Many people would like to buy real estate in their IRAs but have a mistaken belief that they do not have enough money to do so. Nothing could be further from the truth! You may invest in real estate with your IRA without a lot of money in several ways, including partnering with other IRAs or non-IRA money, buying property with debt, or by using one of the most powerful and under utilized tools in real estate investing today – the option.
First, what is an option? Once consideration for the option is paid, it is the owner’s irrevocable offer to sell the property to a buyer under the terms of the option for a certain period of time. The buyer has the right but not the obligation to buy.
You might wonder why an owner would agree to tie up his property with an option. Advantages to a property owner include: 1) the owner may be able to time his income for tax purposes, since option fees are generally taxable when the option is either exercised or expires (always check with your tax advisor); 2) if the owner needs money, an option may be a way to get money that he doesn’t have to repay, unlike a loan; 3) options are very flexible, and the owner may be able to negotiate an option which allows him to keep the property until a more opportune time – this is especially true of an owner in a pre-foreclosure situation.
Do the paperwork right! Options are extremely powerful and very easy to mess up. Be very specific, clear and complete about all the details. Remember, with options, you have to negotiate for both the option and for the purchase of the property. With a well written option, the following must be, as my old law professor was fond of saying, “patently obvious to the most casual observer”:
a) Who is granting the option? Does it include heirs, successors and assigns?
b) Who is receiving the option? Does it include assignees of the buyer, or is it an exclusive option to purchase by the buyer only?
c) What property is being optioned? Property can be anything, including real estate, a beneficial interest in a land trust, a real estate note or nearly anything else.
d) What is the consideration for the option? Remember, there must be some consideration for the option in the form of money, services or other obligations.
e) How is the option exercised by the buyer? This is one of the easiest things to mess up in an option. If the procedure is not clear for exercising the option, it is an invitation to litigation!
f) What will be the purchase price of the property if the option is exercised?
g) How will the purchase price be paid when the option is exercised? Will it be for cash? Seller financing? Subject to the owner’s existing mortgage?
h) Will the option consideration be credited to the option price or not?
i) When can the option be exercised? For example, does the option holder have the right to exercise the option at any time during the option period, or can the option only be exercised after a specified amount of time?
j) When will the option expire, and under what circumstances? The option should have a definite termination date, but might also include other circumstances under which the option terminates, such as a default under a lease.
k) When it comes time to close, what are each party’s obligations? For example, who pays for title insurance, closing costs, etc? Are taxes prorated?
So what forms do you use? The answer is my favorite as a lawyer – it depends! There is not and cannot be a “standard” option for all purposes. They are simply too flexible. You must decide on a specific use for the option and then, as Shakespeare said, “Get thee to a lawyer!” (Okay, it was “Get thee to a nunnery” but I like it better as revised!).
When you have negotiated an option agreement for your IRA, you have several choices. First, you can let the option expire on its own terms. Sometimes this is the best course of action if the deal is not what you expected, especially if you only paid a small amount for the option.
Another choice is that your IRA could exercise the option and buy the property. Since there are ways to finance property being purchased by your IRA, including seller financing, bank financing, private party financing or even taking over property subject to a loan, this may be a good strategy for your IRA, even if the IRA does not have the cash to complete the purchase. Be aware that if your IRA owns debt financed property, either directly or indirectly through an LLC or partnership, its profits from that investment will be subject to Unrelated Business Income Tax (UBIT). This is not necessarily a bad way to build your retirement wealth, but it does require some understanding of the tax implications.
A third choice which is often employed in the context of self directed retirement accounts is to assign your option to a third party for a fee. Your option agreement should specifically allow for an assignment to make sure that there are no problems with the property owner. This is a great technique for building a small IRA into a large IRA quickly. I had one client who put a contract on a burned house for $100 earnest money in his daughter’s Coverdell Education Savings Account, then sold his contract to a third party who specialized in repairing burned houses for $8,500. In under 1 month the account made a profit of 8,400%, and all parties were happy with the deal! The account holder then immediately took a TAX FREE distribution to pay for his daughter’s private school tuition.
A fourth choice that sometimes is overlooked is the ability to release the option back to the property owner for a cancellation fee. In other words, this is a way for your IRA to get paid not to buy! Let me give you an example of how this might work. Suppose you want to offer the seller what he would consider to be a ridiculously low offer. When the seller balks, you say “I’ll tell you what. You sign this option agreement for my IRA to purchase this property at my price, and we’ll put in the option agreement that I cannot exercise my option for 30 days. If you find a buyer willing to offer you more money within that 30 day period, just reimburse my IRA the option fee plus a cancellation fee of $2,500.” Either way, your IRA wins!
There are various ways in which an option might be used to turn small amounts of cash into tremendous wealth in your IRA. Some examples of the uses of options include the following:
Simple Options. The most basic type of option is simply to have an option to purchase a piece of property for a specified price within a certain period of time. This is much better than a loan because it is similar to zero percent interest financing. For example, if a Health Savings Account (HSA) has a five year option to buy a piece of property for $50,000.00, then the HSA does not owe any more for the property at the end of the five years than it did at the beginning, yet the HSA effectively controls the property. This amounts to a five year, zero percent interest loan, but with no unrelated business income tax (UBIT)! You could even structure the option to have monthly or yearly renewal fees, so that it feels similar to a regular seller-financed loan for the property owner. With options all the burdens of owning the property, such as property taxes, insurance, and maintenance, continue to be on the property owner, thereby reducing your IRA’s risk!
Fix Up and Sell Options. Many investors are familiar with the typical buy, rehab and resell strategy for real estate. Suppose you created a deal in your Roth IRA where the repairs to be done are the consideration for the option? You and the property owner would agree on a specific list of repairs to be done, and the money for the repairs would come from your IRA. The option price would be based on the value of the property in its current condition. When the repairs are done the value of the property will have substantially increased, but your IRA has an option to purchase the property at the lower price. The value of your Roth IRA’s option is equal to the difference between the current, after repair fair market value and the original option price. As discussed in the prior article, your Roth IRA may, among other choices, 1) exercise its option and purchase the property, 2) assign the option for a fee to a retail buyer and let him purchase the property directly from the property owner, or 3) allow the property owner to sell directly to a retail buyer at a higher price while paying your Roth IRA a substantial fee to cancel the option!
Options on Ugly Property. What do you do if you locate a property that you think could probably be sold for a profit, but it is such a trashy piece of property or has so little equity that you are nervous about your IRA taking title to it? The solution is simple: have your IRA purchase an option from the property owner, stick a sign on the property, and try to find a buyer for the property which will give your IRA a profit. Options under these circumstances can often be purchased with very little money from your IRA. Even if your IRA ends up not exercising its option sometimes, overall this can be an incredibly powerful wealth building strategy.
Options on Partial Interests. What if there were several heirs owning a property you wanted your IRA to buy, but the heirs did not get along or did not agree to a certain price? Rather than giving up, have your IRA buy an option to purchase each heir’s interest separately. The price would not have to be equal to each heir. Once you have negotiated options with all the heirs, you could add up the price and see if your IRA could market the property for a profit.
Low Ball Offers and the Right to Cancel. Suppose you want to make a low ball offer on a piece of property. The seller wants too much for the property, and you think he won’t get his price. On the other hand, he has to sell by a certain date for whatever reason (foreclosure, closing on a new house, moving out of town, etc.). Tell the seller this: “If you sell my daughter’s Coverdell Education Savings Account (ESA) an option to purchase the property for my price, I will give you the right to cancel the option within the next 30 days if you return the option fee plus $2,500.00. That way, if you find someone to pay you more than you would get from me who can close quickly enough you can sell the property to them and cancel the option, but you know you have a guaranteed sale if you can’t sell it to someone else on time.” How’s that for overcoming objections to a low ball offer? Your daughter’s ESA either gets the property at a bargain price or the seller pays her ESA not to buy!
Long Term Options. Long term options can be particularly powerful within an IRA, especially if your retirement is not imminent. Although many options used by IRAs are for shorter time periods, a long term option can turn out to be a fantastic investment. For example, inHouston,Texas there is an area called the Heights. This is close to downtown and many urban professionals are purchasing property in the area to avoid the horrible commute. Old properties are being purchased by individuals and developers who knock the houses down and build new homes on the lots. It is an area in transition. Prices have skyrocketed. Wouldn’t it be great if your IRA had 5 or 10 year options on several pieces of property in a redeveloping area such as the Heights or in the growth path of a city? Even if the option was to purchase the property for full fair market value or higher in today’s market, the longer term of the option may allow for a natural increase in the fair market value of the property
Rights of First Refusal. Another technique that can be used either alone or in conjunction with an option is a right of first refusal. A right of first refusal by itself is not an option to buy. It only means that the seller agrees not to sell the property to anyone else before first offering it to the holder of the right of first refusal. This is commonly used in business transactions, and can be used in real estate as well. Sales price and other terms are not typically negotiated in a pure right of first refusal, since it is only the right to buy the property at whatever price and on whatever terms the owner wants to sell.
When combined with a long term option, this strategy can pay off even if the option price is as high or higher than the current fair market value. For example, what if your IRA has an option to purchase a property in a growth path area for $100,000.00, and the option has a right of first refusal clause in it. In other words, any time the property owner wants to sell the property to a third party he would have to offer it to your IRA under the same terms. If the property owner wants to sell the property to a third party for $80,000.00, your IRA will also have the option to purchase it for that price because your IRA’s option has a right of first refusal clause. But suppose $80,000 is at or near the current fair market price and so exercising the option is not a good deal for your IRA. Assuming your option agreement is structured in a way that the option does not expire merely because of a transfer of ownership, the new owner of the property will have to take the property subject to that option. This of course limits his ability to sell the property in the future for more than your option price. Also, if a notice of option is filed in the real property records the buyer’s lender may require that the option be released. What is the value of your option under these circumstances, even though it is at a higher price than the current fair market value? The answer is however much the owner and buyer are willing to pay your IRA to cancel the option if that’s what you want!
Options and Shared Appreciation Mortgages. Has your IRA ever made a hard money loan and you thought, “I’d sure like my IRA to have a piece of that property! What a great deal!” Here is an interesting concept: loan the money to the investor at a low interest rate in exchange for an option to purchase a certain percentage of the property at the initial purchase price. One investor I know was able to use this method to purchase a property at a discount with a tenant in the property. Because the tenant was already in the property with a long term lease, he could not make the deal work using regular hard money rates. His solution was to borrow the money for the purchase and rehab from a friend’s IRA. The IRA received 6% interest plus an option to purchase a 50% interest in the property at one-half original purchase price. The investor walked away from closing with $3,000 in his pocket, a rental property with cash flow, and 50% of the future appreciation! Another possible structure is a loan with an option to convert from debt to equity.
Options on Personal Property. Options are most commonly discussed in terms of real estate. However, there is nothing which says you cannot purchase an option on personal property. For example, in many states the beneficial interest in a land trust is considered to be personal property. You may want to have your IRA purchase an option on a discounted note to see if it can be sold for a profit. I have even heard of people having an option in their IRA on automobiles being purchased by an investor at car auctions.
Options can be purchased in all types of Quest self-directed accounts, including Roth, traditional, SEP and SIMPLE IRAs, Individual 401(k)s, Coverdell Education Savings Accounts (ESAs), and even Health Savings Accounts (HSAs). Options are so incredibly powerful and flexible that I cannot discuss all the opportunities in one short article. I hope this article has opened your mind to new possibilities for your IRA. As I always say in the context of self-directed IRAs, “I don’t think outside the box, the box is just bigger than you think!”