Investing IRAs in real estate has been available, legal and appropriate for decades. I'm surprised that IRA account holders are still falling for the line — "You can't do that." Of course you can.

For over a year now I have been writing in my column about the ins and outs of investing self-directed retirement plans in real estate, trust deeds, and limited partnerships and still I receive calls that start out with, "I didn't know you could do that."

At first I thought the lack of knowledge was a phenomena that was only indicative to the west coast. Maybe we were just out of touch with the laws that Congress has passed and what was allowed in Section 408 of the Internal Revenue Code. That theory was dispelled when I recently received two calls from the Washington, D.C., area.

Both who called had read articles of mine and immediately called their respective CPAs to verify that real estate and IRAs really were compatible. One of the CPAs said he had never heard of such a thing. The other advised that while he thought it could be done he know of no administrators that would accommodate real estate.

I have had numerous calls from readers in the Pacific Northwest who checked with their current administrators (their banks and stock brokers) and were told flat out, "You can't do that." Of course, if you have been reading my columns you know that what they really meant was, "You can't do that here."

Rules that don't apply

Often CPAs, administrator, and financial advisors confuse the rules that apply to qualified retirement plans with those that regulate IRAs. Self-directed pension plans (including IRAs, Keoughs, and SEPs) are the most flexible of all retirement vehicles.

They are much more resilient than employee-sponsored qualified plans. The rules that apply to qualified plans and are enforced by the Department of Labor do not apply to IRAs.

One of those rules that is often misapplied is the one regarding maximum contributions by retirement funds to limited partnerships. It states that no more than 25 percent of a limited partnership can be funded by retirement funds. This is a good rule when you consider that in an employee-sponsored qualified plan, retirement money from many parties are commingled into one investment plan.

The individuals who have their money in such a plan have little or no say as to how that money is to be invested. They are at the mercy of the plan administrator. A non-prudent retirement plan administrator could make a mistake and lose the whole bundle in one investment. This administrator, whom you have probably never spoken to in your life, does not consult you regarding the investments he makes and therefore needs the D.O.L. limitations to prevent them from putting all your eggs in one leaky basket.

The IRA, on the other hand, does not have these limitations. It is not governed by the D.O.L. The account holders of the self-directed IRAs have complete and total control over the investments they choose. They have the obligation of thoroughly investigating each investment to be considered and, hypothetically speaking, should be less vulnerable to poor investments. Because of the personal due diligence they are able to perform, they don't need the extra protection/limitation of the 25 percent rule.

The absence of this regulation on IRAs opens tremendous potential for profit-making for the self-directed pension. Additionally, real estate investments that other wise would be out of the reach of individual pensions can be acquired by banding two or three together in a limited partnership or limited liability company.

An example is a development project that needed $75,000 for acquisition costs. The developer agreed to pay 9 percent annual interest on the invested capital for two years. In addition to the annual interest rate, the developer agreed to pay the investors a whopping 75 percent return on their invested capital from the profits of the development within the two-year period. That is a 9 percent annual return plus a 75 percent overall return over the life of the project or approximately 46.5 percent per year.

In fact, depending on when the profits were taken, that return could go up dramatically. Since the developer agreed that invested capital and the returns would be paid prior to the developer taking any profit, the developer had great incentive to fast-track the development. If the investors were taken out in the first year, the annual return would be 84 percent or higher.

The only problem with this investment is that it was out of the reach of many IRAs. Some IRAs might not have the $75,000 or may not want to risk that amount on one project. Anticipating that, a limited partnership agreement was drawn that allowed limited partners to buy into the partnership for as little as $18,750 (1/4 of $75,000). That allowed the smaller investors or ones that wanted to spread their risk to still participate.

Each investor still had the ability to conduct a thorough investigation into the viability of the investment, and they were able to participate in the kind of return that would enhance their retirement income in a way that was significant. In this particular case three investors were used; one of the IRAs bought two shares.

Another investment prohibited by your bank and stockbroker is the purchase of trust deeds. Long a common investment for banks and stockbrokers alike, the purchase of trust deeds can also be an excellent way to double or triple the return of traditional IRA investments. Typically, banks and stockbrokers buy the trust deeds in bulk at a discount and then either hold them for the yield or re-sell them at a lesser discount.

These same opportunities are available to the IRA investor. The difference is that they are not bought in bulk. Each trust deed is investigated and purchased separately. The good news is that the IRA can obtain even better discounts and better products than when buying in bulk, which causes the failure rate to be much less.

What would your bank or stockbroker say to you if you asked to do one of these types of transactions? Well, we now know the answer should be, "You can't do that here." Then again, you probably can't make that kind of return there either.

How do you prepare your IRA for these types of opportunities? Designate the amount of your retirement funds that you wish to use in real estate investments and open a new IRA account with an independent administrator. There are no limitations on the number of accounts one may have.

I suggest that you use separate accounts for each type of investment: one for your CDs, one for your stock or mutual fund investments, and one for your real estate investments. By having separate IRAs for each type of investment, you will have a better sense of which investments are producing good results and which are not.

Call your current administrator (bank or stockbroker) and ask about these types of investments for your IRA. IRAs were designed to allow you to invest in opportunities other than just CDs and mutual funds. A word of caution: Do use a CPA, attorney and investment advisor.

Copyright © 1996 by Patrick W. Rice