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

IMG_3397

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?

Mail Attachment

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.

Financing a Second Property: Part One of a Quick Guide

 

IMG_8874Although most financial experts will advise you not to cash out your retirement funds to purchase real estate, it was the right choice for me. I’m going to walk you through the steps I took to make it happen. There are at least two special circumstances that stacked the deck in my favor, but some of the practical advice I give below is worth considering regardless of what your case may be.

Some Background 

When the ex and I split, in 2011, the United States was still recovering from the recession. Although we had more money saved for retirement than the average couple, I had invested everything in equity funds, which were still down considerably, as was the value of our modest house in Austin. The lawyers with whom I consulted about asset division did not believe that I’d be able to remain a homeowner, let alone purchase a second home.

“What will you do? Move in with your parents?” one of them asked.

Among other things, these gloomy speculations made me realize that if I retained an attorney, I could stand to lose a great deal of money, especially if my ex and I got embroiled in a court case. I resolved to employ attorneys on a consultation only basis, hiring one to write up the final divorce paperwork for a flat fee. The whole thing, which included advice from two of the top family lawyers in Austin, cost about $4,000.

In order to keep the house — pretty much the only way I could remain a property owner, given my lack of a stable work history and the stringent mortgage qualifications at the time — I did a cash out refinance while we were still legally married, tapping into our existing equity. My ex got most of that so he could purchase a house for himself; I reserved a small amount as an emergency fund.

This turned out to be a wise move. Austin recovered more quickly from the economic downturn than the rest of the country, and the value of my home rose 26 percent in the next four years. Early last spring, I checked the account balance of the 203b funds I’d been awarded in the form of a Qualified Domestic Relations Order (QDRO). I didn’t log into the account very often; the whole thing reminded me of the difficult days right after the separation. This time, however, I was pleasantly surprised to find that my stocks were up almost 100 thousand dollars as well.

Assessment

I sat down with a pencil and paper and made a complete accounting of my financial situation under various scenarios. I estimated approximately how much I would receive in Social Security and how much the Federal Government would offset the modest pension I’d receive from the community college if I stuck in the plan long enough for it to vest. I also had some Roth and regular IRA funds that were not marital property — not a lot, but not nothing, either.

I realized that I would not be in bad shape even without the QDRO funds. There was not a lot of money, but my needs are modest, and even if I became seriously ill, I was never going to be wealthy enough to afford top-notch assisted care, which these days exceeds even the cost of attending a liberal arts college per year. I would have to be proactive about my health — watch my weight, reduce stress, keep up regular exercise — and hope for the best.

I had been searching MLS listings in coastal Maine for months; now I contacted Realtors and narrowed the field of choice. My best friend and her husband had connections with the Blue Hill Peninsula, so I focused my real estate search there. Good restaurants and a strong artist community were definitely bonuses.

Gathering the Funds

I decided how much money I would need at minimum to afford a house that fit my requirements. Ideally, I wanted a place that would continue to bring in rental income even after I moved up to Maine for good, and properties like that were slightly more expensive. Although QDROs are exempt from the 10 percent penalty that one ordinarily has to pay on an early distribution, I would still be taxed heavily on the retirement funds — more on that in Part Two — so I decided to supplement this amount with another cash out refinance.

For what it’s worth, I love cash out refinances. For an initial $15,000 downpayment on the house in Austin, my ex and I have purchased well over a million dollars worth of real estate. If I had to guess, I’d say we have about $400,000 in equity stemming directly from that initial investment. Subtract the mortgage payments, and that still leaves $150,000. That’s about 17 percent interest over 15 years. Not bad. If we had bought on the west side of town, like our Realtor recommended, we’d be millionaires.

I had my excellent mortgage broker, Jim Loughborough, dig deep to try and get me the maximum amount he could manage out of the refinance. Since I freelance part time and work at the community college part time, the paper chase was excruciating; the lender wanted to know everything about me, and after we ran into problems with the IRS that pushed the closing date back into June, they wanted to know it all over again.

That was nothing, however, compared to my last minute realization that the tax burden from the QDRO distribution would be tens of thousands of dollars more than I initially thought.

Parts Two and Three of this guide discuss some of the ways in which I will be able to cushion the tax blow. I’ll also impart some of the wisdom I learned about the importance of cash flow from one of my freelance clients, a successful Realtor in the Bay area.