REtipster provides real estate guidance — not tax or investment advice.
This article should not be interpreted as financial advice. Always seek the help of a licensed financial professional before taking action.
I just sold a property last week for $20,000.
This was the same property I bought about a year ago for $4,587.57 (plus a few hundred bucks in closing costs).
A lot of people would look at an ROI of 300% and think,
“Holy &^$@!, that’s amazing!”
…and I suppose it is, but for the business model I work with, it’s not uncommon to 2x, 3x or even 4x an investment like this (not bragging – that’s just how it works).
But even beyond the numbers and logistics of how this deal got done, there was one thing that made this transaction particularly exciting.
My profits were tax-free.
Rather than cutting Uncle Sam a GIANT check for this deal (for all the NOTHING he did to help out), I decided to avoid the usual punishment for my success. I chose to keep 100% of my profits, and I did it all with the full blessing of the U.S. Government.
Granted – it did require a few extra steps along the way, but with a little bit of education and a neat little tool called the “Self-Directed Roth IRA”, it wasn’t hard to pull off – and I’m going to show you exactly how I did it.
The Roth IRA: A Brief History
To explain this adequately, we need to start at the very beginning.
For the past century, most people in the U.S. have relied on a few standard retirement plans (e.g. – 401k, 403b, Simple IRA, etc.). Thes plans allow people (and/or their employers) to deposit their pre-tax income into an investment account, where the money usually goes into a mix of stocks and bonds to grow very slowly over time.
As the decades go by, their retirement savings starts to build on itself (at least, that’s the idea), leaving them with more money in the end than a simple savings account would have generated.
People invest in these accounts for a few reasons. One of the reasons is that they’re pretty easy to use. You don’t need to be an expert in the stock market to invest in a 401k, you can just hand your life savings over to a fund manager and they’ll handle it for you. It’s a standard “low risk, low reward” investment vehicle.
When people put their money into these retirement accounts, they deposit the funds BEFORE they’ve paid their taxes. This means that when the day comes for them to take their money out, they’ll have to pay their taxes at that future date (when they’re most likely in a higher tax bracket, where the IRS can hit them hardest).
For many years, this was the established norm until the U.S. Government enacted the Taxpayer Relief Act of 1997 and the Roth IRA was born.
The Roth IRA took a new approach to retirement savings. It allowed individuals to deposit their after-tax income into their retirement account (when they typically have a lower tax burden) and then withdraw it in retirement tax free.
For most people, having a retirement account that grows tax free is a pretty big deal (whether they realize it or not). In the end, this can make a pretty dramatic difference – here’s a basic illustration to give you an idea:
Of course, for those who are familiar with Roth IRAs, there are a few standard rules that always apply:
- The IRS has an annual limit on how much can be contributed to a Roth IRA each year. As of 2015, that limit is $5,500 per year, and up to $6,500 per year if age 50 or older. (source)
- In order to withdraw these tax free earnings from a Roth IRA, the owner of the account must be at least 59.5 years old and the account must be at least 5 years old. (source)
- You can withdraw the principal investment at any time without penalty, but not the earnings. (source)
- Roth IRA funds can never be co-mingled with personal funds. (source)
Introducing: The “Self-Directed” Roth IRA
A Self-Directed Roth IRA is an individual retirement account that allows people to pursue alternative investments for their retirement savings. Rather than handing money over to a total stranger and trusting them to do the right thing, the owner of a Self-Directed Roth IRA can make these decisions for themselves, by investing in things like:
- real estate
- private company stock
- oil and gas LPs
- precious metals
- intellectual property
- tax liens
And when we refer to “real estate” as an alternative investment above, this is defined as things like:
- residential and commercial properties
- home flipping
- raw land
- new construction
- property renovation
- passive rental income
When I first started looking into opening up a Self-Directed Roth IRA, I already had a Traditional IRA through my employer and a Roth IRA that I had set up on my own. After talking with the folks at Equity Trust, I was surprised to learn that I could open up a new Self-Directed Roth IRA, in addition to the two IRAs I already had in my name.
When I opened up my new Self-Directed Roth IRA, I was also able to roll over some funds from my existing Traditional IRA (a taxable account) to the new Roth IRA (a non-taxable account). Since my Traditional IRA funds still hadn’t been taxed when I rolled this money over, it resulted in a “taxable event” (I had to pay several hundred dollars in taxes on the funds that were rolled over).
I’ll be honest – I didn’t enjoy writing this check to pay these taxes, but it was still worth the price, because it also allowed me to get around this $5,500 “annual contribution limit” and have A LOT more money to work with, which allowed me to go after properties that were much more substantial.
Supercharging Your Retirement
Most people are stuck with the erroneous notion that the path to retirement has to be a long, slow and boring (and when an 8% – 12% ROI is considered a “good return”, it’s not hard to understand why).
The beauty of a Self-Directed Roth IRA is that you’re not just stuck with stocks and bonds. You can invest your retirement funds in all kinds of things – even real estate! And given how quickly we can multiply our money with real estate, this is a pretty big deal.
As I mentioned at the beginning of this blog post, I just got a 300% ROI on a property I sold last week. If you could get even half that much on a regular basis (which is absolutely achievable with our land investing model, btw), you would be doing dozens of times better than the “great return” of 8% – 12% the stock market will bring you.
To put this in perspective, let’s take a look at a comparison of two retirement savings models. In the table below, we have two prospective retirees – John and Sarah.
John is investing in a standard Mutual Fund.
He invests $5,500 of new money every year while continually reinvesting his returns, which average 8% annually. He continues to do so until he reaches $2,000,000.
Sarah is investing in real estate with her Self-Directed Roth IRA.
Using the land investing business model, she invests $5,500 one time and is regularly able to find properties at a fraction of market value and sell them within a time frame of 12 months. She reinvests her returns, which average 200% annually and she continues to do so until she reaches $2,000,000.
(note: most of my properties have sold in less than 6 months for a return of anywhere from 100% – 300%, so this is a fairly reasonable assumption for someone who is taking the business seriously)
As the chart shows, Sarah’s path to retirement only took her until age 27, when she literally blew past her goal by over $800,000.
John’s path to retirement took him until age 60 and even then, he still hadn’t reached his goal.
Just to put this in another perspective, this is what the comparison looks like on a line chart:
Of course, when we’re projecting paths to retirement like this, we have to make some pretty broad assumptions. Just like John’s return on his mutual fund isn’t always going to be 8%, Sarah’s return on her real estate investments won’t always going to be 200%, and she won’t always sell them in exactly 12 months.
Sometimes John will see returns of up to 20% when times are great, and sometimes his investment growth goes backward when the economy is terrible. Likewise, Sarah’s returns may dip down to 100% on some of her “sub-par” deals, and sometimes they’ll spike up to 400% or higher when the stars align and everything goes as planned. It’s also worth noting that sometimes her properties may take more than 12 months to sell (just like my recent example did) and sometimes they’ll sell in a matter of days (see Karl’s recent example).
The point here – is that a Self-Directed Roth IRA will allow you to supercharge your retirement savings. Whether you’re 20 years old or 70 years old – if you’re using the right business model and consistently pursuing it year after year, it won’t take long to inject mutant-like powers into your retirement account and blast your savings into the stratosphere, with the kind of numbers that are seemingly impossible.
How My Deal Worked
So how complicated is it to buy and sell real estate using a Self-Directed Roth IRA? What extra steps are required along the way?
I will admit that the process worked a bit differently than I was used to – primarily because I couldn’t sign any documents on behalf of my Self-Directed Roth IRA. Instead, I had to have a custodian at Equity Trust do all the signing for me. This took a few additional steps, but it wasn’t difficult. If you follow along, I’ll show you exactly what I had to do below…
Step 1: Finding the Deal
I found this deal the way I usually do. After some back and forth with a seller via email, the opportunity finally arose for me to buy this property at a small fraction of market value. I estimated the property to be worth anywhere from $20K – $40K and I got it under contract for less than $5K.
Step 2: Signing the Purchase Agreement
Once we settled on the price, the Seller and I both signed my standard purchase agreement. The only notable difference was that since I was buying the property in the name of my Self-Directed Roth IRA (and Equity Trust was acting as my custodian), my name had to appear slightly different as the “Buyer” of the property:
Note: It was extremely helpful to work with Equity Trust on this transaction because they were able to coach me every step of the way – informing me of what is and isn’t allowed, how my documentation had to look, and what steps I had to go through to get the deal done. If I didn’t have their help, I probably never would’ve gotten through the process.
Step 3: Closing the Transaction
When you’re buying and selling real estate with a Self-Directed Roth IRA, you must use a third-party closing agent (i.e. – title company or attorney). Contrary to the way I handle some of the cheaper deals, you cannot close these kinds of transactions in-house… so don’t even think about it.
Luckily, just about any legitimate title company or closing attorney should be at least somewhat familiar with how these transactions work. The main difference is that the communication will have to flow through three parties:
- The Closing Agent
- Equity Trust
This works through a set of instructions called a “Direction of Investment” form. It’s a form that you have to fill out, instructing Equity Trust on what you’re asking them to do on your behalf (e.g. – which documents they need to sign, how much money they need to send the title company, etc.).
To be completely honest, I found these forms rather confusing and I probably would have messed them up if I hadn’t called Equity Trust and asked for help filling them out. With a little bit of hand-holding, I was able to get through it with no problems.
To give you an idea for what the forms look like, this is the exact direction of investment form I submitted when I was purchasing the property (several areas are blurred out for obvious privacy reasons – this is intentional):
Once I notified Equity Trust of what they would need to sign for me (see above), the closing agent mailed them the documents, a representative at Equity Trust signed where needed and then sent them back to the closing agent along with a cashier’s check from my account to pay for the property.
I’ll admit, on my first time through this process – it wasn’t always easy to keep track of things and make sense of the logistics, but now that I look back on it – it wasn’t all that bad. The bulk of the heavy lifting was done by the closing agent and Equity Trust – once I submitted the direction of investment form, my work was basically finished.
Step 4: Selling the Property
On this particular deal, the selling process was by far the most time-consuming aspect of it. It took me an unusually long time to get this property sold, but I attribute most of this to the fact that I frankly wasn’t marketing the property very hard.
Aside from creating a good listing and posting it on both Craigslist and Postlets, I didn’t go to great lengths to get the thing sold. I wasn’t overly concerned about finding a buyer because I knew the property would sell to the right person eventually. This particular property was big, valuable and very inexpensive to hold (only $66 per year for property taxes – and that was it)… so the longer selling time never caused me any real anxiety.
Step 5: Finding the Buyer, Closing the Deal
I had several “tire-kickers” call me over the 12+ month time frame that the property was listed (which is to be expected with a property like this). Each of these people sounded like they were serious about buying the property at first and I was responsive to all of their calls, but eventually, they would cease contact and go silent on me.
When the right buyer finally came along, I knew I was working with “the one”, because I didn’t have to bend over backward to contact them or get the deal closed. They were actively pursuing ME and they were very easy to work with.
The closing process to sell this property worked very similar to the buying process. It was a matter of getting the list of documents that Equity Trust would have to sign on my behalf and then filling out a direction of investment form to send them. These are the exact page I submitted when I sold the property (again, several areas are blurred out for obvious privacy reasons):
After I sent these documents to Equity Trust, I got in touch with my representative and let them know that (in accordance with page 2 above), the closing agent was going to mail the following documents to them for their sign off:
- Settlement Statement
- Closing Acknowledgment
- Request for Settlement Protection Insurance
Once the documents were received and signed by Equity Trust, they were sent back to the closing agent to wrap up the deal. About one week later, the closing agent had mailed a cashier’s check to Equity Trust for the full purchase price, and I was $20,000 richer with no tax bill to show for it.
Any Down Sides to a Self-Directed Roth IRA?
As I’ve already mentioned several times here, there are some MAJOR benefits that come with investing in a Self-Directed Roth IRA.
The first and most obvious is your ability to buy and sell properties without paying taxes on these transactions (and if you’ve ever had to pay a tax bill on a profit of $50,000 or more, you know it’s a very painful experience).
The second is the ability to supercharge your retirement savings. Rather than slogging away for years with the minimal returns that most people have resigned themselves to, a Self-Directed Roth IRA (when coupled with the right real estate investing model) has to power get you there at light-speed.
On the same coin, I’ve found that investing in a Self-Directed Roth IRA can be less-than-ideal in certain scenarios. For example…
1. It’s all good and fun to make tax-free money… but when your funds are tied up in a Roth IRA and you can’t touch it until you’re 59.5 years old (and the account has been around for 5 years), it’s kind of a buzz kill (and for some, it’s an automatic deal-killer – especially if you need immediate access to the money AND you don’t meet these two criteria).
2. If you’re going to invest with a Self-Directed Roth IRA, you need to be very careful about tracking your sources and uses of funds. If you own a property in the name of your Self-Directed Roth IRA, you cannot use ANY of your personal or business funds to pay for property taxes, improvements, closing costs or anything else related to the ongoing maintenance or holding costs of the property. All the funds must come from the IRA that owns the property and nowhere else. If you co-mingle your IRA funds with any other person or entity (even if it’s by accident), you could be up against some serious penalties from the IRS for breaking the rules – so don’t do it.
3. A Self-Directed Roth IRA may require a few more days of additional lead time to get each transaction closed (more than some of us land investors are accustomed to waiting for). When you have to get your IRA custodian and a third-party closing agent in the loop, it can slow down the process when multiple parties have to approve and sign off on all the documentation. It’s not impossible (and to a lot of people, it’s just normal), but it does require a bit more time and patience – so be ready for this.
Lastly – I should reiterate that this blog post is not intended to be an all-inclusive explanation that outlines all the rules that pertain to Self-Directed Roth IRAs. I’ve outlined the most pertinent issues that applied to my situation, but there may be other things you need to be aware of in your situation (whatever that is). If you aren’t sure what rules apply or what you’re allowed to do, you can do what I did and contact Equity Trust for more information.
And in case you were wondering… I am not getting paid or compensated in any way for plugging Equity Trust in this blog post. I only mention this company because they are the people I worked with on this transaction and they did a great job of helping me through each step of the process.
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