By Kelly Greene
RISMEDIA, Sept. 18, 2007-(WSJ.com)-In the midst of the mortgage meltdown, some lenders are actually rooting for foreclosures: investors who make mortgage loans with their IRAs.
Through a little-known tool known as a self-directed individual retirement account, individuals can pursue a wide variety of investments, from real estate to businesses. Now, at least several thousand people are trying to goose their retirement savings by using self-directed IRAs to invest in mortgages, according to companies that promote the strategy.
Typically, IRA investors aren’t looking to back 30-year conventional mortgages; more often, they make loans with terms lasting from three months to a few years to fixer-uppers, small-scale developers or families who are relocating and need a bridge loan between home sales. They normally find borrowers through an informal network of real-estate agents, mortgage brokers and other investors.
IRA owners pay an annual custodial fee and transaction fees, ranging from $50 to a few thousand dollars a year, depending on asset size and activity. They typically charge borrowers a rate of at least 10%. If the borrower defaults, the IRA can wind up owning the property at a deep discount, since these deals are typically structured with the property as collateral.
“I really don’t trust the stock market right now, and by doing this I can get a great return secured by real estate,” says Doug Blackwell, a Phoenix real-estate adviser who set up a self-directed IRA last month with $100,000 from other retirement savings so he can fund mortgages.
For investors, one risk in foreclosing on a house is racking up so many expenses — from legal fees to repair bills — that the IRA runs out of money. If that happens, the IRA owner faces a difficult choice: Get a loan, or close out your IRA and pay any taxes or penalties.
Still, some IRA lenders welcome foreclosures because they increase their potential returns. No one tracks IRA loan defaults, but experienced individual lenders say it has happened rarely — though they are bracing for an uptick, given the shaky state of the housing market in many areas.
“You don’t want them to pay you,” says Charlie Adams, a Houston investor who has made about 20 mortgage loans through his and his mother’s IRAs in the past 10 years, typically charging 15% interest for one-year loans. “What’s the worst thing that can happen — you wind up owning a house at 70% of its cost?” He lends no more than 70% of a property’s value and charges interest-only payments. More conservative lenders will go no higher than 50%.
With the one foreclosure he’s done, his mother had lent $40,000 to a renovator to refurbish a house worth $85,000. The borrower made 12 months of interest payments, then stopped, and did not make the balloon payment due. Mr. Adams foreclosed on the house, his mother’s IRA spent $14,000 to finish fixing it up, and they sold it in three months for $85,000, he says, adding that he helped his mother’s IRA increase in value to $140,000 from $50,000 in five years.
Other lenders try to avoid foreclosures. Dennis Galbraith, who also lives in Houston, makes short-term bridge loans with his IRA, for which he says he charges 12% to 15% interest, and takes what’s called “first-lien position,” meaning he’s first in line to get his money back from the borrower. But he’s had to restructure two loans in recent months because the borrowers’ “exit strategy was initially to sell the house, and it didn’t work because the buyer didn’t get financing approval.”
Galbraith extended the loan terms so the borrowers can rent out the properties for a year and pay him off “like a normal mortgage” with the rental income. “If I choose to foreclose, I could, but I’m personally willing to work with the borrowers,” says Galbraith, who works for an energy company and moonlights as a real-estate agent.
Like Galbraith, many people lending their IRA assets are connected to the residential real-estate business. Others are people phasing out of corporate careers who learn about such lending through local clubs for real-estate investors. They say that they usually connect with borrowers through word of mouth.
The maximum loan rates that self-styled IRA lenders can charge are regulated by usury laws that vary from state to state. In California, for instance, interest rates are typically capped at 10%, says Hugh Bromma, chief executive of Entrust Group Inc. in Oakland, Calif., which administers self-directed IRAs.
Self-directed IRAs make up less than 2% of the overall $4.2 trillion IRA market, but they are increasing in popularity. And the handful of firms that handle such accounts are logging increased usage by self-styled mortgage lenders.
Two thousand of the 40,000 self-directed IRAs handled by Entrust are making real-estate loans, and the average account is valued at $250,000, says Bromma. The number of accounts with such activity has doubled each year since 2005.
The story is much the same at Pensco Trust Co. of San Francisco, where about $367 million of the $2.2 billion in IRA assets it has in its custody has been lent for real-estate deals.
Guidant Financial Group Inc. in Bellevue, Wash., sets up limited-liability companies through which IRA owners invest in accounts with an average value of $180,000. It says it has seen interest in lending, mainly for real estate, increase 20% in the past two months.
With a self-directed IRA, you can invest in things other than mutual funds, such as rental property, businesses or community-bank stock — just as long as any profits go to the IRA and not your regular bank account. (You’re also prohibited from using the property as a personal residence).
Entrust charges IRA owners $250 a year to invest in one mortgage, or $2,000 a year for unlimited transactions. Setting up a Guidant account costs $130. IRA lenders also have to pay other mortgage loan costs, including escrow and closing fees. At least some of those costs, though, usually can be passed along to borrowers.
Another risk to investors is running afoul of the Internal Revenue Service’s rules for IRAs. “You cannot take any kind of fee from your IRA for doing something inside your IRA, and if you have to start using money from other sources to bail out something happening with the loan inside the IRA, that’s a big problem,” says Natalie Choate, a Boston tax attorney. So it’s important to make sure the IRA has enough money in it to pay any legal fees involved in foreclosure, or property taxes and insurance costs if you wind up owning a house for a while before you can sell it.
The IRA can borrow to pay those costs, Ms. Choate says, but doing so creates taxable income and complicates your tax return.
Don Baglien, a truck-stop manager in Roseburg, Ore., recently rolled over $100,000 from a former employer’s 401(k) to a self-directed IRA because “I’m just too busy to follow the stock market closely and stay on top of it,” he says. After attending a Guidant seminar, he set up an account and recently made a second-mortgage loan, with a two-year term and 20% interest, to a local pizza parlor in need of repair. So far, it’s borrowed $40,000 for a new heating-and-air-conditioning system and roof, he says. The restaurant owner owes $900,000 on the building, appraised at $1.3 million, “so I definitely felt like there’s some equity there.
“If he doesn’t pay, I guess I’m going to be eating an awful lot of pizza,” Baglien says. “Hopefully, they’ll still have some beer left.”
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