Exploring Borrowing or Leveraging Personal Assets As a Money Source for Real Estate Investment
There are numerous ways to access leverage, I will refer to leveraging your own personal assets, as well as someone else’s, and utilize them as a private money source or an equity partner. By borrowing or leveraging personal assets refers to a home equity line of credit, IRA, 401(k), mutual funds, stocks, bonds, and other methods.
The definition of leverage: you invest a relatively small amount of your own money then borrow the rest. If you are able to secure a property by using more debt than equity then this would be referred to as “highly leveraged.”
Borrowing from your 401(k) is an option to help leverage yourself into a real estate investment. Not every 401(k) plan allows for this, but if yours does then you may borrow the money and invest it in real estate, then take up to five years (sometimes longer) to pay back the loan with interest. There isn’t usually a withdrawal limit for this, and you won’t be stuck with any early withdrawal penalties as you would if you completely cashed out of your 401(k). One thing to mention here is that you have to repay pre-tax dollars with after-tax dollars, so you will have to earn as much as $1.25 to pay yourself back the original $1.00 that you borrowed. If it is an employee sponsored 401(k) that you are borrowing from there may be a condition that should you lose your job you only have a 60-day timeframe to repay the loan. If you are unable to pay the loan back within the time allotted then you will face penalties and income tax based on the outstanding balance.
Cashing out your 401(k), although this will provide you with instant cash to utilize for your real estate investing business there are some ramifications that you need to be aware of. First off is the taxation involved. If you’re not rolling it over into an IRA or another 401(k) plan then you incur an income tax liability based on the entire amount of the withdrawal, and you don’t get the actual amount of the 401(k) as the plan sponsor is required to withhold 20 percent of the distribution for the IRS in order to offset expected income taxes. If you want to be tricky about this, you may be able to try and roll the 401(k) into an IRA first, then take the distribution.
While the American dream has always been to own a home and retire at 65, many cannot afford to retire in this day and age. You can leverage an Individual Retirement Account (IRA) or 401(k) to purchase real estate, while this is a bit more complicated in nature than just leveraging other personal assets, it may pay off in the end by yielding much higher returns than what the money is currently invested in. Allow me to go over the basics of investing with a self-directed IRA, whether it’s your own personal IRA or someone else that desires to invest their IRA in your real estate business in order to realize a higher rate of return. Typically, there is an added expense for a self-directed IRA but most have a cap of $1,500 per year.
Should you choose to leverage an IRA to purchase real estate if it is on a non-recourse basis? Basically, this means that the lender cannot reach the IRA to recover any funds. This rule also means that the IRA holder does not personally guarantee the loan, which means that the lender cannot go after personal assets of the IRA holder either. IRA borrowers can get into an investment property with 30% to 40% down for the loan, as long as the rental income will yield a positive cash flow. Any income and capital gains from the property may be subject to debt-financed income tax (DFIT for short). In acquiring the property everything must reflect that the IRA is purchasing the property, the sale contract must reflect this as well as the escrow. Once the property is closed then the title to the property will be vested in the name of the IRA administrator or custodian to benefit the IRA. You may use the IRA funds to pay for earnest money deposits, down payment, and any repair/improvement costs. All rental income from the property must be written to, and deposited into, the retirement account. If you decide to sell the property then it is done in the name of the IRA and all proceeds are then returned to the IRA account on a tax-free or tax-deferred basis. Make sure to consult a tax advisor if you are thinking of leveraging your IRA or 401(k) to purchase a property. Obviously the biggest advantage here of using your IRA or 401(k) is the capital gains benefits.
The pros are:
- Tax advantages!
- Easy way to gain better returns to put towards retirement.
The cons are:
- This money method does take more time to get set up (account opening process, transferring/rolling over the assets and finding/making the deal).
- Harder to find a bank to do this since it is typically done through a non-recourse loan.
- Since the house is being purchased for investment purposes you cannot, nor can a relative live in or rent the house.
- Everything has to go through the IRA- The rent check has to be made out and deposited into the IRA, repair costs have to come from the IRA, etc.
This is a different take on retirement plan investing; basically it is seen as an alternative investment, and is getting more and more popular to do. If you do decide to go this route you will need to work with an IRA administrative company.