This article was put together with some of our actual investors based on their experience.
Q: Why did you set up a self-directed IRA (SDIRA)?
A: I had a 401k plan while I was working. That account was limited to investing in mutual funds, but I wanted to be able to buy rental real estate. A self-directed IRA permits investing in many types of “alternative investments”, including rental real estate.
Q: How did you set up the IRA?
A: When I retired I decided to first move (rollover) the money from current holder to an IRA account at another company I was concerned that the current one would be more difficult to work with than the new one when I was ready to transfer to the self-directed IRA. For me this was a stepping stone towards my goal. After the self-directed IRA account was opened, I was easily able to transfer funds from the new company IRA to the self-directed IRA. While the funds were being transferred to the new company, I looked into 11 SDIRA companies.
Q: Why didn’t you simply leave the money in the the new company IRA?
A: This company doesn’t offer a self-directed IRA. They have “self-managed”, but not “self-directed”, accounts. That is, their investment options are more limited than with a SDIRA — specifically, it would be impossible to buy real estate with a their account. (By the way, while looking at the investment possibilities with them, I found that you can invest in Real Estate Investment Trusts (REITs), but I wanted to buy actual properties.)
Q: What were you looking for when researching the SDIRA companies?
A: Of course, I was looking for a reliable company, since I was going to give them a lot of my money. That said, one of the details I focused on was costs: account set-up fee, annual fee, property purchase and sale fees, fee for paying an expense, and so on.
I created a spreadsheet to compare the companies. I defined “variables” for the account value, number of properties, number of expense checks per year per property, and number of years, so the fees could be computed based on those variables. I listed the types of fees I expected to encounter, and entered the details for each custodian. Some of the fees are fixed amounts (e.g., the set-up fee), some of the fees depend on the account value (e.g., the annual fee for some custodians), and some depend on activity of the account (e.g., the purchase/sale fees and expense checks).
The spreadsheet enabled me to analyze various scenarios and estimate what the costs would be over a number of years. I decided a 10-year span seemed like a good period to measure these fees over. The range was $2,400 to $18,000 over the 10-year period.
I threw out the low and high ones because they seemed to be too extreme. Actually, the bottom three seemed unusually low, and were all thrown out of the mix. (The bottom three had fees in the range $2400–$3700 over 10 years, compared to $5,500–$7,000 for the “middle” companies.) That left me with seven companies to consider.
Q: What SDIRA company did you end up picking?
A: I actually ended up picking two companies – one for my IRA and one for my wife’s IRA.
I picked custodian A for my IRA. It was at the low end of the range for 10-year expenses (after eliminating the bottom 3). I liked their website and procedures, and their customer service people seemed to be responsive to my questions. I have been with them for nearly two years, and have purchased two properties. I also initiated a purchase that was later canceled.
We picked custodian B for my wife’s IRA. They are less expensive than custodian A for her smaller account. (They would have been more expensive than custodian A for me.) Other than that, they seem similar to custodian A. My wife has been with them for about a year, has purchased one property, and has done two trust deeds.
Q: What have your experiences been with the SDIRA companies?
A: Between my wife and myself, I’ve had experience with three companies.
I have been very satisfied with custodian A. They have efficiently handled the purchases (both of which had complications) and ongoing transactions.
Similarly, custodian B has satisfactorily handled my wife’s transactions.
However, we did have an unsatisfactory experience with one company (which happened to be one of the low-cost ones). We were guided to that custodian by an investment company we were considering working with. The investment company claimed they had an existing relationship with the custodian, so working with them would be easy. However, after we opened an account with that custodian, they were never able to actually execute the investment (which was at least partially the fault of the investment company). I felt that this custodian was not fully engaged. They gave me a bad vibe, as did the investment being considered, so we decided to discontinue working with that particular custodian. Unfortunately, that “lesson” cost us a bit, because we had to pay a set-up fee, an annual fee, and a fee to close the account – all within about three months.
Q: Are there specific things that you like or dislike about the SDIRA companies?
A: Yes, there are some things worth considering, although I’m not sure they would have changed our selections.
As a practical matter, the location of the company’s office can be a consideration. custodian A is located in Illinois, and their office closes at 4:30, which is only 2:30 for me. custodian B is in Ohio, three hours ahead of us, but they do stay open until 6:00 their time.
Similarly, the company’s processing schedule can be a consideration. custodian B requires that requests be in their hands by 10:00 AM their time (7:00 our time!) in order to be processed that day. That can cause a full day of delay in processing something.
At custodian A, I have an assigned account manager who is familiar with me and my account. custodian B uses a team approach in which you deal with whoever answers your call. Fortunately, they seem to do a good job of making notes in their computer system, so the process works okay, but I prefer the assigned contact.
The procedure for requesting payment of bills differs from one custodian to another. With custodian A , I have to send an email with a scanned copy of the bill attached. With custodian B, you simply go to their website and fill in a form, which is easier. Both companies have responded to the requests within a day or two, which has been fine.
Q: Are there other important points to consider when choosing a custodian?
A: I’d add the following points in addition to those I’ve mentioned previously:
1. Fees: Custodians’ fees can change over time. For example, custodian A changed their fees rather significantly after I set up my account. Before, they had one annual “account” fee. Now, they have a fee for the account and a fee per asset. For me, the combination is a couple hundred dollars more per year.
Custodian C was ruled out during my analysis because they had a large exit fee (i.e., when the account is closed), which was unattractive (and, I thought, rather underhanded). Later, they reduced the exit fee to a reasonable amount. If the current fees had been in effect, I might have selected This custodian, because they are well known, have a local (Oakland, CA) office, and their current fees are only slightly higher than custodian A for my scenario.
2. Disclosed Info: While doing my research, 90% of the information came from the Internet. Sometimes, there would be a need to call to get additional clarification on important details. The success of doing that varied from company to company, which I took as an indication of how the companies operated.
3. Time Zone: As I mentioned before, the time zone for the custodian can be a significant inconvenience. Looking back, I would have considered the time zone while comparing the companies.
4. Bill Paying (for taxes, insurance, utilities, HOA Fees, etc.): custodian B offers an online service like a regular online bill payment. With custodian A, you need to send a PDF request via e-mail. With both companies, you can look online to see if the bill has been paid.
5. Checkbook IRA: There is at least one custodian that promotes an IRA for which the owner has a checkbook they can use to pay bills and deposit income. That sounds convenient, but the underlying structure is rather expensive. The self-directed IRA funds an LLC, and the LLC owns the checkbook. Thus, the account owner must establish the LLC, and pay the associated annual fees (e.g., I believe its $800/year in CA). From my (limited) experience, this approach is not necessary.
6. Property Purchase: The details of the purchase process depend on the requirements defined by the custodian, and could cause significant problems. But before I go into the details, I should mention that it’s important that all documents (e.g., offer, closing documents, and deed) identify the SDIRA as the buyer (e.g., “. . . Custodian FBO John Doe IRA”), not the IRA owner. In particular, you cannot initiate a contract in your name, and later assign it to your IRA, because (a) the seller might not permit assignment and (b) the assignment might be considered by the IRS to be a prohibited transaction.
Regarding the processing of documents, custodian A requires that all documents, including the initial offer, be sent to them for signature since they are technically the buyer (I must sign every page “Read & Approved”). The resulting delay can be a serious problem when submitting an offer on a “hot” property. (In one case, I “cheated” and signed an offer myself, and begged forgiveness after the offer had been accepted. Fortunately, the custodian agreed and the seller didn’t realize what was going on.)
In addition to the contract document, providing the earnest money quickly could be a problem. (You cannot write a personal check for the earnest money.) Fortunately, this was not a problem for our purchases, because they were short sales, and the earnest money wasn’t due until after the contract was approved by the seller, which took months. By then we had the IRA custodian engaged in the purchase process, and could get a check issued in a day or two.
With custodian B, the IRA owner can sign the offer documents and submit them to the seller without custodian B’s involvement. But the closing documents must be signed “Read & Approved” by the IRA owner before being signed by the custodian.
It should be noted that the custodian wants the IRA owner to “approve” the documents so it can’t be claimed later that the custodian did something without authorization. That two-step signature process could slow things down a bit, but it has worked out okay for us. By the way, we have not been able to e-sign documents, but that’s probably due to the antiquated processes used by escrow companies. Thus, we’ve had to print the PDF files we’ve received, sign the pages, scan them into a new PDF file, and email the “signed” PDF file.
7. Expedited Processing: Both custodian A and B have a $50 fee that can be paid to expedite their response, for example, for signing offers or closing documents quickly. We paid that fee one time, when we were nervous about the timing. Other than that, we’ve managed to get things done with “normal” processing. Until you’ve been through the process with a custodian, you have no way of knowing how quickly they will do things – their “official” response times are long so they’re covered if something does take a while.
8. Property Value Reporting: The custodians “request” an annual statement of the value of the property(s) owned by the SDIRA. It seems that they don’t insist on this statement, but I don’t know what happens if it isn’t provided. Typically this involves getting a BPO (Broker’s Price Opinion) for the property (which incurs a fee for the broker). In addition, the custodian might want a formal appraisal of the property, perhaps every few years – particularly if the custodian’s annual fee is based on the account value.
9. Overseas Properties: Some Custodians will allow overseas properties, but most will not.
General Topics Related to Self-Directed IRAs:
1. There are many IRS rules about IRA administration and transactions. Some of them regard “disqualified persons” who cannot participate in transactions, resulting in “prohibited transactions”. (Do a Google search for those terms.)
Also, it’s important to remember that every dollar spent must come from the IRA account, and all income received must go into the account. You cannot use personal funds for an earnest-money deposit or to pay a bill, and you cannot deposit received funds into a personal account. Also, you cannot work on an IRA-owned property yourself.
Violation of these IRS rules could jeopardize the IRA. If that happens, you could be forced to withdraw the entire account value (cash balance and transfer of title of properties) and pay income tax (and possibly penalties) on the withdrawal.
2. Beware of the word “Trust”: Almost all the companies have the word “Trust” in their name. Every seller we’ve dealt with has focused on the word “Trust” in the buyer’s identity, and thought a trust was buying the property. Each time, it was difficult to convince them that the buyer was not a living trust or a family trust.
3. Related to that, be prepared to “educate” real estate and escrow agents about your self-directed IRA. Many of them are not even aware of the concept.
4. A self-directed IRA can be a “traditional IRA” (i.e., with pre-tax dollars) or a “Roth IRA” (i.e., with after-tax dollars). Any type of IRA can be self-directed.
5. Starting the year after the IRA owner turns 70-1/2, annual Required Minimum Distributions must be withdrawn from the owner’s IRA account(s). That could require some liquidity of the self-directed IRA. (This does not apply to Roth IRAs.)
If the owner has multiple IRA accounts, their combined total value determines the amount of the required annual distribution, but that distribution can be taken from any one or more of the accounts. Thus, for example, funds could be withdrawn from a “regular” IRA account to satisfy the required withdrawal for a self-directed IRA.
Note: I was once told by an custodian C employee that distributions must be taken from each IRA account according to the value of that account. IRS publication 590 on IRAs explicitly states:
“If you have more than one traditional IRA, you must determine a separate required minimum distribution for each IRA. However, you can total these minimum amounts and take the total from any one or more of the IRAs.”
The moral of that experience is to not believe everything you’re told! ☺
6. A self-directed IRA can get a loan to buy (or refinance) a property. However, it would have to be a “non-recourse loan”. There is a limited number of lenders who make such loans, and the rate would be higher, and the loan-to-value (LTV) more restrictive, than for a “normal” loan.
However, there’s a “secret”, gotcha aspect of such loans: The IRA becomes subject to Unrelated Business Income Tax (UBIT) every year when debt financing is used. That is, the portion of the IRA’s income that can be attributed to the loan is subject to that tax. For example, if an IRA asset is 70% financed, then 70% of the asset income is subject to the tax.
However, I believe expenses associated with the asset can offset the income, just as for a property owned outside an IRA. Note, in particular, that this means the depreciation “expense” for the IRA property might be able to be utilized in that case. (If there’s no loan, there is no “benefit” from actual and depreciation expenses.)
7. A self-directed IRA can partner with one or more other entities to buy a property. The IRA can partner with another person’s self-directed IRA, another person’s “private” funds, or even non-IRA funds of the person who owns the self-directed IRA.
The complication is that all expenses and income must be shared by the parties in proportion to their share of ownership. That could be inconvenient to administer. For example, every expense would have to be paid proportionately from the IRA and from the partner(s), and income would have to be routed separately to the IRA and the partner(s).
8. There are many good sources of information about self-directed IRAs on the Internet. I suggest that you look at the websites for various custodian companies for general information about self-directed IRAs, as well as specific information about the various companies.
This article does not render legal, accounting, or tax advice. It has been prepared solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Any performance data quoted represents past performance. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance is no guarantee of future results.