Please look for holes in this plan! Self-directed RE purchase

[LongHorn]

Large SFH for sale near large university campus, 5 BR/3.5bath, plus 1/1 garage unit. As it is half a block from edge of campus, after I rent this once, it should rent itself (student word of mouth will handle the rest). $3000 per month rent for the house would be snapped up in a second, $500 for the garage unit. So 3500 x 12 - $42,000 per year income. My only concern is spring semester housing arrangements are locked so I have to limp through until May/June before I could rent this out, but it would take 60-90 days to close anyway.

I have an angelic, hard money, private lender lined up. They would loan close to 100%, and would do a non-recourse loan (at lower rate than I could get from a bank on a conventional mortgage). This would enable me to buy through a self-directed Roth (also maybe with a Coverdale Educational Savings Account included). They would allow me to defer repayment until I got the place leased out and had cash flow, but I have some funds available to cover rent in the short term. Lender is NOT a related party.

Mortgage would be ~$1500 per month ($18k/yr). I am budgeting annually $14,000 for taxes, insurance, and maintenance (and that would be a very high estimation, it might be closer to half that, but I would keep that much reserved from repayment to cover unforeseen expenses and allow Roth IRA to cover them -- would put the money reserved funds into CDs or something).

So expenses would be $32k, leaving me $10k annual positive cash flow. I plan to plow all positive (non-reserved) cash flow into loan repayment, because I want to get this paid off quickly for 2 reasons. First, my lender would be loaning their own retirement funds, and I want to give them the ability to "call the loan" after a few years (10 years or so), in the event they needed to consume their retirement dollars. They would give me reasonable time (3-6 months) in which to go get conventional financing if I have not repaid the loan in full.

Second, I hope to get this paid off in 8 years, to coincide with when my oldest child starts college, and have the rental income available to pay for college expenses (if he went to this school, I know he could never live in this property if owned by my Roth/kids' Coverdale).

To pay off in 8 years, I need to cover tax, insurance and maintenance (TIM) costs from a source other than rental income. I have two options for this:

First option, I have another Roth investment (oil and gas royalties) that pays about $7200/yr (but is up and down with market forces on a monthly basis). That, plus adding $5,000 new money to Roth annually and $2,000 to Coverdale, earmarked for TIM, would make up all TIM costs annually and allow me to put all rental income into repaying the loan. LLC docs would require additional contributions from the Roth/Coverdale, like a note. All of the TIM expenses would be lost as far as tax deductions.

Second option, I could set this up so my Roth (maybe kids' Coverdale, too) invests in an LLC and I, individually, own half of the LLC (might do 40/40/20 with me and my Roth owning 40 each and the Coverdale owning 20). That would allow me (individually) to claim at 40-50% of the TIM costs on my tax returns, and I think I could pay and claim 100% of them (make sure the LLC docs permit that). Accounting-wise, the LLC would end up with unequal capital accounts as a result, and that would require the LLC to make unequal distributions to balance that out (would be about $112k after 8 years based upon above numbers). Basically 4 years of rent (after TIM expenses) would be distributed to me to "balance the books" and make up for earlier disproportionate payments. This would come at a time when I needed that $$ to pay for a kid in college, and would be fine by me. If I did it this way, I probably would not put the kids' Coverdale into this mix at all.

Once one kid graduates from college, another will be ready to start. As I understand it, I can withdraw Roth IRA funds to pay for a child's college expenses, so using the rental income into a Roth then out to college would be okay. Of course, a Coverdale can pay for college, and after one kid graduates I can change the beneficiary to next child, and then have until the last one is 30 before I have to distribute any remaining funds (with 10% penalty) or designate another family member (grandchild by then would be highly likely).

Even with diverting cash flow to pay for college, my retirement nest-egg would be well set -- with the equity in the real estate, and would have the cash flow after kids were out of college.

WHAT AM I MISSING? I figure I am overlooking some income tax issues, likely UBIT taxes on the Roth/Coverdale. Any way to minimize those based upon the setup outlined above?

Do you see one option above as being preferable to the other? Or do you see a third option I have not considered?

I have given this a LOT of thought but I am new at this, so input and constructive suggestions are always welcome! Thanks in advance, and a happy and prosperous new year to all!

PS. Anyone know of a good custodian for a Coverdale account if I go that route? I have a GREAT custodian for my Roth royalty investment at this time ($100 initial fee, $50 annual fee), but they won't do a Coverdale.

 

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[randallg99]

I had to reread this because there's a lot of info. I like a lot of the strategies you mention but before saying anything you'll ideally consult your tax professional. I am sure you use a CPA. I have some questions that probably won't help you, but after reading this and some of JScotts progress my mind is piqued.

firstly, will a coverdale even allow you to use the funds for a private company? My understanding is that coverdale must only be used for public companies, much like the 529.

(I opted to buy the kids Roths and open trading accounts in my name on their behalf so my memory regarding education savings plans is rusty, apologies)

secondly, will the IRS accept the operating agreement to pass 100% of the deductible items through to just a part owner of the LLC?

third, you don't mention depreciation as a deductible. Has that been calculated in your after tax analysis?

forth, your O&G royalties. Are they american or foreign holdings?

fifth, UBIT issues can be an accounting nightmare when investing in public companies, but you can anticipate them in your calculations

sixth, have you considered vacancies?

7- you say: >Accounting-wise, the LLC would end up with unequal capital accounts as a result, and that would require the LLC to make unequal distributions to balance that out (would be about $112k after 8 years based upon above numbers). Basically 4 years of rent (after TIM expenses) would be distributed to me to "balance the books" and make up for earlier disproportionate payments<

I am not sure I understand this part.

 

[LongHorn]

Coverdale will allow this type of investment, just like a Roth; the restrictions from what you are prohibited from investing in are almost identical. Much more flexible than a 529 account, but you can only contribute $2k per year into a Coverdale.

Depreciation wasn't calculated in but should have been, I just cannot do those numbers easily so I left them out. O/g royalties are domestic. It is small and I cannot count on it on a month-to-month basis, but can on an annual basis.

I am not terribly worried about vacancies, given the proximity to campus. I am not renting individual rooms, I'd rent the whole house. I would make the students' parents sign a guaranty of their rental obligation. I think the best way to keep it "leasing itself" is to rent to a group --I am thinking I get 6 girls from a sorority in there, and it will rent itself as one graduates and another moves in. The gas royalties are there as a backstop against vacancy.

A generic LLC can make a disproportionate allocation of profit and loss if there is a specific economic reason as part of the deal. It happens in the real world all of the time. My accountant approached this from the perspective of "could my Roth partner with an unrelated individual and give HIM all of the tax breaks?" He said that would be fine, but he wants me to go see another accountant and run this past him. I am trying to see if anyone else has ever thought of this and/or run it past an accountant.

My understanding, after reading up on this and asking my accountant, is that a disproportionate distribution of profits or losses is permitted as long as (1) it is a deal point, and (2) one party does not "take a hit" on its taxes as a result. In my example above, I would personally take 100% of the tax write offs, and the Roth would forgo them. There is a rational deal point for this, as the Roth has limited resources (by statute; I have limited resources, too, but there is no statutory cap on me!). I end up better off, but the Roth is no worse off. I think.

My accountant says that the partnership books will end up unequal as a result--I will have all of the losses attributed to my side of the ledger for a number of years. If we start out and the books say ME = 1000 and Roth = 1000, and each year there is -50 loss, and all of that goes on my side of the ledger, after ten years the books will read ME = 500 and Roth = 1000. Thus we would have to "balance the books" once the note was paid off, and have an unequal allocation of the profits until the books balanced.

Thanks for your input. Can you point me to some of the posts you were talking about? I am pretty new to the site...

 

[kwerner]

In your prior posts I didn't see it mentioned what your purchase price / offer is vs what the property is worth. That could be a pretty big consideration in the case that the property isn't able to rent out quite as well as planned and you need to sell it.

 

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[hatterasguy]

You said the mortgage payment was about $1,500 a month? How much is the house going for low $2's?

If your numbers are right it doesn't look that bad. College kids trash rentals so keep that in mind, wear and tear is going to be high.

 

[randallg99]

Coverdale will allow this type of investment, just like a Roth; the restrictions from what you are prohibited from investing in are almost identical. Much more flexible than a 529 account, but you can only contribute $2k per year into a Coverdale.

Depreciation wasn't calculated in but should have been, I just cannot do those numbers easily so I left them out. O/g royalties are domestic. It is small and I cannot count on it on a month-to-month basis, but can on an annual basis.

I am not terribly worried about vacancies, given the proximity to campus. I am not renting individual rooms, I'd rent the whole house. I would make the students' parents sign a guaranty of their rental obligation. I think the best way to keep it "leasing itself" is to rent to a group --I am thinking I get 6 girls from a sorority in there, and it will rent itself as one graduates and another moves in. The gas royalties are there as a backstop against vacancy.

A generic LLC can make a disproportionate allocation of profit and loss if there is a specific economic reason as part of the deal. It happens in the real world all of the time. My accountant approached this from the perspective of "could my Roth partner with an unrelated individual and give HIM all of the tax breaks?" He said that would be fine, but he wants me to go see another accountant and run this past him. I am trying to see if anyone else has ever thought of this and/or run it past an accountant.

My understanding, after reading up on this and asking my accountant, is that a disproportionate distribution of profits or losses is permitted as long as (1) it is a deal point, and (2) one party does not "take a hit" on its taxes as a result. In my example above, I would personally take 100% of the tax write offs, and the Roth would forgo them. There is a rational deal point for this, as the Roth has limited resources (by statute; I have limited resources, too, but there is no statutory cap on me!). I end up better off, but the Roth is no worse off. I think.

My accountant says that the partnership books will end up unequal as a result--I will have all of the losses attributed to my side of the ledger for a number of years. If we start out and the books say ME = 1000 and Roth = 1000, and each year there is -50 loss, and all of that goes on my side of the ledger, after ten years the books will read ME = 500 and Roth = 1000. Thus we would have to "balance the books" once the note was paid off, and have an unequal allocation of the profits until the books balanced.

Thanks for your input. Can you point me to some of the posts you were talking about? I am pretty new to the site...

well, firstly welcome to the site. I really appreciate this post because my mind is racing with another idea I have for a property I bought yesterday along with a couple of others I am pursuing.

And quite frankly, this post is extremely refreshing vs many of the rah rah posts that seem to be overwhelming the main purpose of this forum.

ok, a lot of info:

depreciation = 1/29 of commercial property and 1/39 of residential property on the improvements only (someone should double check these numbers because they're from memory) ... but I would use them in the calculations because you can determine how much depreciation will affect your return

JUST an FYI re: Domestic O&G - unlike canadian royalty companies, American royalty trusts are prohibited from acquisitions so be sure the reserve life is significant or create a back up plan (can you disclose the ticker?)

now, I am not the tax guru here, but my understanding in the past is that the LLC needs to distribute the profits (or losses) proportionate to the amount of shares owned.

If the Roth and individual own each 50%, then the losses must be distributed that way.

However, in my experiences you can create an A level or a B level classification and create separate bylaws for them in a SUB S CORP and then have different tax consequences as the losses/profits are passed onto the individual, llc, roth or any other holders..... Now the 64k question is can the LLC have different share classes?

there are ways to accomplish what you're trying to do, but the structure might be costly.

Have you considered using a self directed IRA like EntrustCama? or Guidant (sic?) a lot of info here: http://www.thefastlanetomillions.co...on/22397-self-directed-iras-2.html#post104780

the last thing I can contribute is before establishing the structure, you should run this concept by an estate attorney since this is the kiddie college money....

good luck.

 

[LongHorn]

Thanks all, for the replies. To answer most of the questions:

1. They are asking 375k for the house, I think it can be bought for far under that (I hope 20% under), so I am looking at ~$300k-325k range. The house is worth what they are asking, IMO. This house is right next door to a private university, in an upscale area with upscale students -- so getting mom and dad to guaranty the rents (and damages) would be not out of the norm. Everybody wants to get off campus, lots of 1-2 bedroom rentals in the area but this would be one of the few where several could live. Again, I don't think I have any problems leasing (once the spring semester ends). I am getting a scandalous interest rate, and I am not factoring the annual expenses like tax and insurance into the monthly payment figure of $1500.

2. O/g royalties are direct royalties from the operator of the well, based upon mineral ownership (not ownership of any type of trust). I have 1.5 acres in the unit, primarily gas production. I expect gas prices (which were under $2 at the well head earlier this year) to get back up to the $7 range, and getting back to $13 range like it was 2 years ago will happen again. I don't won't to get into a political diatribe here, but Obama is no fan of natural gas (he prefers "clean coal," which is a myth, BTW), but Congress is a fan of natural gas. I think once the mid-term elections roll around, natural gas will receive more favorable treatment, especially with XOM recently making a huge acquisition of XTO, and other major oil companies likely to follow suit. The well I am part of should last for 20+ years, and while production will tail off somewhat each year, prices should increase and keep the royalty income stream fairly level (over a year, but month to month will swing widely).

3. As I understand it, an S Corp cannot have a trust as a shareholder, so I could not go that route. But an LLC can have different classes of members (A & B). Profits and losses should be distributed according to percentages of ownership, but there are special provisions that can get you around that. What I described, with losses attributed to me, individually, for a period would be permissible, provided profits were distributed to make up the difference.

4. I will use a self-directed Roth, and have talked to several. Pensco, Guidant, Entrust, Equity Trust, Sterling Trust, TMICO. Will any of them give you a written opinion from a tax attorney regarding the structure of the deal? I have applications all filled out and ready to send, just waiting for the right deal to present itself!

5. I do plan to talk to my own counsel (CPA and tax attorney with a lot of experience and writes and lectures on self-directed IRAs). He is pretty expensive, and I think I will get more bang for my buck with him if I get a clear picture in my head of what I want to do (and what is permissible), so that I can send him my ideas in advance and when I go see him we go over those, and use the time more efficiently.

6. So the more I can learn, the better. I have read a bunch on this subject, but everyone just takes it as a given that the tax write offs are just forfeited, and I do not think that is the case. I am trying to figure out how to have my cake and eat it too!

 

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[randallg99]

>>>3. As I understand it, an S Corp cannot have a trust as a shareholder, so I could not go that route. But an LLC can have different classes of members (A & B). Profits and losses should be distributed according to percentages of ownership, but there are special provisions that can get you around that. What I described, with losses attributed to me, individually, for a period would be permissible, provided profits were distributed to make up the difference. <<<

The main objective from what I gather is to have the ROTH absorb the profits while the individual absorbs the losses.

If you go through this much effort to create a system, then you might as well make it so that you can forever avoid tax liability as an invidivual.

so, an LLC can be a shareholder in the Sub S, no?

the LLC can be partially be held by a trust. And then let this LLC absorb the profits in the ROTH.

And with these great thoughts you put here on the forum, I think for the most part you've already created a really good blue print of what to bring to the CPA and tax attorney....

It would probably be only 1 hours time for an estate attorney to review and make recommendations.

lastly, if you create this structure, you'll possibly want to set it up so that you can easily repeat the process and save fees by minimizing professional consultations

speed.+++