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Bruce Norris is joined again this week by Tom Anderson. Tom has served as president of RITA for the last four years. Tom has more than 44 years of experience in banking. He was the founder, former president, and CEO of Pensco Trust Company. He is currently on the board of Pensco Holding, LLC. He was also the founder and president of Pensco Pension Services, an IRS approved non-bank custodian and broker dealer. He was also the founder and president of Financial Information Services, a bank consulting company. This week’s radio show focuses on self-directed IRA’s and retirement plans.
Episode Highlights
- What are alternative investments, and how do they relate to self-directed IRAs?
- What are the jobs of the custodians, and are they involved in obtaining appraisals?
- How do you determine the minimum distribution requirement for your IRA?
- Is fraud prevalent, and what is Tom’s method for dealing with it?
- How prevalent is crowd funding today?
- How can you integrate your self-directed money into real estate?
- What are the rules for self-directed accounts?
Episode Notes
Bruce and Tom began by talking about alternative investments, which allow us to use our self-directed funds. We have $7 trillion of money in these types of accounts. Bruce wondered what percentage of this actually gets to the investment world. Tom said there is no hard number for this right now, but in the RITA organization it is likely around $100 billion. There is also a whole slew of traditional trust companies like Northern Trust who have their own degree of self-directed retirement accounts. There are no numbers right now he is aware of that gather that data.
Bruce said when people self-direct they can also self-direct to stocks and mutual funds, it does not necessarily have to be alternative investments. The whole idea is the custodian does not narrow the choices, possible because of the nature of their business such as a broker dealer with restricted traded assets for the most part. It is basically anything that is permitted by law and the choice of the individual IRA owner and/or investment advisor with whom they choose to work. The custodian or trustee plays no role in the selection of the investments.
Bruce therefore wondered what the custodian does if they are not advising. Tom said they will do the same thing broker dealers who hold IRAs will do as well as the traditional banks. The only difference is the direction of who makes the investment decision or provides advice in regards to that. They do all the administration, both the record-keeping and reporting to the IRA owner. They do the storage of documents related to the investment. This means they will physically hold the investments or will track where they are held. They provide customer support in terms of education, which includes answering questions, providing distributions, dealing with contributions, and all the government reporting for the individual. It is all the record-keeping and administration that is what they generally do.
Bruce asked if they are now involved in obtaining appraisals. Tom said no and that custodians and trustees do not generally perform the appraisals. What they do is they gather them, whether in a hedge fund or piece of real estate, and they will get them either through a real estate appraiser or a real estate broker or electronics source. There is an exception when there is a distribution event involving an alternative asset, such as when you doing minimum distribution requirements for somebody over 70. There is then a higher standard for getting the qualified appraiser to value the alternative asset if it is involved in distribution.
If you have an alternative asset in your account, have reached 70 ½ and are just taking out cash, it is required but there can be exceptions to the degree of requirement. You are wanting to get as close as possible to an accurate estimate for value since the minimum distribution requirement amount is determined by the prior year-end fair market value of the entire account. This includes any alternative assets. You want to get a close evaluation. For example, if you have stock in a 2-year old company that still has not produced a profit, and you are not taking minimum distribution, you may not need to require the client to go out and get a $40,000 evaluation on the private equity stock. You might find that four months earlier somebody bought that stock at a specific price and you can use that as an evaluation.
Tom had mentioned storing an alternative investment, which Bruce wondered what this would entail. Tom said if your client wants you to buy two acres of real estate in Idaho, you would hold a deed to that since the IRA is the owner. The only exception would be if there were multiple owners of the same property, and the custodian would want to know who is holding it since they may be the minority holder on behalf of their client. They want to know where the information is held as well as see a recorded copy of the deed.
The custodian is likely often asked if what they are about to do is a good thing, and he wondered how they would handle this. Tom said they are asked this all the time, and unfortunately it depends on what you mean by “good.” A custodian will not determine it based on the merit of an investment, whether it is a good investment from a return standpoint or a safe investment. Generally speaking, alternative assets with the exception real estate, it could be higher risk. It is a high-risk, high return kind of investment. You would not want to have all your eggs in the private equity space, but from a diversification standpoint having something that does not correlate with the stock market generally can be really helpful if it pays off big time. On the other hand, it is a very high-risk investment.
The only thing to really put input into on the previous question is, “Is there really any apparent prohibitive transaction involved in what the client wants to do.” The owner of the IRA is restricted from doing much more than making the investment decision on behalf of the IRA. This includes putting the money in and taking money out. However, they cannot self-deal to themselves. They cannot give themselves a loan or have any direct relative benefit from a transaction occurring with their IRA. For example, they cannot buy a rental house near their son’s college that he would occupy and pay or not pay rent. They cannot buy their grandfather’s farm with their IRA either.
There are a number of things that would make up prohibitive transaction rules that would take up another 3-4 shows. Custodians can see from their discussion with the client what their intent is and whether or not their investment is a prohibitive transaction right at the get-go. If they are, they generally will share that with the client.
Bruce asked Tom if he has problems with fraud being perpetrated, which he said absolutely. Just like every other investment avenue, they were affected by fraud during the downturn in 2008 and 2009 when people did desperate things. This included stealing money from other people. Like everybody else, RITA reacted to these rising circumstances. Over the last 4-5 years they have really gone the other way in dealing with fraud in that they are very proactive about it. They even provided information to the FBI that they incorporated into their own training program.
They have taught some of the regulators about what they do, so they try to educate the public directly on what they should avoid. He is actually writing material right now on how to avoid fraud. There is a lot you can do if you are knowledgeable about the red flags. They like to hope there will not be another fraud, but usually as soon as one is figured out another is created. It is never going to go away, but you can stay under the curb for sure if you train your employees and customers to look for the signs. This way you can give them information about key ways they can avoid being defrauded. This includes having the right documentation on your transaction and going into the transaction. This also means doing due diligence on the background of the individuals promoting the investment. It is amazing how much you can find before you even make the investment that will stop in your tracks. You never want to take anything or anyone for granted when dealing with your retirement assets.
Sometimes when people chase yield, caution gets thrown to the wind. They hear the good news but not the rest of the news associated with it. If it sounds too good to be true, it probably is. Most of the frauds are associated with investment opportunities that provide on the surface greater gains than the market would either bear or is demonstrating. If you are in a 5% market and somebody offers you 8%, your first inclination is to think it is a great yield and want to take it. The fact is, they may have no way to develop that yield or have any track record or explanation of how it will be achieved.
Tom has managed as a CEO of Pensco for 20 years and has seen thousands of investments. Many of them were sold in the light of day because some of the signs were so obvious. It is not the duty of the custodian to perform due diligence, and they explain to the clients that they neither charge nor are paid for this. Since they have a lot of experience doing things, if they see something they are concerned about they may bring it to your attention. However, they are not responsible for this. They instruct and educate them on how they can do this for themselves or they can hire their own expert advisor to do this.
Not too long ago Bruce had never heard the word “crowd funding.” Now it is pretty prevalent. The irony is the government now wants the regular Joe and not the accredited investor to be able to participate in the capital markets process. Tom said he is in favor of this and the self-directed IRA industry has supported it from the get go. They do not care whether the individual has $2,000 or $10 million. They give them the opportunity to invest if they can find somebody who will take them in as a non-accredited investor. However, this is up to them.
As much as the government has tried to do to crack down on the ones that are most successful like Mitt Romney who made his money in the alternative assets basis, and now they are allowing the regular person to do that as well. Tom Anderson thinks it is a big positive, although they have put some constraints on it which are limiting the degree to which people that are not wealthy can invest in private equity. They would do this by putting on income and dollar limits that are associated in alternative investments. Everybody is very tentative from the regulatory standpoint as to whether or not this is going to be riddled or fraud or successful. The FCC just came out with the final regulations last fall that allowed things to go forward, so it will be interesting to see how it works out. The regulations in place now will likely prevent the vast majority of fraud from occurring.
The Group Bruce is associated with are mostly real estate investors. They next discussed how your self-directed monies can get involved in real estate in ways that are allowed. Bruce wondered what people would do to cross the line. In addition, he asked if he could buy a house with the intent to fix and resell it as a flip and do this inside of a self-directed investment. Tom said you absolutely can, but if you do it very frequently you are really running a rehab business and will be subject to unrelated business income tax. This is a tax that is comparable to a normal business tax. If they consider you running a trader business by virtue of very high activity doing something like that, then you might have a tax. It is not illegal, but you do have to pay a portion of the returns. If you do this occasionally, provided you do not put the sweat equity in yourself, it is legal and has been done for years. There have been books and articles written on this, such as in Forbes and the Wall Street Journal. Nobody has cracked down on this; and there is no reason to because as long as you do not violate the transaction rules then you can do it.
Bruce asked how many is too many, which Tom said there is no perfect answer. Tom said practically speaking he has never heard of it enforced. However, at the same time he would not encourage somebody to do it without getting good legal or tax counsel who is aware of potential problems from running a business.
Bruce said if you bought rental properties inside this type of retirement account, kept them a couple years, then sold them. A lot of the gain came from the upside in price. Bruce asked if this is considered pretty benign. Tom said absolutely and is no different in buying mutual funds or stocks, getting dividends along the way, and selling it when the capital gains are there. Regarding the questions Bruce had just asked, he wondered if the answers are consistent whether it is an IRA, Roth, or 401k. Tom said yes except with the 401k, unless it is solo, they generally will not allow you to buy any real estate. They will certainly not allow you to buy rental properties in General Motors 401k. The trustees will not open up opportunities like that. Other than that, you can do it in any IRA.
Tom said one advantage of using leverage is being able to have the increase gains. If you do this inside an IRA, you will be taxed with unrelated business income tax. There is a book called IRA Lending by Matt Allen that goes through the ends and outs of this. If you do this inside a solo 401k, there is a little provision that came about during the 1980s when all the savings and loans went out of business and the government wanted private pension plans to pick up the real estate that was on their books. They gave the pension plans an incentive by saying they would not tax them on the leverage portion. This carries over to solo 401ks. If you buy real estate with leverage inside a solo 401k, you are exempt from the MLA business.
Bruce asked if he borrowed money in a ROTH, paid it off, then sold the property a year later, would that also not be a taxable event? Tom said they use the average indebtedness over the last year as the means to the calculation. You would only be calculated on the gains associated with it. If you paid off a loan and sold it a year later, then there would be no tax on it. Once the loan is gone, there is no leverage at the time you sell the property.
Bruce said we also see a lot of lending done from self-directed accounts. He asked what the rules are there, including position of trust deeds and loan to value. Tom said this is up to the individual. People generally do this through brokers, who have their own guidelines. There are issues of usury you have to be aware of that varies by state. From the lender’s standpoint, which is the IRA in this case, you cannot charge extraordinary amounts. However, there are some restrictions and limitations on this, mostly to individuals. If you are doing it to the company, the usury generally does not apply. If you are lending to a company, it would be different.
In some states like California, the mortgage brokers in the state are regulated by the state of California. Therefore, they have their own rules and those brokers know the rules. Therefore, when they put people into deals they will satisfy the regulators. At one point, the ROTH was a new product and a hybrid of an IRA. Bruce asked if there were any new products coming down the pike for the self-directed investors. Tom said the only product being promoted right now is the automatic IRA. It is ironic they are trying to put more people into IRAs while also talking about capping them and coming down on the amounts people can contribute. They want more people to have them, so there is a bipolar attitude on them. It has not yet been officially approved by Congress, but it almost has a life of its own. He does not see anyone opposed to it, so it will likely be approved.
For more information, you can go to RITA’s website at www.ritaus.org. Here you can find information on their upcoming event and can register here. Check out their education material and give them a call if you have any questions.
For more information about The Norris Group’s California hard money loans or our California Trust Deed investments, visit the website or call our office at 951-780-5856 for more information. For upcoming California real estate investor training and events, visit The Norris Group website and our California investor calendar. You’ll also find our award-winning real estate radio show on KTIE 590am at 6pm on Saturdays or you can listen to over 170 podcasts in our free investor radio archive.
California Real Estate Investing News is a post from: The Norris Group