Selecting a Self-Directed IRA Custodian to Increase After-Tax Returns with Real Estate Investing

Self-directed IRAs (SDIRAs) can be very effective with online investing to defer taxes on your earnings. This is a second interview by iFunding in our SDIRA series, focusing on selection of an IRA custodian. SDIRAs require that an IRA account holder use a custodian company to administer investments and generate tax reporting. We spoke with Michael McNair – Trust Officer at IRA Services Trust Company about how well this can work with real estate investing online.

Remind us how self-directed IRAs improve the after-tax returns on any investment, including real estate.

In some respects, self-directed IRAs are like any IRA. They defer or eliminate taxes on investment income. SDIRAs can be traditional, taxed-deferred IRAs – including SEP and Simple IRAs – or a Roth IRA. With a traditional IRA, a certain dollar amount each year can be contributed without paying taxes on that income, but eventually, after the participant reaches the age of 70 ½ , they are required to take a distribution each year. The participant will pay taxes on the amount distributed to them. With Roth IRAs, you pay taxes upfront on the contributions, but never pay on the income or growth on the investment, even when withdrawing the money.

The restriction with IRAs that are not self-directed is that you are limited to stocks, bonds and mutual funds. You cannot, for example, invest directly in real estate properties, limited liability companies, promissory notes, crowdfunding opportunities or precious metals. That’s where self-directed IRAs come in. They are especially suited for real estate debt investments, that is, loans to property operators or developers.

Consider that some real estate investment types can average returns that are in the double digits (e.g., over 10%) per year. You can perform quick calculations about your potential savings if you defer taxes on income and growth, or eliminate taxes on asset growth entirely with Roth IRAs.

How did IRA Services Trust Co., and you personally, get involved with SDIRAs?

IRA Services Trust Company originally administered limited partnerships for Wells Fargo. In 2008, we were granted a Trust Charter, which enabled us to act as a custodian of self-directed IRA accounts. Since 2008 we have grown the business from less than 15,000 to over 40,000 accounts. I’ve been with the company since 1995.

Note that some providers in the SDIRA market only are “administrators.” Administrators can perform administrative duties and reporting but need to work with a custodian that is allowed to hold title to investments.

How do fees work with SDIRAs? They must be designed to accommodate the smaller transactions typical of an investment in a crowdfunded property, correct?

You should look for a SDIRA custodian that offers a fee structure compatible with online real estate investing, or crowdfunding. In a traditional, direct property investment, the investor is likely to make one big investment upfront then have a variety of outbound payments or inbound income each month. With crowdfunding, many investors will only put up $5,000 to $20,000 upfront per asset, and receive monthly interest or a lump-sum payment at the end. Our fees at IRA Services Trust are crowdfunding friendly – $35 to set up an account online; $125 one-time to purchase an asset/property; then $100 per year to maintain the account and $80 per real property asset per year. There is a small charge for a wire, while ACH transfers don’t generate a fee [note that iFunding will accept investment contributions, and pay returns, via ACH].

So, the benefits of the SDIRA outweigh the costs?

Very often that’s the case, though it depends upon your situation. SDIRAs tend to shield taxes best on income-generating properties paid for in cash (without debt). The use of SDIRAs has grown exponentially over the past decade.

iFunding suggests considering this simple case: $15,000 invested in each of two real estate crowdfunded properties at the same time. They each have a target return of 12% after one year, or $3,600 total (2 x $15K x 0.12). The one-time fees to open and fund the investments would be $285 and the ongoing maintenance fees would be $260/yr. In this situation, the annual maintenance fees come to .5% of the assets and 7% of the income.

Next, you would make a calculation with respect to your marginal tax rate on the profit of $3,600. This represents the tax savings benefit of using an SDIRA. Many US investors’ marginal tax rate is 25% to 39%. If you calculate the taxes you would not have to pay with a Roth SDIRA, and net out the fees, you arrive at the economic benefit in this example. At the 39% marginal tax rate, the SDIRA would let you keep over roughly $1,000 more of your $3,600 gross profit versus investing with a taxable account (you would keep slightly less than $1,000 in year 1 with the IRA account, and somewhat more thereafter). This is equivalent to a 50% increase in your net profit per year by using the SDIRA.

What else are customers looking for in a SDIRA custodian?

The question about fees usually comes up first. A very close second however, is the helpfulness and promptness of the client service staff. You want to be confident that your custodian can process transactions quickly so that, for example, your real estate deal can close promptly with your available funds. You also want experienced staff that are readily accessible and care about the account holders’ questions and challenges.

At IRA Services Trust, we have 55 employees, many of whom have been with us for 10 to 15 years. We also offer a special Concierge Service, for investment advisors and investment providers who want a single point of contact and often want transactions to be expedited.

How long does it take to set up an SDIRA?

The primary determining factor is where the funds are coming from. One can make a new IRA contribution, roll over funds from a qualified plan (401k, profit sharing plan, etc), or transfer funds from an existing IRA. Making a contribution to fund an IRA is very quick, but it is limited to $5,500 (under 50) or $6,500 (over 50) per year. If you are moving funds from an existing IRA to an SDIRA, the timing depends on how quickly the custodian will process the request. It is our experience that it will take from one to two weeks. In either case, it’s fair to say, a typical set-up time may be a week, but leave a buffer if you have an important investment to fund with a firm deadline.

If you are investing in what’s known as a Reg.D/506(b) investment (ask your real estate investing platform about specific property offerings), then there can be a “cooling off” period after you sign up and before you can invest. The period is intended to protect the investor by reinforcing the need to learn about the offerings and build a relationship with the issuer. This can be perfect timing to establish your SDIRA.

One more note is, that with 401K plans, some employers do not allow plan participants to transfer funds while they remain active employees.

What related services does IRA Services Trust offer?

Our systems are set up so that we can work with a crowdfunding platform to capture and securely share basic SDIRA account set up information from the platform’s website. Alternatively, a visitor to the crowdfunding site can be easily directed to a custom landing page on our site to start the account set-up and account funding processes.

Single Family Flips and Social Media in Cincinnati – with Wendy Doris

Real estate investment opportunities come in big and small ‘packages’. For many investors, the small-to-medium sized, single-family house refurbishment, or “flip,” is often attractive due to the speed of the project. iFunding interviewed one of its real estate operators that specializes in quick-redesign flips and makes use of social media to promote her projects.  Wendy’s projects can be found at her customer facing page: www.facebook.com/dwellingstudio or her peer-to-peer focused account,  http://instagram.com/flippinwendy .

Q: Wendy, what’s your background in real estate? 

A: I’ve been refurbing homes since 2006 and have completed about 20 properties since then.  My mother had always been a DIY-er and money was tight, so that’s probably where I caught the budget conscious redesign bug. Right around ’06, some of the early house-flip TV shows appeared on cable, and after watching I thought I could make a go with my own projects. I started by doing cosmetic updates to my own home, then branched out from there.

Q: What types of properties do you invest in?

A: I focus on small, single family homes: 1,000 to 2,500 square feet, which in my Cincinnati area typically have an all-in, purchase and construction cost of $100,000 to $250,000.  They can take from 4 to 6 months from close (purchase) to close (sale).  That includes 3 to 6 weeks to renovate, 2 to 3 weeks on the market, and 45 days to close after going to contract.

Q: Given the projects are relatively straightforward, what kind of help do you rely on?

A: I often will look to wholesalers to locate properties with potential for a good return, then visit the sites immediately. I also use contractors for the on-the-ground demolition and construction.  My very first project was completely DIY but took 6 months of work, so I’ve since become a fan of investing in trusted contractors to speed up project turnarounds. In terms of selling, I will promote the home via social media, as well as turn to brokers for assistance. And finally, I have a young daughter who I just took with me when first looking at the property I’m fundraising on iFunding. She tags along with me to the job site when it’s safe. I like to say tongue-in-cheek that she will be my next assistant.

Q: You mention social media to market your projects. I notice you don’t have your own website up yet, but are prominent on Facebook and Instagram, as well as a few other sites. What’s your online strategy?

A: First, I plan to have my own website soon. But my first focus is on the quality of the projects themselves, which is most important to selling the homes at a profit. Beyond this, a number of the social media sites work quite while themselves. Bigger Pockets (https://www.biggerpockets.com/users/flippinwendy) is an excellent community to discuss real estate questions.

In addition, Facebook is a great way to promote fixed-up homes to potential buyers. You can target by location, age group, and interest such as HG-TV (www.hgtv.com), the home investing and design cable channel. I placed my first ad recently and received 5,000 click-through views back to my FB page (www.facebook.com/dwellingstudio). The click rate was close to 10%.

I use Instagram for connecting with other flippers and interior design pros.  Previously, I had written a blog (for travel) but found writing takes too much time, especially when I think about my projects more visually. Instagram (http://instagram.com/flippinwendy) provides a platform where I can share my work quickly, as well as get feedback from my peers. It has really been helpful in connecting with others in the same line of work.

Q: Let’s return to your project investing strategy.  Tell us more about neighborhoods, design approaches, etc.

A: I stay focused on Cincinnati and its suburbs, which I know very well (with the exception of the West Side).  There’s a particular district that has caught my eye, the “Over the Rhine” neighborhood. A few years ago it was more downtrodden, but now it’s turning into a hip, artsy scene.  You have to carefully consider these projects and think about the opportunity, street by street, but there’s potential for upside returns here.

My favorite part of the flipping is the design.  I try to make each bathroom and kitchen a little unique, to fit the space and the feeling of the house. Then there are common upgrades, like granite tops in the kitchen, that sell well.  I look very closely at tile patterns and at how all the home’s finishes from stone to wood complement each other.  Depending on the house, there may or may not be budget and timeframe for opening up the floor plan.  We examine the location of load-bearing walls and beams to make an initial decision on that.

Q: Finally, what’s one of the biggest lessons you’ve learned about real estate?

A: I’ve learned that staying focused on a style and size of house makes your projects more reliable and efficient.  I have put systems in place to make the entire process run more smoothly, within budget and complete on time. Early on in my real estate career, I turned a 2-family home into a large single family. The size added complexity to the design plan and I found potential buyers of larger homes tend to be more particular about layout and customizations. Since then I’ve narrowed my focused to modest-sized, single family homes. With more focus and a bit of luck, that hopefully will enable me to do 10 projects this year. I’m already on my fourth!

Early Adopters and the Rise of Crowdfunding

There are people who wait for the world to act and then they join the big movement. These people are known as the Majority. They often like to play safe and never stray from the beaten path let alone jump off it.

Then there are people who cast a vision and create a new world. These people are known as entrepreneurs and are often seen as risk takers, visionaries and/or crazy.

Then there is another type of person or group of people who haven’t been getting the attention they deserve. These are people who get the opportunity to see or be a part of this new world first, either through luck or active searching by exposing themselves to the “new thing”. They believe in this vision. They, too, can see the future. These people are what we call the Early Adopters.

 

Early Adopters are some of the smartest, most strategic and wealthiest people in the world. In today’s society, so much emphasis and media coverage has been focused on the entrepreneur.

An entrepreneur’s life is not always filled with impressive startup stories, Venture Capital-backed deals and multi-billion dollar exits, instead it’s a life saturated with hard work, going way against the norm and putting everything on the line over and over again. Without bashing too much on my own peer group as I, too, am guilty of having the entrepreneurial seizure constantly pushing forward and recreating my business, entrepreneurs and innovators are needed and serve a major purpose in the world at large.

However, what I am focusing on here is ‘the man behind the man’. The person or group of people who not only back the entrepreneur and the idea but actively mobilize, publicize and commit resources to the entrepreneur or the idea.

These people are a combination of customers who talk about a new product that they discovered and fell in love with and in turn sharing this new discovery to their friends and family. Chances are you can name a few people in your own life right now who do exactly this. You hear these individuals talking about the newest lotion on the market or how they just started trying out the new craze in the fitness industry that they are pulling you along to join.

The other side of Early Adopters are people who not only love the idea, product or service but who have the business mindset and/or resources to actively plug into the opportunity. These people are often referred to as Angel Investors or Venture Capitalists.

People such as Sequoia’s Jim Goetz who created a relationship and backed the cofounders of Whatsapp eventually leading them into the biggest tech buyout to date. Then there is Steve Anderson. He is the guy responsible for backing the cofounders of Instagram lending them money to the photo-sharing app way before it was ‘cool’ to snap a selfie. These people are often unheard of yet their involvement makes them the true winners.

The characteristics of Early Adopters are impressive. These people are confident, bold, strategic and financially secure. They are explorers not necessarily discoverers. They are similar to entrepreneurs in that they are able to see where the world is going and they champion for that vision.

Crowdfunding via the Internet is a technology that is destined to disrupt a number of industries from banking to the mortgage industry to investing in general. A great example of this disruption can be used by comparing what Twitter and Whatsapp has done to the SMS and text message business globally. Twitter is a site that was created so that everyone could see what people were texting, people could share what they were texting globally. This is similar to crowdfunding where previously investing was done via closed doors of investment bankers or brokers without much transparency.

There is definite adoption timeline and Twitter only started gaining critical mass in 2010. Four years later, it has grown into a platform that has changed the world and now has a $30 billion dollar valuation. Traditional cellphone carriers had to adjust the stronghold they had on texting plans to accommodate for the likes of Twitter, iMessages and Whatsapp. This pathway is similar to how the banking and investing industry are going to have to change to adjust to the transparency, fluidity and returns offered directly to the investing community through crowdfunding.

The entire world is changing. The question you have to ask yourself is if you are being a part of it.

In Summary:

Benefits of being an Early Adopter:

Often early adopters or lighthouse customers often get additional personal attentive service as well as preferential pricing and terms. They are often the ones to benefit the most from the technology as they become so familiar with the product or get the returns that come along with a new industry before it breaks into the mass market.

How to be an Early Adopter:

Early Adopters are bold, strong, and confident people. They don’t mind hearing what the majority has to say at the same time they won’t necessarily follow them either. Early Adopters surround themselves with people who are actively trying to change the world and they jump in and engage in opportunities that are a fit for their needs.

Erin Wicomb, Cofounder and Managing Member of The Mavrix Group 

Preferred Returns – What’s The Point?

Often people that are new to investing think that real estate transactions have to necessarily be overly-complex and abstruse. After all, most private equity deals are laden with large operating agreements, private placements, subscription agreements and rather complicated legal documentation. There is certainly no denying that all of this documentation can be burdensome for a layman and thus the SEC and state securities commissions want to make sure that promoters must follow strict rules when soliciting investors for money. Investor protection is a paramount concern and the regulators despise the concept of guarantees or anything that smacks of an unrealistic amount of return a project can deliver.

Truth be told, no investor no matter their level of sophistication can guarantee anything. The world is simply too complicated and there are uncontrollable risks like the mortgage crisis, geo-political risks, currency risks, inflation risk, etc. that at times will drastically impact a given project in ways that the promoter could have never foreseen. If you examine a properly documented private placement it will specify tens or hundreds of things that can possibly go wrong. It is kind of like watching a pharmaceutical commercial where they spend 90% of the commercial telling you how perfect the drug is and the last 10% listing all of the side effects and what can go wrong.

So if a promoter can’t look into their crystal ball and tell what is going to happen in the future and they can’t guarantee anything what is the next best things they can do? Enter the concept of a preferred return. A preferred return is simply a benchmark threshold an investment must hit before the promoter is able to participate in any profits. So if the threshold is set at 8% this would mean that the investment has to return this amount before any participation would be realized by the promoter. It is then typical for the remaining profits to be split in some fashion among the investors and the promoter based on what was specified in the agreements.

One of the primary concerns you as the investor should have when investing in a syndicated real estate transaction is alignment. Heavy fees in projects can create misalignment between those supplying the capital and those utilizing the capital to invest in a given project. A certain grade school sense of fairness should be applied in all situations. A preferred return helps to create alignment along with fairness in a real estate profit sharing arrangement. The investor has preference to any pool of profits that comes from a project and the promoter is only allowed to participate if they deliver enough dollars on the money invested for there to be excess after the preferred minimum is paid. Thus promoters will only select projects with that will clearly clear the hurdle of the preferred return so they can maximize their chances of being able to participate in projects.

An investor that wishes to create additional alignment should carefully examine whether or not the fees to the promoter are paid before or after the preferred payments as well. Payment of fees prior to preferred payments could potentially incentivize the promoter to take projects that maximize their chances of making fees instead of the ones that will make the most money for the shareholders. This is a classical problem with real estate brokers who operate under straight commission. The true goal of those operating under this structure is to err on the side of making sure the transaction happens instead of making sure the project is the best one for those with the money at risk.
In summary, investors should seek maximal alignment between themselves and the promoter asking for them to invest their hard-earned money. There are many things that should be closely examined in complex real estate structures, but one of the primary things investors should scrutinize is alignment. Preferred returns help to create alignment as does making sure that the promoter largely gets paid at the same time as the investor instead of deriving much of their income from fees that are payable regardless of how successful the transaction turns out. Following these high-level guidelines when examining investments will serve to protect you when you choose among many investments available.

 

This article is a guest post from Bryan Hancock, head of the Acquisitions Department for Bullseye Capital’s Real Property Opportunity Fund.

The information contained in this article is not to be construed as constituting tax, legal, accounting, financial or investment advice.