Wish you could invest in real estate without having to own or manage a rental property, while earning tax-exempt or tax-deferred income from that real estate? Well, financial planners are increasingly recommending an investment strategy that allows investors to do just that.

Buying real estate property using an individual retirement account is a way to earn tax-exempt or tax-deferred income. And buying or creating mortgages or notes is a way an investor can invest in real estate without actually having to own and manage the property itself. Now more investors are combining the two — using traditional and Roth IRAs to buy or create mortgage notes.

One example of how the strategy works: A seller of a property would create a private mortgage or real estate note for the buyer. (Such real estate notes or mortgages are usually created between individuals, not traditional lenders.) The borrower/buyer would make monthly payments plus interest to the seller. The property seller would then sell that mortgage to an investor for cash upfront, often at a discounted price. The investor would buy the mortgage through his or her IRA and would earn income through the interest on the mortgage as well as the difference between the actual mortgage amount and what the investor paid — all without having to own the actual property or manage it. (See accompanying chart for details.)

The investor would normally have to pay tax on the income earned. But with an IRA, the investor would defer or wouldn’t have to pay taxes on that income. Profits gained from investments aren’t taxed in a traditional IRA until the money is withdrawn. And withdrawals from a Roth IRA are tax-exempt, provided the individual is age 59½ or older and has the Roth IRA open at least five years.

Using IRAs to buy notes isn’t new, but financial planners and advisers are increasingly urging their clients to do it now. One reason is that interest rates on these kinds of notes or mortgages are typically higher than the average market interest rates, which remain relatively low, says Patrick W. Rice, president of IRA Resource Associates Inc., a Camas, Wash.-based advisory firm specializing in real-estate investing for IRAs. Other investments pegged to market interest rates aren’t offering rates of return as high.

Also, in contrast with owning property outright, there are few tax advantages with owning notes. But by using an IRA to buy notes, an investor gets the tax advantages of the retirement account. IRAs are “a great vehicle to hold these instruments,” says Dyches Boddiford, a real-estate investor based in Atlanta.

There are some risks, however. If the borrower stops making payments, Mr. Rice says, the IRA may end up having to foreclose on the property, a sometimes costly and lengthy process. What’s more, the money to cover the expense associated with a foreclosure has to come out of the IRA and can’t come from the investor’s own pocket. That could erode an investor’s retirement account.

Hubert Bromma, chief executive of Entrust Administration Inc., an Oakland, Calif.-based administrator of IRAs, recommends that investors conduct credit checks on borrowers. In addition, he says the IRA holder should require the borrower put up a significant equity stake, which could give the borrower more incentive to pay off the loan.

Mr. Boddiford adds that investors want to make sure that the mortgage they are buying is the so-called first lien. The first lien holder gets priority repayment treatment over other lienholders.

By RAY A. SMITH
Staff Reporter of The Wall Street Journal

Using your self directed IRA to purchase real estate notes offers a tax free wealth building vehicle.

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