Due Diligence

Estimated reading time: 5 minutes

Due diligence is a step by step process to help protect your IRA from investment fraud and to determine if it is the right investment for your IRA. Investment is the application of money in order to gain profitable returns, as interest, income or appreciation in value. All investments have risk and there is a constant battle between risk and reward. The more you know about the investment the better you will be able to judge whether the risks are balanced by the reward and whether investment fraud could be possible. That is why at Quest Trust Company we recommend that you invest in things you know. We believe you should be more cautious when you are investing your IRA funds because they are intended for retirement. We had a client who invested all his retirement funds in a big investment that was guaranteed to payoff big, but his widow found that it was a Ponzi scheme and she was left with only social security for retirement.

The reason investment fraud succeeds is because people are lured into emotional decisions by the con artist without first completing their due diligence. Due diligence is what forces you to uncover the facts about the investment and make a rational decision. Con artists spend much time and energy preparing strategy and learning techniques designed to convince you to buy on faith without investigating. They study the characteristics of affinity groups to create a sense of trust and common bond. They have well-rehearsed answers to common questions.  They target small individual, non-accredited investors because individual investors rarely do their due diligence; whereas, institutions nearly always do. That makes small investors easier prey.

Investigators and prosecutors cannot protect you from investment fraud. Even with secured, regulated investments you should always assume that fraud is a possibility. The front-line of defense against investment fraud is an educated and skeptical investor. You must protect yourself and your IRA. That is why due diligence is necessary.

The Due Diligence process begins with broad general questions and narrows down to specific questions about the investment depending on the type.  At any point during the process you find that the investment has too great a risk for the amount of return or has a high probably of fraud, then you can stop the process and move on to another investment. Don’t commit to the investment until you have all the pertinent details.

 The first general question is does the investment offer make good business common sense? If it is too good to be true it usually is. Above market returns only make business sense if a competitive advantage exists that you can exploit but other potential competitors cannot.

Below are two questions to help you address the business common sense test for any investment: 

  • How exactly does this investment strategy create above market returns? What is the competitive advantage?

Ask yourself if the answer you are given is complete, thorough, and makes business sense. Is the answer is glib, laced with jargon and techno-babble, or is it simple and straightforward? Do you understand the competitive advantage well enough to explain exactly how it works to someone else? If you can’t explain it then you don’t understand it.

  • What are the barriers that will lock out competitors so that additional capital and supply doesn’t force returns down to market level?

There must be a legitimate business reason that returns will remain excessive. Again, does the answer pass the common sense test or does the explanation sound like something from the Top 10 Warning Signs of Investment Fraud?

1. It promises “guaranteed” returns;

2. It promises high returns for little or no risk;

3. It’s being pitched by a leader in your community or a fellow group member, such as ethnic, racial, religious, or other groups;

4. It involves a reverse merger stock or your money has to be sent overseas;

5. It involves “break-through” technology;

6. It’s tied to a current natural disaster;

7. It’s unregistered, or it’s being pitched by an unregistered adviser or salesperson;

8. It lacks documentation, such as prospectuses, offering statements, or financial reports;

9. It’s difficult to understand; and/or

10. The pitch comes with high-pressure sales tactics that push you to purchase immediately.

       Fully exploring these two questions should eliminate most investment fraud right from the beginning. In order for an investment to pay you above market rates of return it must have a competitive advantage and barriers to competition. If it doesn’t then it can’t pass the business common sense test for legitimately offering above market rates of return.

      Be wary of over friendly and charming promoters who respond to your questions with techno-babble terminology or disdain for the question.

       Serious questions are a symptom of a serious buyer and honest salespeople know it, welcome it, and respect it. They have nothing to hide so they will attempt to simplify their answers so you can understand the investment and make an informed decision.

      What you want is a professional sales environment where a rational, fully informed decision can be made. You want to ask your questions and get straightforward answers. Never allow trust, friendship or emotion to get in the way of that task. It’s your money and investing is serious business.

 When you don’t understand an investment it doesn’t mean you are dumb: it just means the investment doesn’t make sense. Never settle for anything less than a complete and detailed understanding that allows you to make a fully informed investment decision. Drill them until you get the answers you deserve.

The next general question: How can I lose Money? All investments have risk.

 To discover the risk of loss ask the promoter the following questions and don’t be surprised if you have to press hard to get a thorough answer:

        (1) What are all the conditions under which this investment will lose money?

(2) What is the worst market environment for this investment strategy?

(3) What assumptions or correlations must remain valid for profits to continue?

(4) What crazy, impossible to imagine situations would result in losses if they actually occurred no matter how remote the possibility of their occurrence?

     Until you uncover the risk inherent in the investment strategy then you don’t understand the deal. If the risk doesn’t appear, then the investment is probably not legitimate or you don’t understand it. Also be wary of guarantees. Guarantees are frequently marketing tactics designed to make you accept claims at face value, invoke trust, and make your decision easy so that you don’t look deeper into the issues.

 The next general question: What are the track records, backgrounds, and histories of the person and company soliciting the investment including information about officers, directors and other key personnel? Research and verify all information about the company and claims by the company. Review recent financial statements for the company and verify addresses.

 With these general questions answered and passed you are ready to investigate the particular investment and its appropriateness for an IRA depending on the type of investment:

 

Understanding The Self-Directed IRA Annual Contribution Deadlines

Estimated reading time: 3 minutes

The individual retirement account structure – and self-directed IRAs in particular – can be a solid foundation for a successful retirement plan. But in order to build the largest possible retirement nest egg, it’s important to make regular contributions to your account. The rules on IRAs specify limits for how much you can contribute each year, so it’s important to make sure your savings plan and budget are synchronized with the annual limits.

The Annual Contribution Period can be up to 15 Months. The period in which you can make a contribution to your self directed IRA for a given tax year is from January 1 of that year until you file your tax return. But in no case can such contribution be made after your filing deadline (i.e., April 15 of the following year).

You May Need to Specify. Even if you only have a single IRA, it’s important to pay attention to how you designate each contribution. Recognize that if you are making a contribution early in a calendar year, before you file your tax return for the prior year, you need to specify the tax year for which your contribution applies.

For example, if you send a contribution to your IRA custodian on January 10, it won’t be clear whether you intend for those funds to apply to the tax year that’s just ended, or to the tax year that’s just beginning. You can clear up any potential confusion by making the appropriate designation in the “memo” line of the check you sent. Or if you make the deposit or transfer of electronically, indicate the applicable tax year in any “note” or “other instructions” field of the submission form. (For electronic transfers, your custodian may even ask you to specify the applicable tax year).

Easing Your Administrative Burden. But note that this contribution calendar overlap also provides you the opportunity to address two years’ worth of IRA contributions in a single sitting. Simply write two checks to your IRA custodian, specifying which check applies to which tax year. Of course, if those two contributions do not meet the contribution limits for either or both years, you can make additional contributions later, provided you are still within the applicable time period.

Use it or Lose it. With a generous contribution period that extends beyond December 31 of each tax year, it’s easy for some individuals to take the contribution opportunity lightly. But because IRA contributions are a “use it or lose it” proposition (meaning that if you don’t make a contribution in a given year – or don’t make the maximum contribution – you can’t make up for it later), it’s important to put yourself in a position to be able to make that maximum contribution year in and year out.

Consider a $5,500 contribution made by a 30-year-old to their self-directed IRA. Assuming an 8% return, that single contribution will be worth well over $80,000 by the time that person reaches age 65. Don’t miss out on this opportunity, and make sure you meet the annual contribution deadlines to the greatest extent possible.

Investor Awareness: Private Placements

Estimated reading time: 3 minutes

A private placement is the sale of securities to a limited number of qualified private investors. While an IPO is the initial sale of shares to the general public, a typical private placement is offered only to institutional investors and accredited individuals and entities that meet certain eligibility requirements.

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For companies, private placements can provide an infusion of cash more quickly and less expensively than a public offering. Private placements are also generally not subject to public disclosure obligations. They typically allow companies to have a great deal of control over the process – the company can decide how much to sell, at what price, and to whom. However, those decisions do require a tremendous amount of due diligence and careful deliberation.

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Private placements are exempt from the registration requirements of the federal Securities Act of 1933 and public disclosure requirements as long as certain requirements are met. The sale of securities through private placements cannot involve any public offering, public solicitation, or advertising. In addition, private placements must comply with state laws and anti-fraud provisions of securities laws. Companies must disclose to potential investors all of the pertinent information needed to make a fully informed decision.

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Securities sold through private placement securities can take different forms. Typically, they involve the sale of either debt or equity.

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Investments in private placements carry a high degree of risk for various reasons. Securities sold through private placements are not publicly traded and, therefore, are less liquid. Additionally, investors may receive restricted stock that may be subject to holding period requirements. Companies seeking private placement investments tend to be in earlier stages of development and have not yet been fully tested in the public marketplace.

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Investing in private placements requires high risk tolerance, low liquidity concerns, and long-term commitments. Investors must be able to afford to lose their entire investment.

A company seeking a private placement issues a Private Placement Memorandum or PPM. The PPM details the company’s financial situation and business plan, as well as any other pertinent information about the company and the offering. Once investors decide to invest, they complete a subscription agreement.

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Due diligence begins with a background inquiry on the company and its management and an analysis of all the information presented by the company and its offer. The principal thrust of due diligence focuses on compensation, self-dealing, background of insiders, litigation history or potential, risks and accurate discussion of the nature of the business. An internet search can provide essential information. Do not depend on the accuracy of information supplied by the company or its agent, but engage in an independent investigation that is customized for each offering. Most offerings may have certain unique features that require additional due diligence. Ask for clarification on any information provided that you do not understand and request back up documents to support their claims. Remember that Ponzi schemes pay until they can’t so follow the money and make sure the income is income.

Investor Awareness: Promissory Notes

Estimated reading time: 2 minutes

New Real Estate Loans:

IRAs can loan money for the purchase of real estate including property owned by the IRA, but not persons defined in prohibited transactions. The IRA should insist that the buyer complete a detailed loan application form and thoroughly verify all of the information the buyer provides. That includes running a credit check and verifying employment, assets, financial claims, references, and other background information and documentation. The IRA owner is responsible for negotiating mortgage rates and terms with the borrower.

 

Title Insurance

Loan closings should be held in a title company or attorney’s office and a mortgagee title insurance policy issued in the name of the IRA.

Hiring a Loan Servicing Company

The IRA can hire a loan servicing company to help draw up the mortgage, mail statements to the buyers, collect payments, and otherwise administer the mortgage. If loan payments are made to the IRA, the IRA owner is responsible for keeping a record of principal, interest and escrow.

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Preexisting Notes, also referred to as cash flows, mortgages, trust deeds, paper:

A note is a debt. When you buy a note, you buy a debt. A note is always written. It is never just an oral agreement. A note is signed by the payor, the party who owes the money. When you buy notes, you’re actually buying a certain kind of note: a seller-financed note. This type of note originates when a real estate owner sells property to a buyer and extends credit for any amount left owing after the down payment, plus interest. The debt is between the seller of the property and the buyer. The buyer of the property becomes the payor on the note. The seller of the property receives the payments made by the payor. You can buy the seller-held note for cash — at a discount. You will pay less than the full amount owing on the note, and you will receive payments over time from the payor for the full amount. It’s a three-cornered relationship: you, the seller and the payor which is different than making a new real estate loan.

 

Things to ask for:

  • Copy of note and deed of trust document or other mortgage documents
  • Verification of payment history
  • Copy of HUD statement for original purchase
  • Statement verifying types and amount of improvements/rehabs completed
  • Copy of latest real estate tax bill
  • Copy of hazard insurance policy
  • Verification of title insurance

Investor Awareness: Real Estate

Estimated reading time: 3 minutes

Purchasing and owning real estate in your IRA, whether it’s a single family rent house, vacant land or a 50 unit apartment building, it will require a time-consuming process of additional due process. It means taking caution, performing calculations, reviewing documents, procuring insurance, walking the property, essentially doing your homework for the property before you actually make the purchase. Here are a few of the steps:
Contract

Know the contract. Read the contract. Be one with the contract. The contract should allow you time, from one week to a couple of months, depending on the nature of the investment property, to perform due diligence and be able to walk away for any reason and have your earnest money returned in full. If you need help with the contract, rely on a real estate professional or an attorney experienced in commercial real estate. If a seller pushes you vigorously to shorten your time-frame, train your mind to hear a warning buzzer.

Title Review

One of the first things you should examine as part of your due diligence is the title history on the property. All title documents are public records that can be researched and reviewed. A thorough title review will expose whether there is any litigation pending that might threaten the title of the property, whether the seller actually has title to the property, and whether the seller has any encumbrances or financial obligations attached to the property such as a mortgage or tax lien.

Inspection

Have a professional inspection performed on the property. A licensed, professional inspector can review the structural integrity of any building on the property and can also point out any potential physical problems with the property.

Appraisal

An appraisal will give you a third-party estimate on the value of the property. This will tell you whether the amount of money you’re about to spend on the property is worth what you think it is. Appraisals are generally necessary if you want to finance the real property purchase with a mortgage loan, but you should get an appraisal even if you are paying cash because it will help you evaluate the value of the investment.
Environmental Assessment

If a visual inspection of the property reveals any potential environmental hazards or problems, you should consider ordering an environmental assessment of the entire property. Things that might cause you to order an environmental report include leaking gas or oil containers, former use of the property as a manufacturing or mining facility, or possible wetlands or clean water issues associated with water on the land.

Land Use Controls

Your final consideration should be whether the property is zoned for the purposes that you want to use the property for. For example, if you want to use the property to start a business, you need to verify with the local zoning authority that the property is zoned for commercial or that you have a reasonable chance of having the property rezoned as commercial.

Commercial Real Estate

Requires more in-depth due diligence and you will want to get a rental history, vacancy rates, maintenance fees, property management fees (if property management needs to be hired out), taxes, insurance, leases (read the leases very carefully – Triple net? – who pays what? – who’s responsible for what? ect.). You’ll want to investigate your financing options, determine your fixed and variable costs, in order to see if your return on investment is in line with what you had in mind.