When done correctly, short-term rentals (like Airbnb and Vrbo) can generate significant profits for property owners. Another lucrative option is investing in traditional rentals and adding accessory dwelling units (ADUs) to increase the rental property’s profitability.
Many potential property investors face challenges when it comes to saving for the down payment and closing costs, particularly with the high home prices across California and the rest of the country.
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However, your hidden treasure trove of funds might be right in front of you.
According to Kaaren Hall, CEO of uDirect IRA Services in Irvine, retirement funds such as IRAs, Roth IRAs, inherited IRAs, SEPs, SIMPLEs, and Solo-401ks can be used to invest in real estate.
It’s important to note that this strategy does not apply to building an ADU on your existing property.
One of the main reasons to consider investing in real estate instead of more traditional options like stocks and bonds is to diversify your assets. It also provides an opportunity to invest in property even if you have limited available cash.
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Real estate generally proves to be a reliable investment over time.
After three consecutive quarters of decline due to rising mortgage rates, home prices are once again on the rise. In the second quarter of 2023, the highest profits from home sales were seen in California. San Jose had a profit of $600,000, San Francisco $416,000, and San Diego $301,500, according to Attom Data.
Looking beyond California, other major metropolitan areas with significant increases in median home prices from the first quarter of 2023 to the second quarter of 2023 include Rochester, NY (up 20%); Madison, Wisconsin (up 19.1%); and Bridgeport, Connecticut (up 18.6%), according to Attom.
Retirement fund mortgages primarily fall within a separate financial realm, separate from traditional mortgage brokers, bankers, and depositories.
First Western Federal Savings Bank, an IRA lender, for example, offers loans for residential units (one to four) with as little as 40% down, and for short-term vacation rentals with as little as 50% down. The remaining portion can be financed.
In reality, due to higher rates and qualifying criteria at First Western, buyers will likely need at least 60% down and mortgage rates starting at 8.5%, according to Roger St. Pierre, a senior vice president at the bank.
However, it’s crucial to consider the cashflow qualification requirements. First Western requires a debt service coverage ratio (DSCR) of at least 1.25%. This is calculated by dividing the property’s annual net operating income by its annualized overhead, which includes all expenses such as principal, interest, taxes, insurance, HOA fees, mortgage payments, management fees, a 7% vacancy factor, and a 6% maintenance factor.
Needless to say, it’s quite complex.
First Western’s program is only available for qualified self-directed retirement plans and LLCs comprised of qualified retirement plans.
It’s important to note that investors cannot directly control the real estate asset.
One way to hold your real estate asset, paid for with retirement funds, is through a Checkbook IRA, where your IRA owns the LLC, according to Hall. This specialized-purpose LLC was established in 1996 and requires a third-party administrator for tax reporting and recordkeeping.
uDirect charges $275 in annual recordkeeping and reporting fees, plus a $50 setup fee. These fees are in line with other administrator fees.
As of my last update in November 2015, First Western’s rates were as low as 4.25%, roughly half of today’s mortgage rates. Higher rates put pressure on profitability, but refinancing is an option when rates drop.
Using retirement funds to pay cash is more advantageous from a tax perspective compared to using retirement funds for a mortgage. If you finance a property using deferred income tax retirement funds, the IRS will charge taxes between 10% and 37% using a form called a 990-T, according to Jeff Hipshman, a CPA partner at Eide Bailly. The tax is only applied to portions of profits related to the mortgaged money.
It’s crucial to remember that property investors cannot access any profit or the principal asset without paying income taxes. The main purpose of a pre-tax investment is to allow your money to grow in a tax-deferred fund.
Once you reach age 73, you must start taking mandatory minimum distributions (RMD) from any tax-deferred retirement funds. For example, if you are 73 years old with a remaining lifetime expectancy of 100 years, and your rental property and Checkbook IRA cash total $1 million, you would divide $1 million by 27 (your remaining years) to get a result of $37,037. This is the amount you would be required to pay taxes on in the first year, according to Hipshman. It’s important to note that the third-party administrator will update the asset’s value and your remaining life expectancy each year, so the RMD will vary.
If you need liquidity, you can refinance and withdraw cash. Alternatively, if you don’t have enough cash in the Checkbook IRA to cover the annual RMD, you can sell the property and keep the proceeds in the Checkbook IRA.
“Self-directed IRAs are great for diversifying investments beyond stocks and bonds. The right real estate investment can be a good idea, but only if the investment makes sense even without the depreciation-deduction tax benefit that often makes real estate investing most attractive,” said Rod Stern, tax and estate attorney and partner at Murtaugh Treglia, Stern & Deily in Irvine.
“When funding a self-directed IRA, it’s important to have a game plan for how long to take distributions when you retire. When it comes time to make required minimum distributions, it may be possible to distribute partial interests in the real property each year. However, this may not provide enough cash to cover the income tax on the distribution,” he added.
Full disclosure: I have professional relationships with Eide Bailly, Hipshman, and Stern.
Prior to attempting any of these tactics to purchase investment property, it’s crucial to seek legal advice. There are specific rules that must be followed to avoid potential IRS penalties for violating regulations and procedures.
Freddie Mac rate news
The 30-year fixed rate averaged 6.78%, which is 18 basis points lower than last week. The 15-year fixed rate averaged 6.06%, which is 24 basis points lower than last week.
The Mortgage Bankers Association reported a 1.1% increase in mortgage applications compared to last week.
Bottom line: For a borrower with average credit, a 30-year fixed-rate mortgage on a loan amount of $726,200 would have had a payment that was $583 lower last year compared to this week’s payment of $4,725.
What I see: In our local area, well-qualified borrowers can obtain the following fixed-rate mortgages with one point: a 30-year FHA loan at 6.125%, a 15-year conventional loan at 5.875%, a 30-year conventional loan at 6.375%, a 15-year conventional high balance loan at 6.625% (for loan amounts between $726,201 and $1,089,300), a 30-year high balance conventional loan at 7%, and a jumbo 30-year fixed-rate loan at 6.625%.
Note: In the Inland Empire, the maximum loan limit for a 30-year FHA conforming loan is $644,000, while it’s $726,200 in the LA and Orange County areas.
Eye-catcher loan program of the week: A 30-year VA fixed-rate loan at 5.5% with 2 points cost.
Jeff Lazerson is a mortgage broker. He can be reached at 949-334-2424 or [email protected].
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