Real estate investing with IRAs. What a concept.

Did you know that this was an option for you? Have you wondered how to do it?

Individual Retirement Arrangements (IRAs) have been a part of the American tax scene for more than 20 years. They were first introduced with the 1974 Employee Retirement Income Security Act (ERISA), yet there are still few who understand the implications of this very significant act.

The intention of the act was to lessen the dependence on Social Security and other qualified plans. The act assumed the taxpayer was able to invest his or her own retirement funds at least as ably as the Social Security system and the employer-qualified plans. Both were in trouble when the act was passed.

The act gave more freedom to the taxpayer in retirement fund investing than ever before, although few took advantage of the system. This was one instance where the government really wanted us to take advantage of the system. They wanted our IRAs to prosper and provided us with the tools to succeed.

Many of us responded in 1974 and contributed our $2,000 per year. We now have more than $40,000 worth of tax-deductible contributions in the account, but what did we do about growth? How did we make the capital grow to benefit our retirement? Most of us established IRAs with our local bank and let it invest in its mutual fund or CDs. The really adventurous opened an IRA with their stock brokerage companies and let them worry about the yield.

The return tells the tale

The Individual Retirement Arrangement was all about self-directing. With that in mind, consider the following statistics:

Recently, Consumer Reports, citing the No.1-rated Balanced Mutual Fund ("top mutual," in accompanying chart), showed a 12 percent average annual return over the last five years. Morningstar Mutual Funds tracked and averaged more than 6,000 funds ("average mutual" in chart) and indicated an 8.92 percent annual return over the same period. Unfortunately, most people are not in the No. 1-rated fund and many don't even reach the average.

Many invested in Treasury bills ("T-bills") or Certificates of Deposit with their local banks. Morningstar also reported the 90-day T-bills over the same five-year period averaged 4.66 percent annually. According to researcher Leonard Magazine of Real Estats in Vancouver, Wash., homes in Clark County ("Clark County" in the chart) appreciated at a rate of just over 9 percent per year during that same period of time.

In the case history that follows, the self-directed client ("self-directed" on the chart) realized an 18 percent annual increase in her IRA funds by investing in real estate.

Self-directing gives you choice. Real estate was a good choice for investment of IRA assets just as the right mutual fund was a good choice.

Directed vs. self-directed

How would these different investments have affected a $50,000 IRA account in the last five years? The No. 1 balanced fund would have grown to $88,117. The average Morningstar fund would have grown to $76,649 and Treasury bills would be at $62,788. If the IRA had been invested in the average home in Clark County, it would have produced $77,072. On the other hand, the case history client who invested in real estate would now have assets of $114,388.

Where does your IRA fit? The graph indicates the annual average returns for the last five years.

Case history

While the following information is from an actual transaction with a self-directed IRA, the names have been changed.

In 1990, Mrs. Smith had $30,000 in a self-directed IRA. Mr. Jones, a developer/builder, was developing an subdivision out of state and needed capital to finish installing the sewer, roads, water, etc.

Mr. Jones needed $30,000 and advised Mrs. Smith that he would secure a loan against existing free and clear lots. Mrs. Smith was concerned about her ability, should the need arise, to pursue foreclosure remedies in a state where she was not familiar with the rules. She also wanted some assurance that the developer would install the improvements and go forward with the development, thereby insuring his ability to repay the money.

To satisfy Mrs. Smith's concerns, we had her IRA purchase 15 lots from Mr. Jones for $30,000, which was far below their retail value of $135,000. At the same time, Mr. Jones was given an option to purchase the lots back from Mrs. Smith. Five lots were to be released to Mr. Jones when the infrastructure was completed in the subdivision.

Mr. Jones completed the subdivision and the first five lots were released. Mrs. Smith's IRA continued to own 10 lots worth $150,000 for which it paid $30,000. the value of the lots had increased because of the services which were now available. Mr. Jones' option to purchase the remaining lots required that he keep the taxes current and make quarterly option payments to the IRA of $1,350.

Mr. Jones claimed his option on all the lots with the net result to the IRA of an 18 percent annual return -- all with very little risk.

What was the risk?

The risk was that Mr. Jones would not complete the subdivision and would not execute his option. If this had occurred, the IRA would have been left holding 15 lots with a ready market value of $9,000 per lot, or $135,000. The lots could have been sold at half the value at a fire sale and still provided a 200-plus percent return to the IRA.

How do you make it happen?

You start by taking control of your IRA. Open a self-directed IRA and transfer your assets, or a portion of them, from your directed account into the self-directed account. You now can consider any legitimate investment you want. Always seek counsel from your law, tax and investment advisors.

IRAs were designed to be flexible. Each taxpayer with an IRA has different and unique needs and abilities. In this instance the government really has provided the tools to help. By all means, invest in what you are comfortable with, but do take control.

Uncle Sam wants you to succeed and you can if you take a little responsibility and do your homework.

Copyright © 1995 by Patrick W. Rice