How should I invest my self directed roth IRA?

Question

I have about $30,000 in a self directed roth IRA and I keep going back and forth on how I want to invest it. These are the options I'm considering:

1) Get a non recourse loan and use it as a down payment on a buy and hold single family property. My hesitation with this option is the UBIT (which I don't know a whole lot about). I'm concerned that it will eat away at my profits.

2) Become a private lender or invest in notes. However, I'm not sure how to get started with either of these. The little bit of research that I have done tells me that to get a decent return I have to be an "accredited" investor, which I am not.

3) I can withdraw it from my IRA, pay the 10% penalty (it's a roth so income taxes have already been paid) and it use it as a down payment on a single family buy and hold to add to my portfolio. This is the option I'm leaning towards at this point unless I can find out more about the previous 2 options. If I went with this option, I would then set up a solo roth 401k and put the money back into a retirement account over time.

What would you do?

Brian Eastman · Answer

@Audrick Brown IV

UBIT is Unrelated Business Income Tax.  See IRS Publication 598.

What is actually being discussed here is a sub-set of UBIT which is Unrelated Debt-Financed Income (UDFI).

When an IRA used debt-financing such as a mortgage, there is a small tax that applies to the percentage of the gains that the IRA receives through the use of non-IRA capital (the borrowed funds).

Here is an example:

$100K Property

$40K down payment with IRA, $60K mortgage

The property is therefore considered to be 60% debt-financed

60% of the income generated by the property is subject to UDFI

There is a $1000 exemption that is applied off the top

60% of the usual deductions such as depreciation, interests on the note, property taxes, etc. are then applied to further reduce the taxable income.

The net taxable amount after deductions is then run through the trust tax table.

The tax due is paid by the IRA on a 990-T filing.  This is entirely separate from the IRA account holder's personal tax return.

In the scenario above with a $100K property, if the income produced was 10%. the net tax would be in the neighborhood of $175-200 for a year, depending on the expenses.

The bottom line is that the IRA can benefit from leverage and a higher cash-on-cash return through the use of smart mortgage financing.

@Kerry Mertz

In your situation, a non-recourse loan from a commercial bank is likely out of range.  They typically want 30-40% down, 10-15% in reserves and a minimum loan amount of $50K.  You could obtain a non-recourse loan from a private lender, perhaps.

I would suggest looking into joint-venturing with another investor.  Avoid disqualified parties such as yourself.  There is the possibility such a strategy as mentioned above is OK, but that is purely interpretation and comes with risk.  Being a private lender with the IRA is probably your best option with your current funding.

Mike Reynolds · Answer

I was going through the same decision myself last year. The difference for me was I had an IRA as well as a Roth. I kept the Roth so I could get  tax free money to supplement my taxable money. I'm 15 years older than you though so I completely understand why you did cash out.

Best of luck and keep us posted.

Kerry Mertz · Answer

Update:

Some time has passed and I wanted to share my decision. It may not be the right decision for everyone, but I felt that it was the right decision for me and my family at this point in our lives.

Well first, I should explain where I am in life and what my strategy is so you understand where I'm coming from. I'm 35 years old with a 1 year old son. My husband and I both work W2 jobs that we don't love, but don't hate either. Our goal is to reach financial freedom before the age of 40 so we can retire and enjoy the rest of our lives. There may or may not be a second child that comes into the picture. We are buy and hold investors with 2 SF properties under our belt. Going forward, we plan to use the BRRRR strategy to aggressively expand our portfolio into multifamily and commercial investing.

So that brings me to my decision- I decided to withdraw the money from my SDIRA, pay the 10% penalty, and use it to add more properties to my portfolio. I understand that I am losing out on the tax benefits of the Roth IRA. At this point, I think having access to every dollar we can get our hands on will only increase our chances of reaching financial freedom sooner. I don't want to wait 25 years before I can access that money when it can have a much greater impact for us now. If all goes according to plan, we won't even need any extra money in 25 years because we will own a paid off portfolio of properties and we'll probably have more money than we've ever dreamed of.

I'm not saying the other options weren't good ones. They just weren't right for me at this point in my life.

After all, life is short and 25 years is a long ways away.

Jessica Zolotorofe · Answer

@Dmitriy Fomichenko may have some additional insight. I'm a big SDIRA investment fan!

Carl Fischer · Answer

@Kerry Mertz

I agree with @Rick Pozos.

Something to add to number one, did you know your SDIRA can partner with another IRA, or with yourself personally? The way this can be structured would be where one IRA owns a percentage is responsible for all profit and expenses for that percent, and the other owner, perhaps your self personally or a private investors SDIRA would own the other percent and be responsible for all expenses and profit for the remaining percent of the property.

Rick Pozos · Answer

It is always about risk and return. You can charge your friend or relative  8% 10% or just about whatever you guys negotiate between you.  it all depends on what you think the risk is to lend to someone you know.

In a 401k stock market might go up 10% maybe 20% or it may drop 20%. That to me is the risky part. If I vet the property that my friend is buying I feel I have a lot more control over the returns that I will make. Not only that but also you are helping someone else to further their real estate investment career.

If you do have a guaranteed or pretty close to guaranteed 10% or even 8% return I would stick with that. Usually the higher the risk the higher the return.

Brian Eastman · Answer

@Kerry Boyle

The self-directed IRA is not limited to non-traditional assets such as notes or real estate.  You can invest in anything the IRS rules allow for, including conventional financial products like equities, mutual funds, CD's etc.  The interest from your note can absolutely be reinvested and allowed to compound.

Kerry Boyle · Answer

@Dmitriy Fomichenko & @Rick Pozos

Regarding lending directly to another investor and getting 12-15% returns on your SDIRA, I'd like to ask the following:

I'll consider two examples:A) Have 100k in a 401k @ 10% YoY.

B) Have 100k in a SDIRA lending @ 12%/year - all costs borne by borrower. Let's just assume a 5 year balloon note with interest-only payments.

After year 1, I have $110,000 in my 401k. $12,000 in my SDIRA and a loan for $100,000.

After year 2, I have $121,000 in my 401k. $24,000 in my SDIRA and a loan for $100,000.

After year 3, I have $133,100 in my 401k. $36,000 in my SDIRA and a loan for $100,000.

After year 4, I have $146,410 in my 401k. $48,000 in my SDIRA and a loan for $100,000.

After year 5, I have $161,051 in my 401k. $160,000 in my SDIRA.

Any downtime would further hurt your SDIRA rate of return. What do you do to combat the lack of compounding that happens with a SDIRA? It is obviously better to earn 12% interest than 10%, but is there any way to do long term loans that exceed a compounding 401k?

George Blower · Answer

@Kerry Mertz

Thank you for sharing. That is one of the benefits of the IRA over a 401k--that you can take distributions from an IRA without having to meet a specific triggering event.

David Faulkner · Answer

You should go with door #2. However, $30k is a bit lite to open that door just yet (or any of the others for that matter). Remember with HML or notes you need to have extra reserve funds available in case you need to exit through the property (via foreclosure) instead of through the borrower (through loan payments) ... $30k would put you into lower quality notes and properties to begin with, could only buy 1 and then would have minimal reserves.

So, if you want REI with $30k, I'd say door #4: REITs. Then when that number builds up to over $100k, revisit door #2.

How should I invest my self directed roth IRA?

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