Using Your Self-Directed IRA to Invest in Illiquid Assets

When most investors think of investments they tend to focus on assets and asset classes that are relatively liquid. We’re talking about investments that you can trade in and out of relatively easily and at relatively low cost – things like stocks, mutual funds, banks CDs and the like. Liquidity means that your money is always available if you have an emergency or other pressing expense. (While it’s true that you may have to forfeit some of the interest you earned in order to liquidate a bank CD before maturation, the money is still there for you to use.)

For this reason, there’s sometimes a tendency to avoid investments that are illiquid. These investments include assets like real estate and investments in private companies. If you ever need to sell these investments, you might find that it takes a bit of time to actually “cash out.” Some investors are reluctant to have their funds tied up in this way.

Fortunately this type of illiquidity is perfectly consistent with the long-term investment timeframe of the self-directed IRA. Withdrawing money from a self-directed IRA before retirement generally incurs penalties (and in the case of a traditional account, taxes as well), so account holders are generally more comfortable with holding illiquid investments because they wouldn’t easily be able to use the underlying funds outside of the account anyway.

Real Estate. Real estate is a popular illiquid investment to hold in a self-directed IRA. Given the costs that are generally imposed on both the sellers and the buyers of any real estate transaction, most real estate investors tend to have a medium-term to long-term outlook, and rightly consider these investments to be illiquid.

Private Mortgages. Owning a piece of property outright is not the only way to invest in real estate. With a self-directed IRA you can lend money to others to enable them to purchase real estate. Many investors find that they can generate healthy returns by becoming active in lending markets that their local banks and mortgage companies don’t participate in.

This might mean commercial lending, or lending to first-time or high-risk lenders that may find difficulty in obtaining financing through traditional means. As you might expect, with higher risk comes a higher interest rate that you can charge.

Remember that as the originator of the private mortgage, you have to be prepared to carry the note to maturity. While a borrower can always choose to pay down their mortgage early, there’s no way for the lender to force early repayment. It’s possible to sell your mortgage note to another investor, but this secondary market is probably quite thin and potentially expensive to take advantage of.

Private Equity. By the same token, private equity investments are also highly illiquid, and therefore are well-suited for self-directed IRAs. It’s important to understand that the investment documents themselves may prohibit transferring the interest to third parties, so these may be the least liquid of any of the investment types we’ve discussed.

If you find an investment opportunity that’s going to tie up your money for a number of years, consider participating in it within your self-directed IRA.

Should You Steer Clear of Real Estate Foreclosures Within Your Self-Directed IRA?

real estate foreclosureSavvy retirement savers are likely to consider every type of investment that’s available to them. Unfortunately, individuals who set up IRAs with traditional custodians are missing out on a wide range of investing opportunities. Those who set up a self-directed IRAs with custodians such as Quest Trust Company can invest in private equity, certain precious metals, and even real estate.

And there are many potential types of real estate investments. Depending on an investor’s account balance, their willingness to take on debt within their IRA, as well as their appetite for risk, they can invest in residential properties. commercial properties, industrial or farmland properties.

In recent years, given the number of residential properties that have faced (and continue to face) foreclosure, more investors are looking at foreclosures as having good potential for significant long-term gains. But there are a number of factors that can make investing in real estate foreclosures more challenging than a straightforward market transaction, so you’ll need to consider each of them before you decide whether foreclosures are right for you.

Long Investing Timeframe. Because there are many legal steps and obligations that must be met as part of the foreclosure process, it can take significantly longer to buy a foreclosure property than to buy a property on the open market. The timing varies from state to state, but the entire process can extend for a year or more in some jurisdictions.

No Opportunity for Appraisal or Inspection. It’s quite likely that once a property goes far enough through the foreclosure process that is ready for public auction, there will be no opportunity to conduct an independent appraisal or inspection on the property. In instances where a pre-auction inspection is allowed, it is often little more than a quick “walk through” by the prospective bidders. Since conducting your research and having a good idea of what you’re getting into is important for any investment – real estate or otherwise – this information gap must be taken into account.

Unhappy Prior Owners. With foreclosure properties, not being able to conduct an inspection is likely to be even more important than would be the case for an open market transaction. It’s not unheard of for property owners who are being foreclosed upon to stop their normal upkeep and maintenance of the home (and in more extreme cases even do intentional damage to the home and its infrastructure).

No Occupants. During those stages of the foreclosure process in which no one is living in the home, it can quickly fall into disrepair or perhaps become a target for theft. Even if there are no personal effects in the home, thieves might target copper tubing, wiring, appliances and other fixtures.

Local Market Dynamics. Finally, it’s important to realize that sometimes you get exactly what you pay for. Look behind the reasons for the foreclosure – did the neighborhood become unreasonably expensive to quickly (in which case there may be more foreclosures in the same area, thus perhaps making it harder to realize a profit on the property you’re interested in)?

Don’t automatically assume that a foreclosure property will yield large investment returns. Take all the relevant factors into consideration so that you can decide whether a particular property is right for you.