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The following was written by guest blogger James P. Schlimmer of IRA Title Pro, an Equity Trust affiliate.
Real estate has long been a popular form of investment. Buying, owning, and selling real estate has several benefits to help investors build wealth, including historically higher-than-average returns, diversifying your portfolio, and tax advantages.
However, many people become overwhelmed with the process, often wondering what their options are for investing, how much money they must put down, and what sort of hurdles they may run into. Fortunately, investing in real estate can actually be a lot easier than most people think.
One strategy for investing in real estate is utilizing a self-directed IRA. This option allows for diversification, investments in non-stock market-based assets, and the ability to go beyond traditional financial markets by investing in real estate with hard-earned retirement dollars.
IRAs in general offer tax-free or tax-deferred advantages for investors. For example, investors that use a Roth IRA can buy houses, fix them up, and rent them out; or they can even sell on owner financing, A.K.A. the path to home ownership. This practice entails a buyer purchasing a home and then finding “good buyers” who don’t necessarily qualify for traditional financing.
Oftentimes, this practice is carried out with self-employed individuals who can’t prove creditworthiness based off their reported income. These buyers are then put into the home on either owner financing or a lease option to purchase. Over time, they work to get their credit restored to a point where they do qualify for traditional financing, and they can then refinance and pay off the home. This method can be a mutually beneficial option for all parties involved.
One way to capitalize on retirement funds for investing in real estate is to unlock your 401(k). This strategy involves rolling money over from an existing 401(k) into a self-directed IRA. Real estate investments in the IRA can grow tax-free, with expenses paid directly from the IRA..
This strategy may also help avoid volatility in the stock market.
There is a limitation on how much you can contribute to a Traditional IRA or Roth IRA, which is $6,500 a year if you’re under the age of 50 ($7,500 if you’re 50 and over).
As far as a 401(k) goes, you’re allowed to contribute up to $22,500 a year if you’re under the age of 50 ($30,000 if you’re 50 and over), and you may also receive a percentage match by your employer.
Either retirement account allows individuals to compound interest in the absence of taxation, meaning accumulating tax-free or tax-deferred dollars, to grow your money.
While Traditional IRAs can help deliver the capital needed to purchase properties within a tax-sheltered environment, contributions are tax-deferred meaning that distributions are taxable.
Unlike traditional investments, alternative investments such as real estate are not controlled by market performance.
James P. Schlimmer, President, IRA Title Pro
Another option is a Roth IRA. For individuals looking to get taxes out of the way up front, they can open a Roth IRA or convert their Traditional IRA into a Roth IRA. While a hefty tax payment initially might be a deterrent for many, Roth IRA distributions are tax-free when certain stipulations are met.
For real estate investors, when individuals buy properties with their Roth IRAs and sell them, they’re avoiding capital gains while enjoying the compounding effect of tax dollars that would normally go to the IRS. Theoretically, investors can acquire additional properties on the tax dollars that they save over time, once again capitalizing on opportunity.
The benefit of tax-free compounding cannot be stressed enough, and while the concept may be esoteric to those that are unfamiliar with how it works, the best way to get perspective on its significance is looking at a possible scenario:
Meet John. John made a series of private loans over the course of a year. On the first loan, he made a 6-percent return on investment. On the second, he made 8 percent. On the third, he also made 8 percent. These transactions were all made back-to-back, with the first loan given to a rehabber (someone that purchases a property with the sole purpose of fixing it up/renovating it to sell it for a profit), which was paid back in three months, netting 6 percent.
Four days after being paid back, John deploys his money. He isn’t involved in the rehab; he’s simply the bank in this scenario, offering a loan with a first lien position on that property as well as a promissory note and a mortgage (don’t forget: you can secure your interest in the property with IRA Title Pro’s help).
Over the course of 12 months with these funds, John makes a $12,000 profit, a 20-percent return on investment. Now, because he used his IRA for these investments, he is not going to be taxed. Had he used non-IRA dollars, he would have been taxed because it’s reported income.
Furthermore, John could take these profits, or at least the amount he saved from taxes, and roll that money into additional investments. And while some analysts dislike Roth IRAs because of missing out on tax deductions with each contribution, if the returns are significant enough, investors may make more money in the long term.
While there are benefits associated with buying properties with your self-directed IRA, there are some limitations for investors.
For one, flipping real estate may still have potential tax implications.
Kelly subscribed to IRA Title Pro’s free foreclosure report and decided to buy a foreclosure property with her self-directed IRA for $100,000. She put about $30,000 worth of work into fixing up the property. After selling her property and factoring in all associated closing costs, she makes a $38,000 profit.
If Kelly invests outside of her IRA, she would pay about 30 cents on the dollar in the form of short-term capital gains tax (her ordinary income tax rate). This equates to $11,400 in taxes. Looking at this information from a yield perspective, her return on investment comes out around 20 percent compared to 29 percent in her IRA.
Increasing return on investment is one way to reach retirement goals in a shorter period of time, as outlined by the Rule of 72 concept, a formula that has been around for hundreds of years. The Rule of 72 is a simple, effective formula used by investors to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can obtain a rough estimate of how many years it will take for an initial investment to double itself.
Let’s use Kelly’s venture as an example: if she flips her property without her IRA and nets a 20-percent return:
This numerical value (3.6) represents how many years it will take for her money to double.
Suppose Kelly uses her self-directed IRA for the flip instead and nets a 29-percent ROI, how long will it take her to double her money?
Theoretically, Kelly will double her return on investment using a self-directed IRA in just over half the time it would take if she made the same investment without her IRA. Not only does this showcase how rapidly investors can increase their return on investments but also how effective compounding interest is in the absence of taxation.
More and more people are discovering their investing potential by maximizing their IRAs while buying and selling real estate. If you’re still wondering which account is right for you, get in touch with Equity Trust Company and discover your options.
If you’re already set with an IRA and ready to invest in real estate, check out IRA Title Pro’s suite of real estate resources designed to help you during every step of your buying, selling, or lending journey.
James P. Schlimmer is the CEO of Equity Real Estate Services and the President of IRA Title Pro. Renowned as a pioneer in the real estate industry, Schlimmer has been paving the way for innovation in a field that has been stagnant and overly complicated for far too long. For nearly a decade, Schlimmer has worked diligently, assisting buyers and sellers by revolutionizing the closing process with a more modern, seamless approach.
IRA Title Pro is a real estate closing company specializing in IRA-funded transactions, providing a quick and seamless process compared to traditional closing companies that may not have the experience needed for a streamlined IRA real estate closing.
IRA Title Pro is powered by Investors United Title, who is an affiliate of Equity Trust Company through common ownership. Neither company is an agent of one another. Equity Trust Company is a directed custodian and makes no recommendations or representations as to IRA Title Pro and any information communicated by Equity Trust Company is for educational purposes only and should not be construed as tax, legal, or investment advice. Clients are in no way obligated to purchase services from IRA Title Pro and are free to purchase such services from any title company as they deem appropriate. No customer may rely on any statement made by Equity Trust or any of its officers, directors, employees, or agents for any decisions regarding the use of the service offered by IRA Title Pro. Whenever making a decision related to your account, please consult with your tax, financial, or legal professional.
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