Money Mastermind Show – Alternative Investments: Should You Invest Outside Of The Stock Market?
Intro: Welcome to the Money Mastermind Show, Let’s talk money.
Glen: Welcome to the Money Mastermind Show. When we think of investing, we tend to think of your typical Wall Street movie. I think of a movie Trading Places where they were all on the floor, throwing tickets in the air, sale-bonds, sale, buying. I think we tend to think of stocks generally as what we invest in. But, there are a number of things or alternatives out there that we could be investing with.
That’s what we’re going to discuss today. We have Kirk Chisholm of www.InnovativeWealth.com. He’s going to talk about alternative investments. Welcome to our show Kirk.
Kirk: Very well. Thanks for having me on.
Glen: Thanks for being here. If anybody’s out there watching live on our event page and you have any questions on alternative investments, please go to the event page and feel free to ask as any questions. Also, from our Money Mastermind Show, we have Kyle Prevost of Young and Thrifty (youngandthirfty.ca), Miranda Marquit of Planting Money Seeds (http://plantingmoneyseeds.com/), Peter Anderson of Bible Money Matters (http://www.biblemoneymatters.com/), Tom Drake of the Canadian Finance Blog (http://canadianfinanceblog.com/). He’s usually with us. He couldn’t make it tonight. And, I’m Glen Craig from Free from Broke (http://freefrombroke.com/).
So, alternative investments, I’m sure that it’s a pretty broad subject but there’s probably a small or handful of items that we would generally include in that category. What type of things would be considered an alternative investment and where would we use these? I mean, I think would we put this in an IRA? What would we use this for?
Kirk: Well, I think the term alternative investments is itself a little hard to define. Recently Wall Street has made this a trendy term. In the past, it was used to define hedge funds or private equity funds and now that 2008 happened, investors are definitely afraid of the stock market. Wall Street has seen that trend and taken advantage of it. Now many mutual funds call themselves alternative. I’m not sure why or how but they managed to do it.
I would characterize alternatives as non-traded investments; anything outside of the stock market, the bond market, or anything that’s traded. You could look at it from the perspective of the investors as well. Some people might look at traded options as an alternative investment or MLPs or business development companies (BDCs) because they’re not widely known. I would still consider all those traditional assets or traded assets.
Alternative investments are characterized as things like physical real estate, tax liens, private mortgages, private business perhaps and anything that you can invest in without having to go to a broker to buy it. I think that’s probably the best definition I can come up with to define alternative investments.
Glen: Fair enough. I think the question maybe is, “the alternative to what?”. You are saying everybody’s afraid of the stock market. I guess that’s the alternative to that these days, but you never know how that alternative start switching up and then alternatives to alternatives and ends up you start investing in stocks again.
The investments that you mentioned, these seem a little heavy for the average person? Like what type of people goes into that type of investments?
Kirk: Well I think for any alternative investment it’s really important for people to “invest in what they know”, as Peter Lynch said. You shouldn’t just invest in an alternative because you read about it in an article or saw it on TV.
If you invest on something like tax liens, they’re very complex in regards to the rules, but in my opinion they are also one of the best investments when you measure it from the risk to reward perspective. They are one of my favorite assets. But, it’s not something you can go into lightly. It requires you to do your homework. It requires you to do research to actually understand the ins and outs of the process.
The thing with alternative investments is; it’s not like you’re investing in a stock. You can’t just go to your local broker and click a button and buy a hundred shares of Microsoft. You actually have to do the work.
It’s like buying a piece of real estate. Most people who have gone through the process of buying real estate before understand it’s not easy; you have a lot of contracts to sign, you have to buy it from somebody, you have to find a property, you have to do due diligence, inspection and all of these different things. It’s a lot more work, but you also can find a lot more better opportunities.
See the downside of alternatives is many of them are illiquid. With the stock market you can buy and sell right away. With a piece of real estate it takes you awhile to buy it; it takes you awhile to sell it. If you do it right, that can work to your advantage because there are people who need to sell right away and will take the lower prices. Illiquidity can work both ways depending on which side of the coin you’re on.
Glen: That was exactly the question I was going to ask about liquid there, because it seems like not only are some of these things, at least to me, they seem somewhat esoteric. But, I’m guessing that if you have to do so much research to get into it, you’re not going to turn these things around very quickly unless maybe you know the industry and like you said if you find opportunities where people are trying to get out; maybe one thing you kind of jump on that.
For these type of investments, how does a person even start to get some sort of expertise in this? How do you find that and then really get your head around it if you’re not part of the industry itself?
Kirk: Assuming someone’s not working with professionals. We’ve actually developed a network of different investments that we can access for clients. But assuming that you’re not working with a professional, I think it’s really important that people go with their strengths.
If you have a background in real estate, you’re an agent or you develop real estate or rehab and things like that, you should not be focused on investing in diamonds or investing in rare paintings. You should be focused on investing in real estate. I think that’s the most important thing.
This is true for the stock market as well. In the late 90’s, everybody thought they’re an expert to technology companies. Nobody had the foggiest clue but everybody was making money. So they just assume that it’s okay.
Glen: Just like the mid-2000s everybody thought that they can handle real estate too.
Kirk: Right. There are plenty of people who should have not even been anywhere near real estate that owned five or six properties. I think it’s important for people to focus on the areas that they know, that they can get their head around and grasp.
For instance; if you happen to live in a town, you have a local dry cleaner. They do very well but they’re looking to expand in the neighboring town. You know the person running the shop very well. You know the business reasonably well and he’s looking for capital. That might be a reasonable investment to make.
If you know nothing about the business, you don’t know the person. Somebody just said, “Hey, I need some money,” it’s probably not the best strategy.
I think with any investment, the same rules hold true. You need to know what you’re investing in. You need to do your research. If you’re not going to do your research, then you shouldn’t invest in it. You should find someone else to do it for you.
Glen: Yeah. I think we kind of touched on that in this show in various different ways. There’s no real shortcut to getting to that golden pot at the end of the rainbow. You really have to put a little grace into it no matter what you’re doing, right?
What are the advantages to somebody? Let’s say I’m willing to put in the work, I’m willing to put in the research, I really want to learn about whatever this one particular alternative investment is be it tax liens or type of real estate. What are the advantages in investing in something like that over just keeping something in the market?
Tax Lien Investing
Glen: I’ll use air quotes “in the market” because you know that could really mean anything also.
Kirk: I mean if you’re investing in let’s say tax liens for instance. One of the benefits is you do have predictable income streams. There are actually multiple reasons I like tax liens.
Every single State in US has it in their legislation, that they can sell their tax liens to investors. Every State allows it.
Glen: If I could just interrupt just for a sec for our listeners out there. What is tax lien and how is that something that’s sellable?
Kirk: Okay. Thank you for correcting me. What a tax lien is if you own a piece of property, you probably encountered this before, every quarter presumably require you pay your taxes. If you don’t pay your taxes, then you get accessed a late fee, interest rate.
Every state has a different interest rate. In my state I believe it is 14% now because I haven’t been late on my taxes. But, every state has this. Not every state will sell their liens to investors, but the legislation allows them to do this.
Let’s take a state like Florida. You’re probably asking yourself why would a state do this. A state like Florida pays out 16% interest rate let’s say. Around the time the taxes are due, there are a lot of people who own real estate in Florida that may live up north, so they don’t pay their taxes on time necessarily.
But, the municipalities in Florida need to run their operations. They need to pay the police officers. They need to pay people in City Hall. All these people require tax dollars to pay their salaries.
What a state like Florida does, where they have quite a large amount of people who don’t pay on time, the state could then say, “Well, we’re going to take our 16% and wait a year.” But they need it now. So what they do is they actually will sell these liens to investors who will get that 16% and the municipalities would get their money right away. So it’s a win-win for both sides. The tax payers are paying anyway.
One of the best parts of the liens in a state like Florida is the people will actually collect the taxes for you. As an investor, you don’t have to worry about collecting the taxes. The municipality will collect the taxes and then pay you when they pay you off. It’s really a good situation for investors.
Now a process you have to get through to get the liens would be; you’d actually have to go through an auction process. Some counties are online, some you actually have to show up in person. Every state is different with their process. But depending on the year, sometimes the liens are up in the 16% range. In a time period like 2007, they’re actually down to 25 basis points (.25%) which is lowest allowable amount that you can bid for a lien.
There’s a process you have to understand. But, now the new technology has increased quite a bit, it allows investors to take advantage of these places while not actually having to go to visit. Because of things like Google Maps and other technology, people don’t actually have to show up in a property to check out. They can look in various ways.
Somebody wants to get into the tax lien investing process, then they can learn. There are a lot of resources available.
Kyle: That is really interesting Kirk. I have not used to learning about new investing concepts on the show. I frankly have no idea that you can invest in tax liens. What sort of risk profile do these things carry though?
Kirk: Well, this is actually the best part. If you own a piece of real estate in US, you have a certain seniority of liens on a property. If you take on a mortgage on your property and you are the first mortgage, you have first right of collection. If they don’t pay the mortgage bill, you can foreclose and you will get back all of your money for what the property sells for.
The second mortgage, they’ll get second position on any remaining equity and thereafter. Now above that surprisingly, if you don’t pay the IRS and they attach your house, they actually have seniority over any sort of mortgage. They are the most senior person on that list. After that comes tax liens.
Tax liens take seniority over any mortgage. They take seniority over condo liens which are actually next in line of the process. Tax liens and condo liens are above any sort of mortgage which is interesting. Not a lot of places have the ability to do condo liens but those also are a nice source of investment if it’s possible.
But, tax liens have a superior position. What many people will do is they buy a tax lien. So a state like Florida for instance, you can bid as low as 25 basis points interest per year on the note. But, Florida has a minimum amount of 5% that they allow. So even if you bid 25 basis points, in the first year you will get 5% of that flat rate. There is some incentive for people to bid even lower than 5%.
Now, what typically will happen is if somebody wants to get paid right away, what they’ll do is they have a certain period of time that they can foreclose. So there are time limits. I think you have to wait two years for you can foreclose and within a certain period of time you have to foreclose. If you don’t, then you lose your right to.
But what a lot of people will do is as soon as possible they will initiate foreclosure. They will notify the bank and the bank will pay them off because the bank’s not going to lose their position to a $100 lien when the bank has $200,000 mortgage.
Glen: Let me interrupt you just one second and I apologize to stop you there. So when you’re holding a lien, you’re holding somebody else’s they didn’t pay taxes or whatever lien is put unto their home so they can’t basically get another type of loan without first paying that off. I’m correct there, right?
Kirk: Correct. So the lien holders and there’s many different types of liens. There’s also mechanic’s liens, another liens that go on the property. If you have somebody fixing your roof, you don’t pay them they typically put a contract or sort of mechanics lien on your house. What that means is that you cannot sell your property without paying them off.
Glen: Right. I remember when I bought my home like they have to do a big check and make sure there were no liens outstanding on it so this way that everything have go through.
As a lien holder, you can initiate a foreclosure on their home?
Kirk: It depends on the legislation per state. Think of it this way; if you live in a state like Florida, you didn’t pay your taxes for three years. The municipality is going to foreclose on you on some point. They’re not going to sit on forever. At some point they will foreclose on it. Most states will do this.
Like I said, every state has their guidelines for what they can and are willing to do. But if they want, they can foreclose anyway. So whether it’s the investor or the municipality, the home owner is not going to know because the investor doesn’t actually participate in the process except for the foreclosure procedures which depending on the state; they may or may not have to be involved in.
When it comes to the home owner, the investors are not putting them out on the streets. This is something that would happen anyway.
Glen: They’ve already gone through process of not paying something long enough that this is the expected consequence.
Glen: This isn’t like a guy with the crooked nose coming over to you as a loan shark going to you like, “I just bought your loan. Now you owe me everything,” You know, right? “But now I own you,” instead of a getting down there. Now it’s really that going everything to, right?
Kirk: States are very careful to protect the home owners as well. I mean, not every state will sell their liens. The state like Massachusetts, where I live. I’ve find it very hard to actually find the lien to purchase and they’re usually on pieces of properties that nobody would ever want to own for any reason whatsoever.
It’s very challenging and I don’t want to speak poorly about my state but I think they have the kind of friends and family plan for the lien auction business. Some states, there’re quite a few like Florida, Colorado. Some states, there’s so many that’s full access and there are websites you can go to that will show you house auctions and what they’re gone for.
But, in integrating steam of things it’s a process. The state does want to protect the home owners but that’s one of the reasons why they manage it as well which makes it so much easier for investors.
Glen: Imagine just even like buying a home, as an investment in property, it really depends on where you’re living and what state you’re in because different laws apply better to the owners than they do to the people who were living there. So, yeah. You really have to do your research as to where you’re buying them.
Kirk: Right. I’ll mention a little known that there used to be six large US banks that owned $200 to $300 million in these liens each.
J.P Morgan actually recently got out in the last two years. Apparently, they didn’t want to be seen on the front page of the paper for closing on granny’s home. But to my knowledge, five other big banks do own enormous portfolios of these liens because they understand that they’re getting a good yield with relatively low risk.
I met one of these people who manage these properties. When J.P. Morgan got out, he actually called me up and he said, “Hey, I want to start running a portfolio like this.” And I said, “What experience do you have?” He said, “I’m feet on the ground.” “Yeah, I know but that doesn’t make equate to running a portfolio, totally different skill set.” But, the here is the guy who for the right person, that would have been a perfect add-on for somebody who wanted to run a portfolio, $200 million.
I think in general, it’s like I said one of my favorite asset classes and from a portfolio perspective, there’re very few people who are actually managing tax lien portfolios. We’ve considered actually doing that ourselves, but the logistics are extremely complicated.
There are a lot of $100 price range liens. You could probably go to Florida any day of the week and find the $100 lien for 16%. So if they don’t get auction off, they’re pretty much they will give it to you for 16%.
Glen: So like a layperson could get their feet relatively lower cost maybe low risk type of like use a 100 bucks there, nobody wants to lose a 100 buck. you floated a number before so like 250 million. I think most of us aren’t really going to touch that range. If I did, I would have a whole bunch of different…
Miranda: We wouldn’t be doing this, right?
Glen: Maybe, but right. We’re going to have a whole bunch of different problems to deal with. For a person is that something that can be an entry point for them or?
Kirk: I think there are a lot of alternative investment such as private mortgages and real estate which are very challenging for people to get introduction to without taking a lot of risk. Tax liens is one of those areas where it’s very easy to get involve with, with a very little amount of money.
You could contact the municipality, look to the liens and say, “I want this $100 lien.” You give them a $100 and they give you the rights of the lien. From my perspective, that’s a very easy entree low-risk way for most people to get into the tax lien investing business. If they lose a $100, it’s not the end of the world. I know people that will buy quite a number of $100 liens because they’re paying 16% and they’ll do virtually no do-diligence on the property.
If they happen to find a swamp land, they’re okay with that because out of all liens, they’re losing one, they’re getting 16%. It’s kind of a cost to doing business.
Glen: Like if you get enough of them, maybe you mitigate the risk among all of the different loans.
Kirk: Correct. Diversification effectively. It does work from that perspective. Quite frankly, even if you’re investing in a number of liens, really your biggest risk is if you do foreclose and, if you’re doing this on a grand scale, approximately 5% of the liens you will be able to foreclose and actually own the property. So you could own a $100,000 property for a $100 in a 5% of the cases.
Now, I’m not suggesting that that’s going to happen all and often but that statically what the odds say. You could make a lot of money. The downside to that is if you foreclose and you don’t realize that it’s on a toxic waste dump, then that would be an issue.
But, the worst case scenario is you foreclose, spent a little money. Instead of $100, maybe you spent 500 or 1000 on attorneys and you own it. But if you find that out, you can easily just not pay the taxes and someone else will buy that lien.
Glen: It’s interesting like you’re talking about this and it sounds so interesting, but like I think you said in the beginning of the show, you really do need to kind of know what you’re doing. This isn’t something that to play around with in your spare time and hope to get rich.
Kirk: This is not a get rich quick scheme by any means. You need to do your homework. There are a few books written about this. There are people who specialize in this.
It’s really a great thing for people to break their teeth on with a small amount of money. But in general, like any alternative investment, you need to know what you’re investing in. If you want to gamble on your money, go to casino. It’s easier. At least you get some free drinks.
Peter: Talking about diversifying earlier, you know really is that part of the alternative investments is that you’re diversifying against stocks and bonds and normally what people buy in the stock market. You’re maybe buying some assets that aren’t necessarily as closely tied to the rise and fall of the stock market.
Kirk: That’s actually a great point and if you look at some of the top ivy league universities in US, you’ll realize that over 50% of their assets are invested in alternative investments. That amount is actually increasing. The reason is because just like you said that diversification is an important tool.
We did a study back about 7 to 8 years ago about correlations in stock market, bond market, publicly traded market as you can say. What we found is very interesting. What we found is that when the stock markets, when I say stock market I mean stock market, bond market, any sort of publicly trading market.
Diversification is important because you never know what’s going to do best. So you really kind of moderate your return and you find kind of equilibrium in many different market. But when the market crash, they all crash together. The correlations come really close. So diversification within the publicly traded markets are not actually doing you much good.
There are times where it does help. In 2008, if you look at the numbers and we looked at commodities, stocks, withstanding treasuries, gold and cash; you’re more or less down around 38½ %, give or take 5% in that in 2008. It’s crazy! That should not happen, but apparently within bear markets that tends to happen in other period of time as well.
So a lot of people are comfortable in the fact that they’re diversified but they’re not as protected as they believe that they are.
Miranda: I’m sorry because that kind of goes back to I’ve talked to a few hardcore people who say like modern portfolio theory is like dead. And, if you’re just doing stock and bonds, you’re not truly diversified. Would you stand on that or where are you at there?
Kirk: I think if you look prior to 2000, there were a lot of studies done and they show certain things, modern portfolio theory. We ascribe to that to some degree. I think in a large part that is true. Unfortunately, another study that we’ve done which we haven’t published yet is even more interesting.
If you want to know why the correlations have become so close, it’s a lot more interesting. The reason is that it’s because institutions get into a market, they’re the ones that correlate it. So stocks, bonds, anything publicly traded; institutions are in those market so those are correlated. Real estate, a lot of the large pension funds and institutions and endowments started investing in real estate in the mid 2000’s. All of a sudden, real estate became highly correlated with everything else.
That also includes timberland. Back in early 2000, 2001, I read a study that timberland had a correlation to all publicly traded market close to zero is -.02 which is as close to zero as I’ve ever seen. Now, timberland is highly correlated to the stock market.
It should have absolutely no barring on it but yet it does because institutional money flows push the markets where the institutions want to go with their funds. This has happened with managed futures in 2003. Their correlation was almost non-existent. They were probably the best non-correlated asset you could find in terms of how they work because it was a traded portfolio.
They’re just trading. It wasn’t buy and hold. They were a great asset and a lot of institutions started putting money there and now they’re also highly correlated.
The culprit of all this is institutional money flow and they’re the one that cause it to be correlated.
Glen: Again, just definition wise for those out there who maybe this is getting a little heavy for them. I think I could follow what you’re saying here. But, what do we mean by the institution? You’re talking about the big banks and brokerages and houses?
Miranda: Like college funds and pensions.
Kirk: Yes. Pension funds like Calpers, Harvard University, Yale University, endowments, large institutions, institutional management like hedge funds, people who are managing billions and billions of dollars. Those are people who can push a market at a click of a button because they have a huge amount of money to place.
I mean Calpers is a perfect example. They invested at real estate at the peak of the market and at the bottom of the market they pulled out. They moved so slowly because they have so much money. But, if they want to get into an asset class, they’re going to get in because for allocation purposes or whatever they see as best fit what they’re doing.
What a lot of people don’t realize is money flows or one of the more important aspects of how investments perform. So if you can look at the Federal Reserve’s of effect of quantitative easing that has pushed money flows into stocks. So all the big institutions or many of them were pushing money into stocks which of course pushes the stock market up.
It’s not always just, if companies are growing, then their price should go up. It really not is more influenced by institutional money flows than any sort of other rational thought which is unfortunate, but that’s seems to be the trend.
Glen: So the market theory itself is being influenced by the fact that it’s not really the pure market that’s driving it. It’s these other factors that have so much money in there that when they act, it moves the market more than should be natural maybe.
Kirk: Correct. If you look at it right now, many markets around the world are dropping. Emerging markets, Europe, bond markets in these countries as well, they’re all dropping for many different reasons. In the US, economy is doing well but yet it’s highly priced.
One of the reasons it’s highly priced is because all of these international investors are looking for where is my money safe? Well right now, it’s safe in the US. But if you look back in August, about a month ago when US market’s crash, if you look at what did well, it was the German bond and the yen that did really well during that time period.
What that tells me is people from those countries pull their money out of the US and brought it back home. So you see a lot of international investors pulling their money out. That’s really going to be in my opinion one of the triggers of the US to perform more poorly.
It’s not because our economy is not doing well. Our economy is doing fine. But, as I said many times in the past that the economy is not the stock market. I don’t think a lot of people realize that.
Kyle: When I’ve read about this Kirk and the correlation like you hinted out was relatively recent between a lot of these liquid asset classes. A lot of people that I’ve read were speculating that. A lot of these guys that are pushing these money around these billion dollar guys; when they’re losing money in one asset class, either on a margin call or to cover their losses and keep cash full consistent, they often have to sell things that have no inherent or fundamental weaknesses and that’s why these things are correlating?
Do you have any insights on that or are they full of crap basically?
Kirk: That’s actually a great point. I actually believe that to be a 100% true. If you look at 2008; it’s a perfect example of this.
In 2008, the banks effectively were, I don’t want to call them insolvent, but they were effectively insolvent and they held a lot of assets. Hedge funds as well; they held a lot of assets. But, what happen is that the liquidity of the market froze up, which means that there was not a lot of money to buy. Everybody was stuck; a lot of people were stock in assets or leveraged assets.
If you own an illiquid asset and the market is dropping, you need to get out. Or around the time of the end of September, hedge funds that’s when they have calls. That’s when investors pull their money out.
If they need to pull their money out, these people need to raise their capital. But what are they going to sell? They’re going to sell position that is liquid, that is easy to liquidate and they can actually make money on it or are they going to sell a poor position that will take them five weeks to get out of without pushing the stock price.
What ends up happening is they sell their good positions instead of their poor ones so then it brings everything down to the same degree. That comes back to the same argue of the money flow. It’s not necessarily a rational thought. It’s correlated because of the money flows; not necessarily because they’re bad investments.
In 2008, there were a lot of great buys you’ve could have had; not because they were bad stocks but because people needed to dump them because they needed cash and no one had cash.
Glen: It’s really, really interesting talking to you and listening to this because like you said the market isn’t the economy. I think we watch the news and you hear all these unsteadiness about the market but then you hear about companies that are making record profits. It’s hard to get your head around how that’s possible, how can the market be kind of wishy-washy when Apple is selling quadrillion iPhones over the weekends.
But now the way you’re talking, you kind of get the fundamental feel for how the market really is influenced. It is very interesting how finicky it could be.
Kirk: I think there’s one point I’ll make because I think you’re kind of alluded to another point is that right now, interests rates are effectively at zero around the world. So if you’re investing in bonds, you’re making no money.
A lot of these investors feel they need to make money. This kind of goes back to a more elaborate concept which I won’t get into now. But, a lot of this is all based around on the theory of inflation.
For the last 60 years, people have assumed that inflation was the norm. If you go prior to 1950, inflation-deflation were more natural forces. They came and they went and they balanced out the market. We haven’t had deflation for a long time so people forget about it. They forget what it feels like.
But what people assume is that they need to make a return in order to out pace inflation. But we don’t have very much inflation right now. But people still have this psychological thing built into them that they feel they need to beat inflation.
If you have zero percent interest rates, you’re not making money. You feel like you’re losing in the long term. So they feel they need to take more risk. They need to buy dividend stocks that are paying more than zero. So they’ll buy something paying a 1% dividend which is really not that great. But they’ll chase yields; they’ll chase anything they can.
I think this was about a year ago, high-yields bonds reached the lowest yield they ever reached. It was around 5%. I mean, historically speaking, high-yield bonds default at 7% and you’re getting 5% a year.
It’s ridiculous. You’re effectively losing 2% over long periods of time. That assumes you’re not going to have a big crash in a high-yield bond market which a lot of people suspect.
Glen: It’s crazy that you say high-yield bonds are 5% when I remember it wasn’t long ago that my savings account gave 5%.
Miranda: Yeah, I remember those days. Those days are long gone.
Kyle: I actually don’t remember those days.
Glen: I’m a little older than you Kyle. But it wasn’t that much far ago. Can you tell us something about self-directed IRAs and how those can beneficial?
Self Directed IRA Investing
Kirk: The term self-directed IRA doesn’t actually have the legitimate meaning which is interesting.
Glen: We’re just really going off like that.
Miranda: It’s sort of when they call a spouse or IRA, right? Isn’t that a real meaning? IRA that spouse could contribute so.
Kirk: If you look at the tax code, there is no word self-directed IRA. Technically, every IRA is self-directed. If you kind of go back to the basics; that’s really what an IRA is it’s something you’re directing it yourself.
The term self-directed IRA; I don’t know when it was actually coined but I believe it to be probably about 20 years ago and they use it to define an IRA that will hold non-publicly traded securities. So if you wanted to own a force in your IRA or piece of real estate or tax liens, or gold or whatever you might want to own.
Glen: Baseball cards?
Kirk: You cannot own baseball cards. Potentially on a company that trades and invest in baseball cards but not baseball cards. Baseball cards are to be considered a collectible. So there are a few things you cannot invest in inside of a self-directed IRA. One is collectibles which includes wines, certain coins, baseball cards, things like that. You cannot invest in life insurance on yourself or an S-corp; virtually anything else you can invest in.
People will get very creative around this. But, what it really does is it allows investors to invest in what they know. A perfect example is a real estate investor. If you ever met one, you know only they want to own is real estate. Every nickel they earn goes right back into real estate. They do not believe on anything else.
If you tell them you have to put money on the mutual fund, they want to strangle you. They hate that. Many of them will not even contribute to their IRA or 401K because they don’t want it going to something else.
Really it benefits people to understand that they can do these things because they can truly invest in what they know and not have to put money away and invest on something they’re not familiar with.
Miranda: Pretty much like you said. The only things you really can’t put in your IRA like you said collectibles, life insurance and in some derivative positions. But, almost anything else you can. You’re alluded to the fact that some coins you can’t hold in your IRA?
Kirk: So there’re certain sovereign coins which were allowed to be held if they’re minted by the sovereign and they’re gold, silver, certain materials. Those can be held inside of a retirement plan; an IRA or 401K, but not all of them. The IRS clearly outlines which ones are allowed and the required purity. There’s a lengthy thing. But if you want to invest in like collectible coins or rare coin, you couldn’t do that.
Glen: Very, very interesting. What are the advantages of putting it in the self-directed IRA. I mean, you said something about like, “I could put a race horse in there.”
Kirk: We actually have a client who invests who has a farm and he trains dressage horses. Then if you don’t know, if you’re like everybody else I’ve ever met, you don’t know what a dressage horse. I didn’t know this quite either.
Glen: It’s not expensive?
Kirk: They are. You can ask about what dressage horses are. They’re effectively horses that dance. They compete but they’re dancing horses.
Miranda: The Romney’s have one.
Kirk: I bet they do.
Miranda: I remember that from the campaign and she was talking about the horse. Okay, go on.
Glen: That might be part of the reason why people might have said he was a little out of touch of the…
Miranda: I can’t imagine.
Glen: That’s a whole other issue.
Kirk: Because she left the dog on top of the car.
Miranda: I’m sorry I interrupted your awesome explanation of how you keep your dressage horse in your IRA. So let’s go.
Kirk: Alright. What this person did is he buys horses from Europe and he brings them over and he trains them and he sells them to people like George Soro types. And, he makes a very good return in doing that and he did that within his Roth IRA.
He made a 100% plus returns in Roth IRA which is effectively tax free for him. Believe it or not, you mentioned Mitt Romney, he has a $100 million IRA because of tactics just like this. Not because he is a great investor but because he had some great investments scenarios that he knew well and they happen to do really well.
If you’re investing in investments you’re getting your 10% per year, you’ll probably not get to a $100 million. But, if you’re doing certain things, like these individual invested horses, he’s getting a 100% return on investment. I’ve seen people make many thousands percent return on investments but they’re in investments that they know.
For instance, if they wanted to flip a piece of real estate; I will give you one little creative little tidbit for you. To some people flip properties. They’ll find a good deal. They’ll lock it up for a $100 or a $1000 and they’ll flip it to somebody for $10,000 or $20,000 to make a quick profit. A lot of people do this.
However, let’s say you decided to do that in your Roth IRA. You just turned let’s say a $1,000 into $10,000 and you did that maybe in a months time. That’s a pretty good return for a short period of time. Not to say that you can do that every week but I think you don’t have to do it too many times to get a decent return of your money.
There are many creative ways that you can use your self-directed IRA to continue to make good returns on your tax deferred or tax free money. The best part I like about working with self-directed IRAs is not only the creativity you can use to keep this money sheltered and to get good returns, but more importantly we see some incredible investments out there that I mean I’m astounded constantly by things that people bring to us that are just absolutely amazing.
Miranda: If you’re going to use this technique, you can’t just like go to your bank for the most part, right? And just open it up because most of them have specific custodial guidelines, isn’t that right? You have to go to kind of a specialist to be able to do this.
Kirk: What is required, what the IRS requires for an IRA or 401K is a qualified custodian. Now, they have a very specific definition of this. But, if you go to your local broker dealer like Fidelity, or TD Ameritrade, or an E-trade, or Schwab. They are custodians. They could invest, They could help you with this.
However they have chosen not to for the most part. They’ve chosen to specialize in publicly traded securities. You not only to find a qualified custodian, but you have to find one that actually can and wants to do these types of investments. Quite frankly, then if one of those brokers did want your business, I wouldn’t use them because they’re not equipped to deal with this. It’s more complicated than most people realize to deal with this in the custodian side.
We’ve actually compiled a list of all of the self-directed IRA custodians and administrators that are legitimate that people can choose from. Now we’ve put together a number of resources to help people out to do do-diligence on them, but there are many things that people have to consider. One is the fees. These are not fees as you would expect one of these other broker dealers. They’re not $10 a trade.
They in some cases charge per transaction. They might charge for wire transfers, or they might even charge at percentage per asset that they manage. They have different fee structures based on the type of business that they’re running custody for. So fees are important part of the equation.
One of the more important parts of the equation is service. Some of these custodians are quite large and their service is not good. You might have problems and if you’re trying to buy piece of real estate, you need somebody who’s on the ball. You need somebody who’s going to sign the documents and make sure they’re done properly and get the ball rolling so you can meet your deadlines.
If they drop the ball, lose paper work and don’t get back to you and all these things happen you could lose a deal. So it’s very important when you’re working with a custodian or the administrator to make sure that they’re doing it properly and they provide really good customer service. That is a very important part of this process and that’s not something you can easily quantify.
What they put on their marketing materials is not going to show up. You really have to have insight or knowledge who’s good and who’s not. Those are some of the more important factors that people have to consider.
Some of these factors will depend what kind of business you do. If you’re buying one piece of real estate and you’ll never going to sell it, then it doesn’t matter what the transaction fees are. You can look for custodians where you’re finding a cheaper cost. But, if you’re turning over investments every week, you really don’t want to pay transaction cost because that’ll be very expensive. You want to make sure that the custodian you find is suitable for your needs for what types of investments you’re trying to pursue.
Glen: Now imagine when you’re using a self-directed IRA, there’s some limits on what you can do with the money if you’re selling an investment or moving it around.
Kirk: You have to understand generally how it’s structured. If you’re buying a piece of real estate; you have to look at your IRA from a different lens. So you have to look at your IRA as if it’s the neighbor on the street that you really hate.
You wouldn’t lend that person money. You wouldn’t fix their roof for free. You have to look at this as a third-party. You cannot do business with your IRA.
For instance if you own a real estate, then your IRA, you can’t go fix the toilet. You can’t go fix the roof. You can’t take rent money and put it in your pocket.
Actually, the IRA owns the real estate. You don’t even do the transaction. Custodian actually will sign all the documents, not you because it’s not you effectively. The IRA is like its own person.
Glen: It’s almost like a trust-almost sounding.
Kirk: Well IRA is technically are a trust although nobody refers them on that way. They are technically a trust. So you have to look at it as a completely separate type of entity and transaction. If you look at that way, it will be fine but a lot of people get into trouble because they think that they can either outsmart the IRS and they found a loop hole. Believe me, there are no loop holes.
A lot of people come up with what they call a checkbook LLC IRA, which is a very commonly used term in some coordinators out there try to sell that as, “Hey, we’ll create and LLC for you and you can use it.” And people think they can somehow circumvent the rules of the IRS. The rules don’t differ because you have an LLC.
All that means is it’s harder for people see what you’re investing in and makes it a little bit easier in some ways to do business. But, it doesn’t give you the right to break the rules because people think they can beat the IRS, they can’t. We’ve seen so many instances where they…
I’ll give you and example, there was an engineer; a guy with a kind of engineer background. He was investing in bus shelters. This guy knew the rules inside and out. He’s very focused on the rules, not breaking them. He did everything right and this guy made a lot of money inside of his IRA. He had to use a qualified custodian.
We’ll apparently, the person who he was using said they were qualified custodian and actually they weren’t. So the IRS, when they found this person, they went through this guy’s client list and said, “Oh look at all these people who think they’re using a qualified custodian.” Of course the IRS has no qualms about going after people even though they’re innocent.
They went through every single person and they contact and said, “You created prohibited transaction. You owe taxes as a full distribution on this date.” They don’t find you right away because if they can find you right away, you can correct it. They find you six years later. That six years of interest and penalties compounded overtime.
I mean this person virtually lost his entire IRA because of something he had no control over and didn’t deliberately do. Fortunately, the judge took pity on him and gave him a one time transfer of money into his Roth IRA but it was a travesty.
I think people have to be weary that they’re following the rules to the T because it’s not the right now issues. It’s the down the road issues that hurt.
Self-Directed IRA Custodian
Miranda: How do you make sure your custodian’s qualified? Because it sounds like this guy picked the wrong person to trust. So how do you find that qualified custodian?
Kirk: We’ve classified these vendors if you will in different categories. There are custodians or qualified custodians and you can find these people; many of them are registered; most of them are non-depository banks. We’ve created a list on our site that we update consistently. They’re not that many; I think there’s like 22 of them out there.
There are other ones that may do it but generally don’t want the business. But if you went to your local bank, they would qualify. They may not want the business but a bank would qualify as a qualified custodian.
There are administrators and these are people who if you’ve ever had a 401K plan they are what you would call TPA or Third-party Administrator and they would administer the plan and deal with certain tax related issues and things like that. There are people like that and they will administer your IRA for you. What they will do is, they’re not qualified custodians; they will find a bank or trust company and they will setup accounts and they will administer the process.
They could go to whatever your local bank is and they could setup an account and they would administer it and act as it would be as if you went to TD Ameritrade and somebody was administering the account for you. That would qualify.
There are administrators that are legitimate out there and I think there’s probably about approximately 22 of them as well. They will help you and they have track records because they’ve been around for awhile.
There’re also people who refer themselves as facilitators. This is a confusing category for people. Actually I’ll label two other categories so it is clear.
There’re investment sponsors. These are people who sell product; they’re trying to sell you some investment product and sorts. Then there are licensed professionals.
The facilitator category are people who don’t really fall in the category. They’re trying to sell you something. They might be an investment sponsor trying to sell you a product. They might be trying to sell you an LLC or some sort of arrangement. But, they really don’t provide much value.
It doesn’t mean that you shouldn’t work with them or they’re bad people but they’re not really required. You don’t need them. We kind of refer to them as coordinators. They’re there to help people but you don’t need to use them as kind of like an extra cost.
The problem is that the industry itself is not well regulated and there’s not a lot of oversight. So the qualified custodians do have oversight. They have oversight from the OCC, or the state banking regulations or other regulators. All of them have some sort of oversight. The administrators, some of them have oversights, some do not. Facilitators have no oversight.
Then there’s licensed professionals like myself. There are CPAs or attorneys who also specialize in this area. They have some oversight.
There are some people who fall into this miscellaneous category and they might be good people. They might provide value but I think that’s the category that people have to be weary of because many of those people do not make clear who they are and what they do.
While some of them might be okay, people have to really be careful because there’s a lot of misleading advertising out there that say, “Hey, you could invest in real estate in your IRA and make x amount of returns.” Really they’re trying to sell you some real estate property they have they’re trying to rid. That happens a lot.
There’s a lot of bad players and every once in a while we see somebody gets caught for doing something that probably they shouldn’t have done. People have to exercise a good bit of caution when they’re investing in this.
Glen: Yeah. It sounds like not only you need to do your homework in the investments themselves, but depending on what you’re going to do with that investment. You might have to do really a lot of homework on the brokers as well.
Kirk: We’ve done a lot of this due-diligence. We’re actually creating a thick report on each one because we have experience. So people can actually figure this stuff out. We’ll have pretty thorough nature on some of them. But to some degree, even some of the legitimate ones, sometimes things happen.
For instance, one of the larger ones few months ago got implicated by the SEC for fraud. They weren’t committing the fraud. It was one of the investment sponsors that was involved with them, selling products to people.
They weren’t committing the fraud but the SEC doesn’t care. They said, “Well, you custodied the assets so you’re in trouble.” I don’t know if they’ll ultimately be in trouble because I don’t think they did anything seriously wrong. But, fraud happen because people see, “Hey, you can use your IRA money,” and they sell people in a dream and there’s no oversight and all of a sudden they think, “Oh, I got this great idea, why invest in stock market?”
There’s a good amount of fraud that happens. The SEC has put out a notice a few years about about self directed IRA fraud; number of steps that people can do to be careful and to actually prevent these things from happening. I think there’re steps that people can take.
I found that if people are actually using a licensed professional, they’ll protect themselves from a lot of problems and in many cases you actually need one. You need an attorney to do you some sort of legal documents with the transaction.
I think it’s in people’s best interest to at least initially. Some people are experts; they can do it themselves. But at least initially they should use some licensed professionals that they know does it.
If you are in a small town and you have a local attorney or accountant; I can guess that the vast majority of those people got no knowledge of how to do this or how it works. There’s only a small percentage of people who specialize in this in those different fields because there just aren’t that many people doing these transactions so there’s no reason for people to know the rules inside and out, but there are people who specialize.
There are attorneys and accountants each state that do this. There are ways to find these people. We’ll probably work on that as our next project as well as printing a big list of those people.
Glen: Kirk, you suddenly dropped a lot of information on us. I know my head is spinning a little bit. But at the same time, it is nice to know that there are some real alternatives out there that aren’t these wacky things. But there’s really things that if I wanted to get into and get my head around, it could open up a whole new world of opportunity for.
One thing we do in the Money Mastermind Show is at the end of the show we sum up everything with a final word. So we’ll go around and take everybody’s opinion here. Peter, what’s your final word on alternative investments?
Peter: My final word is we like to talk about diversifying when we’re investing in stocks and bonds and so forth, but there’s something I honestly haven’t really thought about a lot. This sounds like this could be a good way to kind of diversify even further across different types of assets and managing your risk even keep it further and assets as necessarily is correlated are tied to the stock market.
It’s definitely, you need to do your due-diligence and make sure you’re sitting down and evaluating these investments and make sure they’re suitable for you; that they’re something that you understand and you can figure out. You’re not just investing in the first thing that somebody brings to you at after church on Sunday or something like that. But, it does seem like it could be definitely a very good thing.
Glen: Miranda, what’s your final word on alternative investments?
Miranda: I don’t know ditto Peter.
Peter: I’m sorry Miranda.
Miranda: I just echoed that. Make sure you know what you’re investing in. It goes beyond just due diligence. It goes back to what Kirk was talking about earlier when you said you need to understand what you’re investing in.
One of the reasons why I’m such a big indexer is because I’m so lazy. I don’t take the time to learn about these things and really get into it so I index.
But if you’re going to do this, make sure it’s something you truly understand so that you can move forward and feel a little more confident and you don’t taken advantage of, and that you can kind of follow-up on whoever is advising you. Because even if you have an adviser for a reason, at the same time it’s sort of like my tax-accountant.
I usually double check what he has done. I mean, obviously he knows more about it more than I do but I still kind of look it over just to make sure because you really do have to. It’s like Larry Ludwick Lori Ladd what always says, “Nobody’s going to take care of your money like you do.” So make sure you pay attention.
Glen: Yeah. This is definitely has been an interesting lens into what maybe the wealthy do to increase their wealth. A lot of people think it’s really just about stocks and bonds and maybe some real estate but really there seems to be this whole other world out there that people invest in and use as a means for building wealth. Thank you so much Kirk for helping us there.
What is your final word on alternative investments?
Kirk: I guess I would say as I mentioned before one of the most important things is knowing what you’re investing in. So doing due diligence on any investment. It doesn’t matter if it’s alternative or traditional. Due diligence is important.
If you don’t know how to do due diligence properly, find someone who does or read. There’s one thing that I think a lot of people miss is they think that they have money so they need to invest it right now. Cash is a position. There’s nothing wrong with keeping cash. If you don’t have anything to invest in, keep it in cash.
It’s like the casino. If you show up with the $1,000 in your wallet, it doesn’t mean you have to gamble with it. It’s the same thing with investing.
Take your time. Do your proper due diligence. We do a lot of risk management which is can be combine with due diligence and a factor is finding ways to reduce risk in portfolio.
If you want to stock, you can use options to mitigate your risk which is what they’re truly intended for. A lot of people don’t use them that way. But in other ways you can manage risk by buying insuring some property or finding ways to reduce the risk of your investment. That is also an important factor.
I think if anybody is getting into a new area, they need to figure out all those things out. If nothing else seems for the first time, use someone who knows what they’re doing because there are a lot of complicated areas that people need to understand like tax liens. Don’t start big, start small. Just figure it out and then once you understand it well then you can put more money into it.
I will make one final interesting point because you all have your own blogs and I think this is one of the more interesting things that we’ve come up recently. Another interesting alternative investment; you can invest in URLs for affiliate sites in your IRA or 401K.
Miranda: I’m like… 401K and IRAs.
Kirk: Yes. If you start an affiliate site, you could use retirement accounts to shelter that income. You can be very creative and like I said it goes back to investing in what you know.
Glen: Very, very interesting! I think you kind of popped some brain cells in all of us there. It reminds me a little bit.
Kirk: Save that to the end.
Glen: Thank you again Kirk. I really appreciate you bringing on knowledge both to us and to our viewers and listeners. For those out there that may not be familiar with you and the work that you do, can you please tell them a little bit about what you do and about InnovativeWealth.com.
Kirk: Sure. Once again my name is Kirk Chisholm. I’m a principle and wealth manager at Innovative Adviser Group. Website is InnovativeWealth.com.
As wealth managers, we manage money for people. We provide financial planning services and other ancillary wealth management services for people that need them. We are unique as you can tell; working with alternative and self-directed IRAs. But, one of the most important things that we find with what we do is risk management which I think is an overlooked skill set with many in the wealth management profession.
Glen: Excellent! Thank you again Kirk and thank you everybody out there for listening and watching and until next week, be good with your money. Goodnight.
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