Standard disclaimer: I am not an accountant or financial advisor, and am not providing tax or financial advice, this article reflects my understanding of the rules as they currently exist and is not a recommendation on what you should do. I always recommend talking to your tax and financial advisors before making any financial decisions.
Assuming you are interested in investing in a syndication, one important question is where to get the money from. Being a passive investor requires you to bring $50k-$100k to the deal, which is a lot more than most people have sitting around in their savings account on a typical day.
If you haven’t been active in real estate, then chances are good that a lot of your money is invested in retirement accounts (i.e. 410k, IRA, Roth IRA)and hold traditional paper assets such as stocks and bonds. Pulling money out of these accounts before you hit retirement age incurs large penalties, so it is easy to feel that there are limited options for what this money can do for you. But that is not necessarily the case.
My understanding is that it is possible for you to invest your IRA / Roth IRA money into real estate, businesses, or other alternative investments [1]. This can be a great way to build up your retirement account faster that investing in the stock market, since the IRR on a syndication can be much higher than the average stock market return, especially when you factor in the tax deductions. However, there is a lot you need to be aware of before making this move.
First of all, you will need to have your IRA managed by an IRA custodian that allows you to self-direct your IRA. In most cases, people have their retirement funds in one of the big brokerage firms (such as Fidelity or Vanguard) which only allow you to invest in their financial products (stocks, bonds, funds, ETFs, etc). To get a broader range of investment options, including syndications, you need to transfer your money to a custodian that allows you to self direct. The money can be transferred without any tax penalties (work with your custodians and tax professionals to discuss how to do this properly). Once your funds are moved, you can work with the custodian on investing in a syndication. It can take time to move the money and get everything set up, so you want to make sure you do this before you need the money for an investment. Be aware that these custodians typically charge an explicit management fee to your account. The big brokerage houses also charge fees (no-one works for free:)), but those are typically hidden in their offerings and not as visible. As a result, you should take those fees into account when evaluating the returns on your deals to truly understand what your overall rate of return is.
Second, while self-directing opens up a much greater set of opportunities, there are rules that need to be followed for these investments. For example, you can’t invest in a business that you or a close family member are active participants in and you cannot get direct benefits from that investment. Failure to follow the rules and the IRS may consider your funds to have been withdrawn from the account and assess taxes and penalties on those withdrawals. However, if you follow the rules you are able to invest in a broad range of investments, including many syndications.
Finally, you need to think closely about the tax implications of the deal. ”Isn’t the point of a retirement account to avoid taxes?” you might be thinking. Yes, but only under certain circumstances. You need to consider two important things when you are considering an investment within your retirement account:
- If the deal you are investing in is planning on using leverage (e.g. a mortgage), you need consider the impact of UDFI taxes [2] on your returns. UDFI is meant to “level the field” with a investor outside of tax advantaged accounts and applies to both traditional and Roth IRAs (interestingly, it doesn’t apply to 401(k)s yet). UDFI attempts to bring everyone onto equal footing by taxing the profits that are obtained due to leverage. It isn’t fair to investors outside of retirement accounts if you can make the terms of the deal more favorable because you don’t have to worry about taxes on the profit from the money you borrow (as opposed to the money you have set aside in the account) when they do. This doesn’t mean that you shouldn’t take the deal, as your taxes are only a portion of the profit generated by the borrowed momey, but you need to be aware of the tax you will need to pay when projecting your returns.
- If you are using a traditional IRA, the money you make will be taxed as ordinary income when you withdraw it from the account. This means that you may ultimately be paying higher taxes on the profits from the deal that you would if you invested in the deal outside of the retirement account and were able to pay only capital gains taxes on the money. This concern doesn’t apply to a Roth account since you don’t pay taxes on any money withdrawn from a Roth.
Personally, I haven’t used my IRA funds to invest in real estate. I prefer to take advantage of the tax advantages inherent in real estate and use money outside of my retirement accounts for REI and am fortunate enough to have enough money outside of these accounts that I can make these investments. I keep most of my stock and bond portfolio within IRAs and 401(k)s so I don’t need to worry about taxes when I rebalance those funds. I adjust the amount of money I put into the retirement accounts to maintain my desired portfolio allocation.
However, I know many investors who make heavy use of their retirement accounts – in particular their Roth accounts – to invest in notes, make hard money loans, and do syndication deals that give them larger returns than the stock market. This makes a lot of sense since, once the money is within a retirement account, you want to grow it as fast as possible and REI is a great way to accomplish that.
As always, the right strategy for you depends on your current situation and your goals. However, if you are interested in going into syndications and looking for the funds to do so, you may want to look into your retirement accounts to see if moving that money outside of the stock market makes sense to you.
If you have any questions about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.
For additional reading:
[1] https://www.amazon.com/Self-Directed-IRA-Handbook-Second-Authoritative-dp-0692122400/dp/0692122400/