Have you thought about becoming a real estate investor, but aren’t sure where to get cash to start? I first learned of investing with small-dollar IRAs by attending a lunch-and-learn, and then spent part of my career working with the Notes department to help account holders understand the rules of using IRA funds to lend on real estate transactions. I’ve seen firsthand how, using your self-directed IRA, you can invest with as little as $500, build passive income tax-free (until you withdraw the monies from your IRA) and deepen your real estate investing knowledge along the way.
Small-Dollar IRAs And Private Money Lending
Private money lending is the new wave for real estate investors. With your self-directed, small-dollar IRA — an account with a balance of $50,000 or less — you can become a private money lender either on your own or by pooling your resources with other self-directed, small-dollar IRA account holders.
Private money lending is relationship-based and secured by real estate. The duration of a private money loan is negotiable between the lender and borrower, but most small-dollar IRA account holders prefer a loan time frame of five or fewer years, with 6 to 12 months being the most common.
Typically, private money lenders who use their self-directed IRAs charge 10% interest and two points to the borrower. But again, everything is negotiable. Sometimes, if the relationship is strong enough, the lender may reduce their interest rate or charge fewer or no points on the borrowed money.
Opening The Right Type Of IRA
Before you can become a private money lender with a small-dollar IRA, you have to have an IRA account that is self-directed. If you don’t already have such an account, you’ll want to look for a financial institution that offers one or more of these account types, which can be self-directed and used to invest in real estate:
• Health savings account (HSA).
• Traditional, Savings Incentive Match Plan for Employees Individual Retirement Account (SIMPLE) or ROTH IRA.
• Simplified Employee Pension Individual Retirement Arrangement (SEP-IRA).
• Coverdell Education Savings Account (ESA).
• Individual 401(k) and checkbook-controlled IRA.
Here are a couple of real-life examples where self-directed, small-dollar IRAs were used to passively invest in real estate:
Example 1: An investor used small-dollar IRA funds to buy a single-family home for $10,000 and now owns the home free and clear. It is later sold to a buyer as an owner-financed property for $50,000. The buyer made a $10,000 down payment (which went back into the IRA) and financed $40,000 at 10% for 15 years with the investor. The buyer makes monthly principal and interest payments for $430 and ultimately pays a total of $87,372 to the investor over the course of 15 years.
Growth of the IRA on $10,000: Over 800%.
Example 2: A real estate investor needed to borrow $136,000 for a property purchase and light rehab (paint and carpeting). Small-dollar IRA account holders pooled their funds to lend private money for the investment. The borrower paid 10% interest and two points.
• Total monthly interest payment to the lending pool: $1,128.
• Total for two points to the lending pool at closing: $2,720.
1. IRA Account Holder A: Investment of $50,000 = 37% of lending opportunity.
2. IRA Account Holder B: Investment of $35,000 = 26% of lending opportunity.
3. IRA Account Holder C: Investment of $30,000 = 22% of lending opportunity.
4. IRA Account Holder D: Investment of $21,000 = 15% of lending opportunity.
In the six-month lending period, each account holder earned:
A. $3,521.66 ($2,515.26 interest, $1,006.40 points)
B. $2,474.68 ($1,767.48 interest, $707.20 points)
C. $2,093.96 ($1,495.56 interest, $598.40 points)
D. $1,397.70 ($989.70 interest, $408 points)
Complete Your Due Diligence To Set Yourself Up For Success
The process for private money lending is simple but still requires that you perform thorough due diligence. If you are new to private money lending, you’ll also want to work with a seasoned real estate investor and private money lender who can help you assess the merit of investing in a particular piece of real estate.
Here’s what your due diligence must cover:
1. The borrowers: Do you know them? Do you know their real estate business model, and have you seen their work firsthand? Do they have a track record of paying back their lenders on time?
2. The property: Most new investors need to invest in properties they can physically lay their eyes on. This is your money, and you need to verify the type of property that will be secured on your account.
3. The after repair value (ARV): Is the ARV reasonable when compared with similar properties that have sold in the neighborhood? What repairs are needed, and how is the borrower funding the repairs? Small-dollar IRA investments should never be made for repair items, as you cannot properly secure real estate for repairs on a property. In other words, you could find yourself in a second lien position, which means you get paid only after all first liens are paid.
4. First lien position: It’s essential that your self-directed, small-dollar IRA investment is the first lien holder on real estate, especially if you find yourself in the unfortunate situation of having to foreclose on the borrower.
5. Fees associated with money movement: Every financial institution that offers self-directed IRAs charges fees for transfers out of your account, but not for making deposits into your account. You should always pay these fees with funds outside of your IRA, otherwise the IRA money movement fees will soon eclipse your earnings.
6. Joint venture agreement: Make sure you have one for any pooled investments. Your agreement should specify the terms of lending, and what happens to the investment if the borrower defaults on the loan.
7. The title company where the property is being closed: It’s imperative that you work with a title company that is knowledgeable about the documents you need to put your self-directed, small-dollar IRA as the first lien holder on the deed for the property.
8. The rules: There are rules and regulations about how your self-directed, small-dollar IRA can be used to invest in real estate, and significant tax penalties if you fail to abide by them. Make sure you know the rules or work with someone who does.
I hope this inspires you to actively grow your passive income and wealth through a self-directed, small-dollar IRA investment in real estate.