Real Estate: The Self-Directed Perspective

Many physician-investors have become disenchanted with recent stock market volatility, stories of corporate scandal and corruption. In addition to impacting retirement account values, these events have also strained investor confidence.

It’s no wonder then that more and more investors are pushing their advisors to offer Self-Directed IRAs (SDIRAs) that allow them to invest in alternative assets which they believe will provide greater diversification and control over their retirement nest eggs.

Factors

While the list of alternative investments includes a wide-ranging group of assets—including private equities, hedge funds and mortgages—one area that has captured the greatest level of interest is real estate.

Typically, real estate comprises 60% of clients’ alternative asset investments. Many real estate advisors suggest that falling prices, combined with increasing inventory, is creating new investment opportunities. As prices begin to fall, the pendulum may swing past center to create oversold conditions, providing opportunities to buy real estate at low prices. Some areas in the country may already be starting to experience this phenomenon.

Another factor to consider is that many real estate investors are being squeezed out of the market due to the current credit crisis. This has created a unique opportunity for cash-rich retirement plan investors. These investors are either purchasing the real estate outright, through a partnership, or LLC. It is estimated that the first of more than 78 million baby boomers will begin to retire this year. This group controls more than $14 trillion dollars in retirement plan assets. These assets are being “rolled-over” from employer-based plans to IRAs. Many baby boomers have already begun to shift away from traditional equity investments to those that generate income, such as, income producing property. Add these factors with the possibility of equity appreciation, and it is clear why real estate is growing in popularity.

Opponents of using the SDIRA to invest in real estate focus on key concepts which they believe have a profound effect on individual financial strategies. Before engaging in any transaction prudent investors are wise to consider them. First, profits personally made in real estate, if long-term, are taxed at the capital gains rate of 15%. When a SDIRA sells a piece of real estate there are no taxes due at the time of sale. However, when the owner takes a distribution from their retirement account, the proceeds will either be taxed at their ordinary income rate (for a traditional SDIRA) or are tax-free under the Roth SDIRA.

Additionally, SDIRA investors cannot depreciate property or write off interest from their mortgage on their personal tax return. Another important issue concerns the access and use of property held inside the SDIRA. Neither the account holder nor his/her family members may have personal use of said property; doing so would result in a prohibited transaction. SDIRA firms are well versed on such issues and can help educate investors about the ins and outs of using alternative assets, such as real estate, inside a retirement account.

Taking the First Steps

Any investor that has been intimately involved in a real estate transaction is already familiar with the basic requirements of buying real estate in a SDIRA. There are other issues which must also be considered, such as ensuring the proposed investment is not a prohibited transaction. This is why choosing the right self-directed retirement plan custodian is important. A SDIRA custodian can help advisors ensure these requirements are met. Important factors to consider when selecting a self-directed IRA custodian include experience, a consistent service record, organizational structure and wealth of expertise.

After the proper SDIRA custodian has been selected, the investor should request and complete the appropriate forms for their Traditional, Roth, SEP, Simple, Individual 401(k) or other qualified plan(s). The SDIRA advisor will guide the individual through this process. Once the account is established, the SDIRA custodian will forward the transfer form to the resigning custodian, whether that is a brokerage firm, mutual fund, insurance company, bank or trust company. Upon receipt the prior custodian will transfer the assets to the new SDIRA.

Cost

The fees associated with maintaining a SDIRA vary among firms and is one of the most important distinguishing factors. Most firms choose to charge based on a “percentage of assets,” while a minority employ a “transaction” based fee schedule, which is typically kinder to larger retirement accounts. When considering alternative investments, which have longer time horizons with potentially higher returns, the percentage of assets fee approach may not be as beneficial to the SDIRA account owner. Consequently, each account holder should consider his or her specific situation before determining which is best.

Summary

Ongoing market volatility, combined with the need of baby boomers to generate income, and retire securely, is causing investors of all shapes and sizes to take a hard look at their investment allocations to ensure there is a proper mix of opportunity and risk. As investors needs change, alternative assets and self-directed retirement accounts will become important tools to diversify and grow retirement wealth.

TommyJoe A. Valenzuela (“TJ”) Valenzuela is Vice President of Sales and Marketing for Trust Administration Services, a division of First Regional Bank. He has over 15 years experience in the financial services industry, addressing topics such as taxable investment strategies and retirement plan investing.