by Thomas Phelan
As Published in Early To Rise 2006
Well, times are changing.
Hundreds of millions of dollars are fleeing Wall Street each month to the vaults of Self-Directed IRA custodians. For example, PENSCO Trust Company (one of about 20 such self-directed IRA custodians in the country) recently said that it doubled its Self-Directed IRA assets under management from one billion to two billion … in just the last 18 months.
This migration of dollars is, at best, an irritant to Wall Street. However, if those millions of monthly migrating dollars were to change to billions – and they will – Wall Street may have to change its tune.
In theory, Wall Street could offer Self-Directed IRAs – but it has absolutely zero incentive to do so. If it did, its clients might opt to buy such things as real estate, notes, mortgages, tax liens, etc. – where Wall Street would not make one dime.
You see stockbrokers, financial planners, banks, and insurance companies offer you a limited menu of Wall Street financial products (like mutual funds, stocks, and annuities) for your IRA. Selling these financial products is how they make money – and they aren’t about to change what has successfully worked for decades. Wall Street not only controls your IRA funds, it also routinely extracts money from them via transaction fees, management fees, documentation fees, etc.
On the other hand, Self-Directed IRA custodians don’t charge commissions. They just charge a fee for being the custodian of your IRA portfolio. That’s how they generate income. And if your IRA funds are with a Self-Directed IRA custodian, not only can you buy real estate, tax liens – and even lend money – you can also purchase Wall Street financial products.
In other words, a Self-Directed IRA empowers you to decide what to buy, when to buy, how long to hold, when to sell, and how to sell. An example: If you had a Self-Directed IRA, you might make the decision to purchase real estate – perhaps a rental property in one of the up-and-coming markets that Justin Ford has been talking about. Then, when your Self-Directed IRA sells the property (your decision), it could carry back a mortgage like a bank and earn 6% to 10% interest (again, your decision). Try explaining this strategy to the majority of stockbrokers or financial planners.
Of course, having the privilege of being able to make your own decisions comes with some responsibility. (Just as having the privilege of owning a car comes with the responsibility to have insurance, a driver’s license, etc.)
With a Self-Directed IRA, you have the responsibility to make sound financial decisions for your Self-Directed IRA dollars. This is a caveat that may sound obvious – until you take a look at what’s been happening with the pre-construction condo craze.
Stories about huge profits being made with pre-construction condos in Las Vegas, Phoenix, and South Florida are quickly becoming legendary. Yet, in Message #1589, Michael Masterson specifically discouraged buying condos in a market that is “overvalued and the most likely to see significant price deflation – possibly as high as 50%.” Add to this a November Wall Street Journalarticle that warned: “Some of the nation’s largest lenders are cutting back on financing and are tightening standards for condominium projects, a sign that banks, which helped to fuel the run-up in real-estate prices with cheap debt, may be growing more skeptical about the prospects for residential properties.”
Builders in Las Vegas, Phoenix, and Florida have been enjoying unprecedented sales. Entire tracts of new homes and blocks of condos were pre-sold to ravenous buyers before the foundations were even poured. The demand was so great that many builders began to require unheard of earnest money deposits of 10% to 20% and more.
Unfortunately, too many folks with newly created Self-Directed IRAs have been jumping on that pre-construction condo bandwagon … without doing proper due diligence. Overwhelmed by their new-found control over their retirement portfolios, they’ve been mailing large deposit checks to builders in faraway cities to purchase real estate they have never seen.
And, sometimes, this has led to disaster.
Recently, I heard from a man who told me how he had converted a standard IRA containing $70,000 into a Self-Directed IRA. He then directed the Self-Directed IRA to mail a $45,000 earnest money check to a developer in another state for the purchase of a pre-construction condo. The developer had discounted the purchase price 10% (from $500,000 to $450,000) to induce the Self-Directed IRA to make a quick purchase.
The man told me that the developer promises to have the project completed in six months or less – and that before the Self-Directed IRA will be asked to close on the deal, the developer will flip the condo to another buyer for the full $500,000, thereby earning a hefty $50,000 profit for the Self-Directed IRA.
I asked the man one simple question: “What happens if the developer fails to sell the condo to another buyer by the time your Self-Directed IRA is required to close?”
He admitted that, if that were to happen, he had no exit strategy. But he figured that a non-recourse loan could be obtained if the condo did not sell.
Fact is, there are only a few banks that offer non-recourse financing for IRAs. When they do, they demand a hefty 35% down payment (35% of $450,000 = $157,500) – far more than this man has in his Self-Directed IRA. So if the developer does not sell the condo for his Self-Directed IRA prior to the closing, his Self-Directed IRA will forfeit the entire $45,000 earnest money. (2007 update. The guy’s IRA lost all $45,000).
The exit strategy that he should have had in place was to make sure the property would be able to carry itself when rented. That way, he could hold on as long as necessary. (This is true for any pre-construction purchase, done with or without a Self-Directed IRA.)
When I explained this, he confessed to being blinded by the potential of making such a huge profit. “After all,” he said, “I’ve heard so many stories about people who have done it.”
I highly recommend Self-Directed IRAs. Just remember that along with the power and control it gives you, you have the responsibility to do your homework before plunking down your hard-earned IRA money on any investment.
[Ed. Note: Thomas Phelan is a financial author, an active real estate investor, and a contributing editor to MSM’s “Million Dollar IRA” special report. Tom is an IRAAA™ Certified Consultant and has assisted investors on setting up Self-Directed IRA’s and also with setting up tax-deferred real estate sales through 1031 Like-Kind Exchanges.]