Part Two of Financing a Second Property: Self-Directed IRAs

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If you cash out your retirement account in one lump sum, you stand to lose far more of your money to the IRS than you would if you took your distribution payments over time. The reason is, by cashing out the entire account, you put yourself in a much higher tax bracket for that single year since distributions from a retirement account are taxed as ordinary income. Instead of being in the 25th percent bracket consistently throughout your retirement years, for instance, you might be in a 33rd percent bracket for one year. While you don’t pay 33 percent on all that money, you may pay that rate on the lion’s share of the distribution.

The IRS has made it hard, but not impossible, to recoup some of the losses. I will be able to cushion the blow in two different ways. This post talks about the first, self-directed IRAs.

Self-Directed IRAs: A Quick View

When I told my brand-new accountant what I was about to do, he flipped out. “Do you realize what tax bracket you’ll be in?” he asked me.

He told me I should look into self-directed IRAs. This is a little known investment vehicle that allows you to invest  in “anything you like” rather than sticking to the stocks and bonds that make up most investors’ portfolios. Well, anything except collectibles, S-corp capital stock, and a short list of other prohibited investments.

You can, however, invest in real estate and land, which were the only things of interest to me.

Here’s how it works. The IRA holds the real estate through a company that acts as a custodian of the account. The big investment companies, like Vanguard and Charles Schwab, do not handle self-directed IRAs. You will have to research the companies that do handle these accounts, compare their fee schedules, and check their track records yourself.

The custodian purchases the real estate with rolled over funds from an existing IRA or 401k account after reviewing the purchase sales agreement. They then write checks to pay for ongoing property tax and maintenance and receive rental payments and other revenues on your behalf. It all stays in the IRA. The custodian files the appropriate paperwork with the IRS and charges a variety of fees to maintain your account.

You can theoretically be your own custodian by holding your investment in a so-called “checkbook” IRA as long as you adhere to the rules that govern self-directed IRAs. Checkbook IRAs purport to cut out the middleman — though even these accounts have someone who does the IRS reporting for a small annual fee. However, checkbook IRAs are hanging on to their legal status by the slender thread of one court decision, and the IRS has had its eye on them. I decided not to pursue that course.

Although the IRA shelters your money from taxes, there are a lot of rules that make self-directed IRAs a less than desirable choice for an investment property, especially if you need to pay for a lot of repairs on the property before it generates cash flow:

  • You can’t work on the investment property yourself (there is some disagreement about whether individuals can perform routine maintenance such as mowing the lawn). Thus, sweat equity is out.
  • You can’t live in it or even stay there one night out of the year. Nor can your parents or children live there (siblings are okay).
  • You don’t get any of the tax advantages typically associated with owning an investment property.

How a Self-Directed IRA Worked for Me

Because there is an extensive list of prohibited transactions, I wouldn’t recommend that anyone use this vehicle to purchase a home they plan on living in eventually. Even if you wait until you are old enough to avoid the IRS penalty, you still have to take the entire property as a distribution (and pay taxes at a higher marginal rate). If the property appreciates enough — normally a good thing! — you could conceivably price yourself out of ever buying it from the IRS because you would not be able to afford to pay the taxes.

Because there are two houses on the lot I purchased, and I plan to keep one as a seasonal rental, I toyed with the idea of purchasing the Cabin outright and holding the Anchorage in my IRA. That would have increased my restoration budget for the Anchorage considerably and decreased my tax burden. I already had a good survey of the property, and the surveyor was willing to divide the lot on short notice so that I could make the closing date. The two houses already had separate spring houses, septic systems, electricity accounts, and insurance policies.

But the more I thought about it, the more I realized how difficult it would be to live on one house and keep the other in the IRA. It might raise flags with the IRS. More importantly, I’d never be able to host friends or family at the Anchorage, not even for a few days during the off season. And what’s the point of having a place like this if I can’t use it to host the occasional gathering?

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Fortunately, the family who sold the property had already divided it into two lots; there was a 3-acre field across the street that they listed separately in order to boost interest in the place. The offer I made included both parcels, so I ended up placing the land in a self-directed IRA. Deferring the income tax on that portion of the sale reduced my tax burden considerably, and because it is undeveloped land, there is little that needs to be done in the way of maintenance, so I won’t have to make a lot of future payments into the account.

When I turn 60 I can decide whether to leave it in the IRA for my daughter to inherit or take it as a distribution then.

Taking Stock and Defining Motives

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Now that the work is finished for the season, I’ve decided to write a series of posts about the steps I took to finance this investment. Given my writerly nature, these posts will probably be pretty discursive. I’ll try to focus a couple of them on topics like using a self-directed IRA to purchase an investment property. Others are just going to ramble from one idea to the next.

I want to make clear from the onset that I’m not a financial advisor, a tax attorney, or a CPA. I’ve made some miscalculations already; some of them are dumb things I overlooked even after reading dozens of articles online and poring over the pertinent IRS documents.

Still, people think that a venture like this may be out of their reach, so I want to share my experience with you, focusing on both the emotional and economic aspects of it.

This week, I received all but a couple of the bills for work performed on the place this fall. My carpenter’s bill was the biggest; the painter, well driller, and excavator also took sizable chunks. The breakdown looks like this:

  • Clapboard replacement, foundation repair, sill damage to the Anchorage: $10,234.00
  • Painting of replaced clapboards and the other exposed wood: $3,150.00
  • Well, digging and fracking: $6,545.00
  • Consultation with structural engineer:  $291.00
  • Excavation:  $1,410
  • Chimney cleaning and staging:  $866.00
  • Plumbing, including the estimated cost to winterize:  $948.00
  • Lawn maintenance, plus reseeding and fall cleanup: $1,000.00 (estimated)

Total: $24,444.00

Of course, there are property taxes due on both the main lot and the separate parcel of land across the way; and in addition to those expenses, I had to pay the hazard insurance on both buildings, which have different accounts. I won’t count these figures in the tally because my primary interest going forward is how much it costs to repair and restore the buildings.

I have enough of my cash reserve left to fund the next big project — putting a solid foundation under the cabin — but after that I’ll have to save up for each subsequent restoration. There are two big projects that need to be done in the next couple of years: installing a new septic system for the properties, and roofing the main house.

Meanwhile, I’ll be learning how to do this:

Buying a summer house in Maine been a fantasy of mine since I was 12. I would draw elaborate pictures of how I wanted the house to look. I envisioned a drive that meandered slowly through woods richly landscaped in understory ferns and hostas. The house itself, first visible through gaps in the trees, sat overlooking a final parklike slope.

The origin of this fantasy was the cabins my paternal grandparents owned in Pembroke, Maine, a village close to the Canadian border. There were nine white-painted buildings in a row beyond the farmhouse in which my grandparents lived, each kept scrupulously neat and clean. My favorite was a small cabin with bright yellow trim and a weather cock on its peaked roof. Each one was slightly different. That was the charm of the place.

The smell of cut grass and gasoline from the riding mower is what I remember best, that and the sound of sheets churning in the zinc tubs of my grandmother’s old-fashioned washing machine. Sheets and towels, an endless supply, went through that house. I itched and begged to be allowed to feed them through the electric wringer myself, despite my grandmother’s stories about a girl like me “who lost an arm” through carelessness. I never tired of watching the water rush from one end while a flattened curl of towel emerged out of the other. It was like magic.

I was allowed to help my grandmother make and strip beds, hang towels on the line, and do the folding. My grandfather fashioned a cart for the back of his mower, and I rode on that, feeling absurd and semi-important when guests’ children watched me from the swing set at the back of the property. One whole day we spent picking blueberries at the grounds of an abandoned house with “S” shapes cut into the shutters. Saplings as thick as fingers had grown up through the foundation, and in the back was a graveyard that had jars of faded plastic flowers on the tombstones.

Without meaning to, I learned things about the hospitality business. How to prioritize a list of chores. The value of cleanliness. The importance of customer service. My grandfather took pride in what he did, charging modest rates (because he had no swimming pool) and delivering exceptional value. He didn’t just fix things as they broke. He kept a constant vigil, anticipating what might go wrong. When cars arrived, he rushed outside to greet the guests with a show of enthusiasm, often rising from the dinner table to get their keys and show them to their cabin. Sometimes I would excuse myself and run outside, mosquitos stinging my bare legs, to listen shyly to their conversations.

This reminds me of a trip my former boyfriend Paul and I took, driving down the Baja peninsula to see gray whales. Along the way, we drove through the inland desert to the Sea of Cortez and a fishing town called Bahia de Los Angeles. There, a doctor from Mexicali had bought some land for his retirement and came down every weekend to build stone cabins one by one on the beach. Like my grandfather, he didn’t care anything about the money. We paid something like seven dollars a night to camp on his land. Coyotes yipped in the distance. In the morning, a whale breeched the surface of the bay in front of us.

This was the point.

8515743649_7d67e9576f_z   Bahia de Los Angeles,” by Alessandro Valli

Phase One on the Facelift of “a Magical House” Is Complete

Here it is, the tail end of summer, almost time for the plumber to come and winterize my very own historic Maine homestead for the season. Since the closing in mid-July, the workmen have accomplished the following:

  • Dug a well. IMG_0443
  • Removed a chimney stack.
  • Propped the foundation of the Anchorage.
  • Repaired rot and sill damage from failed gutters.
  • Scraped and painted the worst sections of the house.

I have deferred the next big job — putting a proper foundation on the smaller back house, otherwise known as the Cabin — until I get back up there to watch what the contractors are doing.

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Speaking of contractors, Woodstock says that a check is arriving via registered mail for the work he never did. I haven’t seen it yet, but I remain hopeful. I did, however, get my tax bills. One of the siblings of the family that owned the house before me forwarded them to me with a sweet note welcoming me to the house “with open arms and an open heart.” A different sister, the one who arrived to sign papers at the closing, described the Anchorage as “a magical house.”

Some history may be useful here. The property was on the market 12 years, according to its current Realtor. Before the housing market crash in 2007, it had been listed for over twice what I paid. Apparently it was also in better shape. The family made numerous improvements to the back house, including the installation of all new plumbing. But they had given up on the foundation of both structures and let brush grow up around the Cabin. Weather beat down the roofs, and poorly installed gutters introduced rot.

They also disagreed, as siblings will, about whether the house should leave the family at all. Some prospective buyers wanted to tear down the Anchorage and finish off the Cabin. They wanted the place to remain as is.

My daughter and I choose the suite of rooms upstairs as our own apartment for June, before the seasonal rental market heats up and we have to vacate for our paying visitors. This section of the house includes a toilet at the end of a long corridor, a wash basin in the hallway, and two light-filled dormer bedrooms with a distant view of Eggemoggin Reach.Mail Attachment 2 Mail AttachmentThe fact that the water closet has an arched and paneled ceiling speaks volumes about what makes the house so special. It’s a place where nothing is ugly, and most things are whimsical and charming. My room features framed selections from Antoine de Saint-Exupéry’s The Little Prince, for instance. The banisters going up the steep staircase to the second story don’t match; one is black, the other white. This eclectic touch seems random until you realize that their railings mirror the black and white finish on the stairs themselves.

Both houses are full of neat surprises like that. I was immediately smitten. I’d seen a bunch of places that had good individual features, but over the years the owners had put their mark on them in ways that made the design feel incoherent. In one early nineteenth-century house, the original ceilings on the upper floor were less than seven feet high, yet the owners had remodeled a master bedroom on the ground floor to have the prosaic feel of a 1940s bungalow. Another house had a clawfoot tub seated on a platform in the bedroom. I loved the whimsy of that, but the tub was only five feet long — not ideal for soaking my almost six foot body. And though the tub was the focal point of the room, its location beneath the eaves felt cramped and a bit sad.

The Cabin and Anchorage need repair and restoration, and yet they are complete. The Cabin has such rustic charm that from the first time I wandered its circular layout, I  imagined myself, clad in soft winter clothing, walking from the kitchen with a cup of tea and sitting by the fireplace to do some writing. My Realtor remembers how I sank into the red chair pictured below and announced, “I want to buy this place.”

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Meanwhile, another semester at Austin Community College is underway. Teaching sections of literature and composition to reluctant student writers is probably not the most efficient way to fund the restoration of a 200-year-old property, but I get to take six weeks of the summer off to go up and oversee the construction, and, for the time being, it pays my health insurance premiums.

The community college teaching also gives me enough time to supplement my income by writing ebooks and website copy. I began working this patchwork of different jobs after the divorce, so that I could continue picking up my daughter from elementary school and taking her to guitar practice and gymnastics rather than putting her in aftercare. But now I have to admit that I sort of like doing a little bit of everything: grading papers for a few hours, rushing to meet a client deadline, strategizing before administrative meeting at the College, tutoring students at a campus learning lab.

Nevertheless, it will be nice to slow down a bit. Focus on my writing. Get some goats and chickens.