“Any note that is bought at a discount would make sense in an IRA, since the entire capital gain is tax-deferred.”
I asked William Exeter to tell us about using cash flow notes in a retirement plan. Mr. Exeter is the President and Chief Executive Officer for Exeter 1031 Exchange Services, LLC, Exeter Fiduciary Services, LLC, Exeter IRA Servcies, LLC and their affiliate companies.
What is the difference between a custodian and a trustee? An IRA Administrator and a trust company or bank?
The trustee typically has more responsibility. When the word “trustee” is used, that usually means that the institution is actively managing the client’s account — they make the investment decisions. A custodian is used with a self-directed account. We do what the client asks us to do. Our plans are completely self-directed, and the clients give us written instructions as to what to do.
An IRA administrator is an expert on IRAs and SEP-IRAs. They know the business, they do the administration, which means they handle the paperwork, but they are not licensed by any government agency to handle the custodial work or actually take possession of the assets. Typically an IRA administrator would do all the work but they have to hire a custodian, such as a trust company or a bank, to actually hold the assets. The risk is that assets have to go through the IRA administrator first and then to the IRA custodian. There are numerous ways of setting these relationships up, but unfortunately the industry has had at least four major problems in the past five years where the IRA administrator has been closed down by a government agency.
A trust company, on the other hand, handles everything. The administration and the custodial function are all under one roof. It is licensed by a government agency, which means they are monitored, regulated and audited. Typically their bonding levels and their equity capital levels are much higher — Security Trust, for example, has a $50 fidelity million bond and $10 million in errors and omissions insurance — so the clients are much better protected. It is always recommended that clients inquire into the bonding levels and request verification or proof of the bond or insurance policy.
Trust companies also fall under the fiduciary laws. The corporate assets are definitely segregated from the clients’ fiduciary assets. If the state or the federal government were to take over the company for some reason, the clients’ funds would not be affected. In the case of an IRA administrator, if the government were to take it over, there can be a problem in segregating the clients’ fiduciary funds from the corporate assets.
People need to make sure their retirement funds are with a trust company or a bank with a trust department.
What should be considered when deciding what cash flow notes to put in a retirement plan?
Obviously the highest quality notes are good candidates, for a number of reasons. If there is a loss in an IRA account you cannot deduct the loss on your income tax, so the lesser quality notes should be in your personal portfolio. Also, if you buy a fractionalized note with other investors in your IRA and something goes wrong, it’s more difficult to process the foreclosure transaction and get the others to participate and agree on what to do. What the others may want to do may not be in the best interests of a tax-deferred IRA account. We recommend that you only put whole notes into your IRA, notes that do not involve other investors, so that you have full control over it. (Although this is not always possible with smaller IRAs if you are trying to diversity your investments.)
Any note that is bought at a discount would make sense in an IRA, since the entire capital gain is tax-deferred. Notes that are of better quality, that are producing higher income and capital gains, are the best candidates for IRA accounts.
Is it up to the client to find the notes?
Yes, these are self-directed accounts, and the client finds the notes for the plan.
How is a note serviced when it is held in an IRA?
That’s a good question. When a client is shopping around for an IRA company to handle their account, they are going to get a lot of buzz words thrown at them. Just about everybody says, “Sure, we service notes.” What they typically mean by servicing a note is that they will accept the checks and post it to the account. That ends the “servicing they provide.” A client should have an IRA company that has the ability to really service the loan if the broker does not want to do it. Remember, it is recommended that note brokers/buyers using their own IRAs should not service their own loans. The IRA company should have an in-house loan servicing center that does everything from A to Z: collecting the payments, posting the income and principal, monitoring for delinquencies, sending out late notices, filing notices of default and foreclosures if required, providing 1098 and 1099 tax reporting…all that should be provided to the client. Very few companies offer that, although they don’t tell the client that, so a couple of years later when the client calls the IRA company and requests a printout of the borrower’s payments, he’s told that he’s received monthly statements, look it up. A good loan servicer will print out all the loan activity and fax it to the client immediately.
When notes are put into a plan, where are the original documents physically kept?
That depends on the particular plan. If it’s a self-directed IRA or a SEP (Simplified Employee Pension) IRA and the client is buying 100 percent of the note as opposed to a partial, we like to take physical possession of both the note and the underlying collateral. It is kept in a dual-control, fireproof safe, which means it requires two employees to access it. If it is a partial or fractionalized note, then typically the broker who processed the transaction will hold all the original documents.
What is the cost to set up and administer an IRA?
The costs vary widely, depending on the IRA administrator your select, the investment selection available, the level of bonding and quality of service provided. There are also transaction fees.
Do note brokers face any special potential liabilities when selling cash flow notes to a retirement plan?
Brokers face a much higher level of liability when dealing with a regular ERISA account, which means a 401(k), profit-sharing or pension plan that typically has multiple beneficiaries, a corporate trustee or several trustees. You have many people who are charged with the fiduciary responsibility for that type of plan, and the underlying beneficiaries don’t have the ability to monitor each individual investment as it happens. This situation can really get a broker into trouble. It’s much simpler to sell notes to a self-directed IRA, where you have one beneficiary who approves their own transactions and actually selects the investments through the broker. The liability for the broker still exists, but it drops significantly because the beneficiary has approved and authorized the investment transaction and the presumption is that the beneficiary has done the necessary due diligence.
If a retirement plan owns a mortgage or trust deed on a property that goes into default, if there isn’t enough money in the account to handle the foreclosure costs, what can be done?
That’s a very big problem and it’s very difficult to handle. If there is little or no cash in the account, and if you interpret the IRS regulations very strictly, you cannot use personal funds to help cure the note or process the foreclosure transaction. That would be considered a prohibited transaction. You cannot lend funds to your IRA or SEP-IRA either. That means if you want to be completely conservative, there is nothing you can do.
In reality, nobody wants to walk away from a loan like that. You want to go ahead and process the foreclosure, so you do have to come up with personal funds to advance the cost of the foreclosure process and then at the sale try to get your personal funds back. But the client has to realize that there is a potential risk in doing that. If the IRS ever audited that plan it could be disallowed as a prohibited transaction because you’ve commingled IRA funds with personal funds.
Please summarize what to look for when evaluating an IRA company or provider.
The first thing to look for is strength in bonding. We’ve seen a number of instances where that was lacking and the companies have gone under for a number of reasons, and the clients’ funds were lost. If the bonding is adequate, you go to the next level, which is whether the company is licensed or regulated by any kind of government entity. Is there anybody looking at them, at least annually, to determine if their operation is complying with the law? Third is the question of with whom they are associated. Are they part of a strong family of companies that understand the business? Or are they a local shop, and if something goes wrong they will just shut down and put the client in jeopardy? The next issue is level of service. What kind of service do they provide to the client? Service is more important than fees, because two years down the road you want to be sure your account has been handled adequately, all the tax reporting has been taken care of competently and such. You don’t need surprises. Of course, you need to examine and understand the fee schedules and choose the best company for your circumstances.
Contact Mr. Exeter at http://www.exeter1031.com
FOR MORE INFORMATION ON NOTES IN IRAs:
http://store.papersourceonline.com/tax-free-note-real-estate-investing/
http://store.papersourceonline.com/your-ira-can-buy-notes-more/
