BUYING REAL ESTATE WITH AN IRA AND A NON-RECOURSE LOAN

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1 BUYING REAL ESTATE WITH AN IRA AND A NON-RECOURSE LOAN BY: Mathew Sorensen, Partner KYLER KOHLER OSTERMILLER & SORENSEN, LLP 3033 N. Central Avenue, Suite 415 Phoenix, AZ Phone mat@kkoslawyers.com Serving Clients Nationwide From Our Offices in Arizona, Utah, and California BY: Roger St.Pierre, Sr. VP FIRST WESTERN FEDERAL SAVINGS BANK roger@myiralender.com Phone

2 Disclaimer & About Mat DISCLAIMER All information and materials are for educational purposes only. All parties are strongly encouraged to consult with their attorneys, accountants, and real estate professionals before entering into any type of investment. This presentation does not constitute an attorney client relationship. ABOUT MAT Partner at KKOS Lawyers, assisting clients nationwide from offices in Arizona, California, and Utah. Author of The Self Directed IRA Handbook: An Authoritative Guide for Self Directed Retirement Plan Investors and Their Advisors, an Amazon Best Seller and a textbook for the Retirement Industry Trust Association s Self Directed IRA Professional Designation Course where I m also an instructor. The Self Directed IRA Handbook is already the most widely used book in the self-directed IRA industry.

3 First Western Federal Savings Bank, and its employees are not accountants, nor are we investment advisors, and we are not qualified to provide advice on IRA rules, regulations or eligibility requirements. Please consult with your tax and investment advisors.

4 What We re Covering Today 1. How a SDIRA invests into real estate 2. Why you must use a non-recourse loan 3. Non-Recourse loan terms, options, and lending requirements 4. Property analysis by investor and lender 5. UDFI Tax Explained in detail 6. Pro s and Con s of buying real estate in an IRA with a non-recourse loan

5 Why The SDIRA Real Estate Market is Growing? In trillions e Data are estimated. Note: For definitions of plan categories, see Table 1 in The U.S. Retirement Market, Fourth Quarter Components may not add to the total because of rounding. Sources: Investment Company Institute, Federal Reserve Board, Department of Labor, National Association of Government Defined Contribution Administrators, American Council of Life Insurers, and Internal Revenue Service Statistics of Income Division Assets in individual retirement accounts (IRAs) totaled $6.5 trillion at the end of the fourth quarter of 2013, an increase of 5.3 percent from the end of the third quarter. Defined contribution (DC) plan assets rose 5.1 percent in the fourth quarter to $5.9 trillion. Government pension plans including federal, state, and local government plans held $5.6 trillion in assets as of the end of December, a 5.6 percent increase from the end of September. Private-sector defined benefit (DB) plans held $3.0 trillion in assets at the end of the fourth quarter of 2013, and annuity reserves outside of retirement accounts accounted for another $2.0 trillion.

6 How Does a Self Directed IRA Invest? -Need a custodian (bank, credit union, trust company) for the IRA. - Common investments are real estate, private companies, LLCs, and precious metals.

7 The IRA/LLC Structure Basics Rather than a self-directed IRA taking ownership and buying an asset directly through your Administrator/Custodian, the self-directed IRA purchases the ownership in the LLC and the LLC takes ownership of the asset. In many instances, the IRA Owner manages the LLC (subject to legal restrictions). This LLC can also use a non-recourse loan. SELF DIRECTED IRA $$ $ IRA/LLC Buys Property Receives Rent LLC Pays Loan Payments Bank funds portion of purchase - IRA invests $ into LLC Bank Account NON-RECOURSE - IRA Owner, Manager of LLC, No comp (Ellis v. Commissioner, case) LOAN, BANK - LLC acquires investment (e.g., property) - Non-recourse loan funds a portion of the purchase price - IRA owns LLC 100%, could be multiple IRA or parties owning different percentages

8 WHY MUST I USE A NON-RECOURSE LOAN EXTENSION OF CREDIT PROHIBITED TRANSACTIONS IRC 4975 (c)(1)(b) specifically states that a prohibited transaction occurs when there is a lending of money or other extension of credit between a plan [IRA] and a disqualified person. RULES FOR OBTAINING A LOAN WITH YOUR IRA 1. If an IRA obtains a loan for its investments the loan must be non-recourse to the IRA and the IRA owner (e.g., lender s only recourse is against asset). The IRA owners cannot personally guarantee the loan. Peek & Fleck v. Commissioner. 2. UDFI Tax due on net income from debt. Profits attributable to retirement plan cash or other non-debt investment is not subject to UDFI tax. (more later on this). Applies to IRAs, 401ks other employed based plans are exempt from UDFI tax.

9 Loan Options 1-4 Family Residential 60% LT60% LTV in most states 25 Year Financing Available 3/1 4.25% 5/ % 10/1 5.5% 20 Year Fixed Rate Available 6.25%

10 5 Units Plus/Commercial Properties and Vacation Properties 50% LTV 3/1 5.25% 5/ % 10/1 6.5% Fixed 7.25% Index is the 1 Year T-Bill Rate Caps are 2% annually and 6% lifetime on our 3 and 5 year ARMs No Pre-Payment Penalty on any loan

11 Fees 1% Origination Fee $300 Processing and $300 Underwriting fee Appraisals are required on every loan request, ordered by us in the market where the property is located. Our fees are the same for Refinances or Purchase Money Loans You will have normal and customary closing costs in the market where your property is located.

12 Timing-How long does it take to close? It costs Nothing to Apply and we normally can get you a loan decision in 2 days if we have a complete application. Then, counting appraisals, title insurance, and other processing it takes about 30 days to close. So, start to finish, about days from Ap to Close.

13 4 Main Issues 1. Does the IRA have the funds? 40-50% down Closing costs 15% of loan amount minimum reserves 2. Debt Service Coverage 1.25 or greater 3. Is the property a good one? 4. Does the transaction make sense?

14 Debt Service Coverage Ratio Purchase Price $100,000 Residential Single Family Home Loan Amount $60,000 Gross Rental Income $12,000 ($1000/month) Less Vacancy (7%) $840 Taxes $1400 Insurance $600 Maintenance $600 HOA $0 Utilities $0 Mgmt. (10%) $1200 Net Operating Income $7360 Annual Debt Service $3900 ( %) DSCR $7360/$3900=1.89

15 Debt Service Coverage Ratio Purchase Price $184,000 Residential Home with HOA Loan Amount $92,000 Gross Rental Income $15,600 ($1300/month) Less Vacancy (7%) $1092 Taxes $2200 Insurance 500 Maintenance $1000 HOA $1500 Utilities $0 Mgmt. (10%) $0 Net Operating Income $9308 Annual Debt Service $6373 ( %) DSCR $9308/$6373=1.46

16 Debt Service Coverage Ratio Purchase Price $600,000 Commercial Building Loan Amount $300,000 Gross Rental Income $60,000 ($5000/month NNN) Less Vacancy (7%) $4200 Taxes $0 Due to Tenant paying taxes Insurance $0 Due to Tenant paying insurance Maintenance $3600 (Owner pays for large items) HOA $0 Utilities $0 Tenant pays Mgmt. (8%) $4800 Net Operating Income $47,400 Annual Debt Service $30,136 ( %) DSCR $47,400/$30,136=1.57

17 Look Under the Covers (Do your due diligence) HOA s-get 2 years Financial Statements and a Budget Crime-Research local crime statistics for this area Condition-Must be nearly rent ready (Max $10K in rehab needed for us to close a loan on a given property). Age of property-less than 75 years old or inspection required.

18 Issues that can derail a loan Over-estimating rental income, especially vacation properties (do your due diligence!) Buying the most expensive property in the neighborhood High Crime areas Poor Condition of the Property Global Debt Service Coverage Weak Reserves inadequate

19 Entities Acceptable for Non Recourse Loans Any Self Directed IRA LLC s made up of single or multi-member IRA s Self Directed 401K s or LLC s made up of 401K Members

20 6 Reasons to Tap Retirement Funds Now to Buy Real Estate 1. Tangible Asset - you can see, touch, and feel 2. Real Asset Diversification 3. Many Choices in today s marketplace 4. Affordable Prices 5. Better Cash Flow 6. Upside Capital Appreciation

21 Properties We Lend On Residential (single family, multi-family, apartments) Commercial Farms with income (rental income or CRP income)

22 Unrelated Debt Financed Income Tax Unrelated debt financed income ( UDFI) tax applies to the gains received by an IRA that are attributable to debt. IRC 514. UDFI tax is applied to income from debt financed property that is subject to acquisition indebtedness. Rate is capital gain rate on income from sale of an asset and is UBIT rate (39.6% on other income such as rental). CALCULATING & REPORTING UDFI TAX To calculate UDFI tax, you need to know the following three numbers: 1. The income from the property for the year. 2. The average acquisition indebtedness for the year. 3. The adjusted basis for the year (e.g., the cost of the property minus any depreciation). UBIT/UDFI Rate $0.00-$2,500 15% $0.00 $2,500-5,800 $ % of amount over $2,500 $5,800-8,900 $1, % of amount over 5,800 $8,900-12,150 $2, % of amount over 8,900 $12,150 or greater, 3, % of amount over $12,150 UDFI Rate at Sale is Long-Term Capital Gains Rate, 20%

23 UDFI Tax Basic Example For example, let s consider a property purchased by an IRA for $100,000 and sold over a year later for $130,000. The property was purchased with $40,000 from the IRA and $60,000 from a loan. Let s assume the remaining average debt was $50,000 at the time of sale, and that deductions for the year were $5,000. Based on this scenario, UDFI tax would be calculated as follows: 1. $50,000 avg. debt/$100,000 basis = 50% leverage 2. Gain of $30,000 from sale of $130, % of $30,000 = $15, $5,000 of deductions against $15,000 = $10, Therefore $10,000 would be subject to the 20% long-term capital gains tax rate. Tax owed would be 20% of $10,000 = $2, The tax rate on the sale of property is the capital gains rate. Note the UBIT/UDFI rate on other year to year income (e.g. rental).

24 UDFI Tax: Advanced Example Rental Property Advanced UDFI Tax Example: Purchase Details Purchase Price: $195,000 Closing Costs: $5,000 Total: $200,000 IRA Funds Invested: $80,000 Non-Recourse Loan: $120, yr. loan at 5% ($700/mo. payment) Leverage Ratio: 60%

25 UDFI Tax: Advanced Example Income Annual Rental Income: $19,200 ($1,600/mo.) Expenses Property Mgmt Fees: $2,000 Repairs/Maint: $1,500 Insurance: $600 Property Taxes: 800 Mortgage Interest: $5,944 Total: $10,844 Depreciation: $6,970 (27.5 yr./residential) Total with Depreciation: $17,814 Cash-Flow: $8,356 YEAR 1 AS A RENTAL Apply Leverage Ratio of 60% to Income and Expenses Income: $11,500 Expenses: $10,700 $800 UDFI Income $1,000 automatic deduction allowed End Result = 0 UDFI/UBIT Tax Due, even with $8,356 in cash-flow

26 UDFI Tax: Advanced Example YEAR 1 AS A RENTAL Final Number Breakdown Net Cash-Flow: $8,356 UDFI Net Taxable Income: $800, minus $1,000 automatic deduction, 0 UDIF Tax: 0 Effective Tax Rate on UDFI Income: 0 UDFI Tax Cost: 0

27 UDFI Tax: Advanced Example OWN THE PROPERTY 10 YEARS & THEN SELL Sales Price: $300,000 Expenses/Closing Costs: $20,000 (broker and title/escrow) Loan Balance At Time of Sale: $73,000 (from amortization sched, 25 yr., 10 yrs int, plus an additional loan pay-down of $11,000) Cash Return From Sale: $280,000, less $84,285 loan re-pay, less $80,000 IRA invested, cash gain of = $115,715 Adjusted Basis: $137,000 ($63,000 in depreciation over 10 years) Total Gain: $163,000 Leverage Ratio: 54% UDFI Income: $88,020 UDFI Expense: $10,800 Net UDFI: $77,220 UDFI Tax Rate at Time of Sale: 20% UDFI Tax Due: $15,444

28 Benefits of Leverage Return Over 10 Years IRA Cash Invested: $80,000 Annual Cash-Flow: $7,938 ($8,356, reduced by 5% for vacancy estimate) 10 Years Annual Cash-Flow: $79,380 (assumes no increase in rent) Gains From Sale: $115,715 Total Cash Returns: $195,095 UDFI Tax Paid: $15,444 Account Value at the End: $80,000 (started with) $195,095 (10 years rental income cash flow, and gains from sale.) -$15,444, UDFI tax paid on sale Net Gain after paying UDFI :$179,651 Account Value After 10 Years of Investment $259,651

29 990 Return FAQs Q: What are the filing deadlines for a 990-T for IRAs? A: April 15 th, 3 month extension available Q: Who Pays the Tax? A: Your IRA pays the tax. Q: Who files the 990-T? Does my IRA custodian do this for me? IRA owner s responsivity. A: Your custodian does not file this for you. Q: If I have losses can I carry those forward to offset a later gain when I sell? A: Yes, if you have losses over 3 years you must file the 990 to capture those losses so they can be carried forward to later offset a gain. Q: What are typical fees to prepare a 990-T? A: Our law firm prepares 990-T s and charges between $250 and $750 depending on complexity (assumes you have a set of Quickbooks and bookkeeping completed).

30 Benefits of Leverage PROS I need the leveraged funds (loan) to acquire a specific property. I d rather use leveraged funds and buy two properties rather than all my cash and buy one. I d rather invest my other retirement plan cash in something else and use the leveraged funds to invest in other assets. CONS Interest UDFI Tax

31 QUESTIONS You ve got questions, we ve got answers.

32 THANKS This webinar will be recorded and posted next week on along with the slides. BY: Mathew Sorensen, Partner KYLER KOHLER OSTERMILLER & SORENSEN, LLP 3033 N. Central Avenue, Suite 415 Phoenix, AZ Phone Serving Clients Nationwide From Our Offices in Arizona, Utah, and California