Real Investors have the following in common:

• Buying single assets. What is happening to an entire market is less important than what is happening to the actual assets that you hold. Real investors are holding a portfolio of single assets that are performing well, oftentimes even while the entire market is doing poorly. This may be difficult to do in the stock market, but it’s much more feasible in real estate.
• Buying real estate now. A few years ago, real investors were frustrated that blind investors were running up the price of real estate. This made it more difficult to buy real estate at a price that allowed for profit. Now that all the blind investors are fleeing from real estate, the remaining real investors are breathing a sigh of relief that they can get back to more profitable deals again.
• Looking at comparable sales and comparable rents to analyze a residential property.
• Seeking properties in any geographic location that provides opportunity for profit. Many real investors buy property outside their local area – sometimes even sight unseen. With reliable real estate agents, property inspectors, appraisers and local consultants, a real investor is more concerned with the opportunity for profit than he is with the necessity to drive by the property every time he goes grocery shopping.

Blind Investors have the following in common:

• Buying entire markets. The growth of the mutual fund industry has taught blind investors to bet on entire markets and industries. This leaves them fleeing from real estate while leaving all of the best investment opportunities for the real investors.
• Fleeing from real estate now. While the “buy any property” strategy was working, blind investors were in frenzy. Many of these blind investors have lost their shirt as real estate values have been correcting themselves back to rational prices.
• Looking at comparable listings to analyze a property. Comparable listings don’t tell you what a property is worth; it will instead tell you what a seller hopes it is worth. Nevertheless, blind investors commonly look to listings to justify their hopes for unrealistic sales prices. I can list a small two-bedroom house in San Antonio for $100 billion today, but the listing price has no actual connection to real estate values unless it sells for that price.
• Seeking properties only in their local area. A blind investor derives comfort from seeing the property around the corner rather than from understanding its profitability. This can pose a problem because oftentimes the most desirable areas to live in have the worst cash flow because of that desirability.

Today we unquestionably have a soft and declining real estate market in many areas of the country. Real investors are jumping with joy as the opportunities for real estate investment profits have become plentiful again. If some of these concepts are new to you, a little bit of reading can go a long way. A trip to your local bookstore will show you that there are many real estate investment books to choose from. Try to stay away from those focused on flipping. You may even want to be wary of most residential real estate investing books that have a copyright date between 2003 & 2007.

Recommended reading:

Make More Money Investing in Multiunits
By Gregory D. Warr

How to Buy and Sell Apartment Buildings
By Eugene E. Vollucci

Timing the Real Estate Market
By Craig Hall

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*** This is Part 3 of a series about the dangers of letting an administrator act as custodian. Make sure you read Part 1 and Part 2 first to make sense of this post. ***

The illegitimate custodian test

Ask “Who should the check be payable to for the rollover contribution or transfer?”

Ask “If my IRA buys real estate and rents it out, to whom should the tenant make the rent checks payable?”

Ask “If my IRA owns real estate that needs repairs, who issues and signs the check to the repairmen?”

These questions will tell you who is actually serving as custodian. For instance, if you live in TX and unregulated company Dotrust is marketing its self-directed IRA services to you, the answer to one or more of the questions above will probably be something like Dotrust of Texas, Inc. If this is the case, ask to see its bank or trust charter – if it is an illegitimate custodian it won’t have one, and it will insist that another bank is technically the custodian. It not only matters who’s the custodian on the paperwork is; but it also matters who is acting as custodian as uncovered by the answers to the 3 questions above.

Why would somebody operate an illegitimate custodian company?

First of all, if it’s a franchise operation, the franchisee might not even know that he or she is part of an illegitimate IRA custodian scheme. Secondly, there can be a lot of profit to be made in an illegitimate IRA custodian scheme. The company can earn interest off of your IRA funds, and it may pass only some (or even none) of that interest earned on to you. It may also be able to earn higher interest rates when it collectively has custody of hundreds of millions of dollars in funds.

Surprised?

You may be thinking “This sounds like a company I’ve run into. But it promotes and and advertises and has been in the business for decades… it can’t be illegitimate, can it????”

Many high-profile schemes have been shut down. The private annuity trust scheme was promoted for over a decade before the IRS shut it down. Additionally, being in business for decades doesn’t guarantee that business is legitimate. Look at Bernie Madoff.

Madoff may be a harsh comparison. Those involved in an illegitimate IRA custodian scheme may not be knowingly harming anyone. They may even be attorneys or CPAs. They may believe they’ve merely created a loophole for themselves with the “stepped transaction” arrangement. They may be good people. But the bottom line is that there are significant risks you take in using their services, and you will pay the consequences if uncovered by the authorities. In my opinion, it never makes sense to use an illegitimate custodian because there are dozens of regulated/legitimate self-directed IRA custodians out there. There should be a balance between risk and reward. There is significant risk of using an unregulated/illegitimate custodian, and it offers no unique reward that isn’t offered by other self-directed IRA custodians.

Confused? If you have a self-directed IRA or are thinking of opening one at a custodian company, perform the illegitimate custodian test as described above.

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*** This is Part 2 of a series about the dangers of letting an administrator act as custodian. Make sure you read Part 1 first to make sense of this post. ***

Signs that your custodian may not really be a custodian

1. They sometimes call themselves an administrator. “Administrator” is an accurate label for any company who provides record keeping services. Being an “administrator” doesn’t require any regulation. These types of companies may expand their services to include asset custody without actually registering as a bank or trust company.
2. Their name contains the word “trust” attached to other letters or words. A legitimate custodian usually has the word “bank” or “trust” as a separate word included in its name. In most states, the word “trust” is a restricted word for naming companies – just like the word “bank”. This means that you can’t start a company called “ABC Bank” unless it’s registered as a bank. You also can’t start a company called “XYZ Trust Company” without being a registered trust company. An illegitimate custodian might get around this by calling themselves Trustus rather than Trust Us, Dotrust rather than Do Trust, or Safetrust rather than Safe Trust. You see, if trust is attached to another word instead of used as a separate word, then it sneakily gets around the naming restrictions.
3. They have dozens of offices all around the country. Expanding to dozens of cities across the country can get expensive for a regulated custodian. The self-directed IRA custodian business isn’t nearly as profitable as the securities business, and most legitimate custodians must operate only one or two offices in order to be able offer their services for reasonable and competitive fees.
4. They sell franchises. Franchises can be a powerful and leveraged way to build a brand, but for the IRA custodian business it is nearly impossible to expand a legitimate custodian business through franchising. If a legitimate custodian had 40 offices across the country, its overhead would be so high that its fees would be much higher than the next most expensive competitor and its services would have nothing to offer to justify the higher fees. In reality, it appears that only illegitimate custodians are able to run franchise operations, and this is made possible by not having to deal with the regulatory costs of having dozens of audited and regulated offices.
5. They hire a real bank or trust company to be the custodian, but then they fulfill custodial duties themselves. In the legal world, there is a concept known as “stepped transactions” or the use of a “strawperson”. This is basically where a step is added to a transaction to include a person or company, and this inclusion is only involved to circumvent a law. For instance a self-directed IRA can’t buy or sell assets to or from its accountholder or its family members. So let’s imagine a guy named Joe wants to sell his personal residence to his IRA – which would normally be a prohibited transaction. In an attempt to get around this prohibition, he sells his home to his friend Randy, who then sells the house to Joe’s IRA. This would easily be deemed a “stepped transaction” because Randy did not really want to buy the house; he was just trying to disconnect the real parties from transacting (Joe and his IRA) directly so that it would appear to not break any laws. This same concept can be seen with IRA custodians. An administrator may want to serve as a custodian without being a bank or trust company. So it hires a bank to serve as custodian on the paperwork. Then it gets the bank to outsource custody-related tasks (holding and controlling assets) right back to it. In this scenario, the bank is a “strawperson” and the arrangement is similar to a “stepped transaction”. To understand the legal ramification of what’s really going on, you must remove the step/strawperson. In this scenario, what’s really happening is that a non-custodian is serving as the custodian, and it is illegitimate.
6. They are opposed to the “checkbook control” IRA LLC strategy. Illegitimate custodians primarily profit by earning interest on the funds of others (like a bank) without registering themselves as a bank or trust company. In an IRA LLC structure, most of the IRA funds are invested into an LLC where the IRA/LLC accountholder puts them at any bank of their choosing – where the LLC will earn the interest on the funds. This undermines the primary goal for the illegitimate custodian (earning interest on your funds) so it usually discourages (or even disallows) you to use the IRA LLC strategy.

Coming up in Part 3 of this series: How to tell if your custodian is compliant using the illegitimate custodian test.

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To have a self-directed IRA, unlike a Solo 401k, you must have a self-directed IRA custodian… and you should stay away from unregulated companies masquerading as a custodian. A self-directed IRA custodian is one that will have less investment restrictions than the more common tradition stocks/bonds/funds brokerage-type custodian, and they usually allow investment into real estate, private companies, and other alternative assets.

An IRA is technically a trust, and a custodian is basically a trustee who performs fewer duties than a trustee usually would. As the name suggests, the sole duty is custody-holding assets and/or property on behalf of the trust.

The Internal Revenue Code says that the IRA custodian role can only be served by:

1. A bank
2. A trust company (this is the most common type of company to serve as self directed IRA custodian)
3. A company specially & specifically approved by the IRS (this is very rare)

So, essentially, in the self directed IRA market, most custodians are chartered as trust companies. A trust company is basically a bank that doesn’t lend money. Trust companies are usually audited and regulated by the same state or federal agencies that audit and regulate banks. There are a couple dozen trust companies who offer custodial services for self-directed IRAs. There is also at least one company that offers custodian services without being chartered as a bank or trust company.

The risks of hiring an illegitimate custodian

• Little to no regulation. Banks and trust companies are audited and regulated by state or federal regulators.
• Risk of failure or fraud – Unregulated companies have nothing to lose. Starting and maintaining a bank or trust company is costly. A regulated bank or trust company is usually not going to misappropriate funds or just disappear overnight. This is because it has a lot to lose: the money it took to start and maintain the company and the future profits it will enjoy if it plays by the rules and stays in business.
• Risk of failure or fraud – Unregulated companies have no minimum net worth requirements to be in business. Starting a bank or a trust company requires the owners to meet minimum net worth requirements and have a clean criminal record. An unregulated company has no such requirements – there is no capitalization requirement in most states to just register a corporation or LLC. People operating an illegitimate custodian company have gone through no regulatory approval process. They could have declared bankruptcy recently, have felony convictions, and have a net worth of less than zero dollars.
• Your IRA might be deemed to have been taxably distributed when you hired the illegitimate custodian. Because the law defines an IRA as a trust held at a trust company, one held at an illegitimate custodian is technically not an IRA at all. When you rollover your old IRA, the funds must arrive at a real custodian within 60 days. If that doesn’t happen, you owe income taxes (and possibly early distribution penalties if under age 59 1/2 at that time) on the account balance. Putting the funds at an illegitimate custodian for more than 60 days means you’ve technically distributed your IRA. If this isn’t dealt with for several years, you may be racking up interest to the IRS in addition to the taxes. As salt in the wound, the funds left over will not have any tax favorable treatment for future profits.

Coming up in Part 2 of this series: Signs that your custodian may not really be a custodian.

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