage of opportunities you see in your market while maintaining the blend of risk, effort, and reward that most precisely suits your individual circumstances and goals.