The Tax-Free Retirement Strategy 95% of Americans Don’t Know About

Host:
What if the wealthy have been using a retirement strategy that 95% of Americans don’t even know exists? While most people struggle with market volatility in their 401ks, a small group of savvy investors are building tax-free empires through self-directed IRAs. Please note, this episode is not for the everyday investor. Even though this is an introductory episode, it’s still an advanced discussion, so keep that in mind if you want to listen up.

Host:
Alright. Hello, hello, hello and welcome to the Bigger Pockets Money podcast. My name is Mindy Jensen and with me as always is my fabulous co-host, Scott Trech.

Guest:
Thanks, Mindy, great to be here. I don’t have a pun for fabulous today. I have instead a quick short story. Every morning, we wake up our two and a half year old and we comb her hair and put her in the in in the bathroom and get her ready for school and all that kind of stuff, and we tell her she’s at the salon and at the end we ask her how she looks and she says, “I look fabulous.” Thank you for calling me fabulous today. Um, Bigger Pockets has a goal of creating 1 million millionaires. And specifically, we’re really working on this kind of two and a half million dollar net worth that enables real, true personal financial freedom and escape from the middle class trap. So you’re in the right place if you want to get your financial house in order and potentially use that 401k or self-directed IRA, um, or the new tool of the self-directed IRA to escape from that middle-class trap because we truly believe financial freedom is attainable for everyone, no matter when or where you’re starting. And we hope that the advanced discussion on this episode, um, is a helpful reference for you in years to come, um, as you just are aware of this option, um, with your 401k or self-directed IRA funds. Um, we are so excited to be joined by John Bowens today. John is the director and head of education and investor success at Equity Trust Company. Equity Trust Company is a partner of Bigger Pockets. Uh, we have partnered with Equity Trust Company to provide exclusive benefits to real estate investors who want to set up self-directed IRAs or facilitate 1031 exchanges. We couldn’t be more excited about this partnership and I think you’re going to find that John is an absolute freaking master at all things self-directed IRAs. And I’m not going to pull punches. I’m coming right at him from the beginning of this thing. I see major problems with using a self-directed IRA to invest in a traditional rental property. I see five of them. I see the problems with it losing tax benefits. I see problems with, uh, uh, potential income tax requirements like UBIT or UDFI, complicated topic we’re going to get into. I see problems like not being able to get a 30-year fixed-rate Fannie Mae insured mortgage, which I think is a superpower of real estate investors outside of the self-directed IRA. I see problems with not being able to self-manage the property or materially participate in rental rental activities, um, or partner with prohibited persons like family members. I see problems with major fees and headaches that can pile up when you when you attempt to open up one of these self-directed accounts, um, renew it on an annual basis, file, file certain types of, uh, paperwork with the IRS on an annual basis, and facilitate transactions like forming an LLC or buying properties. Those are real and John is not going to shy away from them, but we’re going to have a great discussion about it and talk about the nuances and when and where it still might be a useful tool for certain of our members who want to invest in real estate using an a self-directed IRA. We’re going to sprinkle in some more advanced topics, but we’re going to really get into the advanced topics over the course of the year. um, later on as we begin exploring things like pairing real estate uh investment syndications, private lending and those types of things with 72T, Roth conversion ladders and more of these advanced strategies. Um with that, caveat, John, welcome to the Bigger Pockets Money podcast. We are super excited to have you on today.

Guest:
Oh, I appreciate that, Scott. Thank you. And uh, Mindy, thanks for for the introduction here. Uh, so this is the the great, I’ll call it self-directed IRA debate that’s been going on for now over 50 years. So the the IRA itself just recently celebrated its 50th year anniversary. Back in 1974 when the employee retirement income securities Act was passed. And out of that act it laid the legislative foundation for the IRA, and then eventually the SEP IRA, fast forward to the late 90s, the Roth IRA, which came about in 1998. Then the early 2000s, the solo 401K. and we can talk a lot about the solo 401k and some of the advantages there. And certainly focusing on Roth and Roth Solo 401K from a tax advantage perspective. But when the law was written back in 1974, and I thank our legislative leaders at that time, because they made the law exclusive in terms of what you can invest in, not inclusive. So they only tell us what we can’t invest in, not what we can invest in. And that’s why we can own a single family rental property in a self-directed IRA. Why we can invest in a real estate syndication, a partnership, a private credit fund. And in terms of real estate, and Scott, I’m glad that you brought up some of those points because I find that in the real estate industry and in the, the real estate education space, there’s a lot of generalization in terms of what one should do and what one shouldn’t do. And I think that you have to look at one’s individual situation and you need to look at where is their capital now? You brought up a great point, Scott, which is what if someone has a majority of their IRA or 401K or other retirement account capital. What if they have a majority of that in an IRA or an old 401k? So that’s going to be much different than someone that maybe has less money in their retirement account and more wealth outside of their retirement account. In terms of investing in single family rental properties, just, you know, sort of right out of the gate, I can give you examples of, you know, whether it’s myself or other investors out there that are utilizing their self-directed IRA funds and some of the use cases and where it can make sense. A good example is, I have a, local, you know I’m from Cleveland, Ohio, Scott. And I work with a local investor here and he bought a house in 2020 for $63,000. Now I know you can’t find a house for $63,000 all across the country. Okay? This is the Cleveland, Ohio market. But he bought this house for $63,000 with his self-directed retirement account. And then in, and then two years later, he sold the property for 115,000. He had it tenanted, cash flowing, and he actually sold it to an out-of state investor and he ended up making a 32% annualized return on investment and he saved $5,000 in taxes. So that’s a perfect example of where it made sense for that individual to use their self-directed IRA. I will agree with the fact that there are some opportunities that make sense inside of the self-directed IRA or self-directed solo 401k. And then there are other opportunities that just make sense outside of the self-directed IRA. And so it’s not really the self-directed IRA is competing with non-IRA funds. I don’t look at it as a competition, but rather I look at it as a rising tide. Opportunities inside and opportunities outside of the self-directed IRA. And the last thing I’ll say, Scott, and then I’ll back to you for any questions that you have for me on that is, in my experience doing this for close to 20 years, studying taxes, studying tax strategy, working with some of the top CPAs and tax attorneys in the country and reviewing thousands upon thousands of self-directed IRA transactions, being a self-directed IRA investor myself, what I have found is the areas of complexity in terms of the the tax code and the tax law, the air the areas of complexity, those particular areas are where opportunity thrives. So where complexity lies, opportunity thrives, is what I always like to say. And so when we talk about self-directed IRAs, there are areas that are complex. There’s unrelated business income tax, there’s understanding depreciation and how that works. There’s understanding the tax-free payout of a transaction within a Roth IRA versus a traditional IRA. There are the private transaction rules such as what you said, Scott, can you manage the property? Can you not manage the property? So there are these complexities, but once you learn and you understand, you’ll find that often times there can be a lot of opportunity within the self-directed IRA, Roth IRA, solo 401k or even an HSA. A lot of people don’t know that you could self-direct an HSA account.

Guest:
Let’s go through the rental property example first here in in fairly good detail because I think it’s important to kind of just describe it as it is, like what what is what is it in a realistic sense because I I agree, I think there’s some use cases for the self-directed IRA to invest in real estate. It’s just as a generalization, I like to I like to prioritize investing in traditional rental property outside of my 401k. If I was an airline pilot with a million dollars in my 401k and that was my main source of what I wanted some exposure, I would absolutely be interested in this tool. Um, but I want to go in eyes wide open um with what those risks are. So the first thing I see is the the is the tax advantages, right? The depre like like the the the depreciation benefits, the ability to uh have have passive losses, for example, um, on some of that income outside of my retirement account. Those are those are lost in the sense that they can still exist inside the retirement account, but the retirement account’s already tax advantage, so that has no near term benefit to me. Is that, is that right? And can you describe what what what uh maybe some offsets that that are to a tax benefit perspective?

Guest:
Yes, so in terms of the depreciation question, often times I hear, well, I lose depreciation or I sacrifice depreciation if I buy this rental property with a self-directed IRA. First, it’s important to understand what does depreciation actually do for a real estate investor. So, if we’re investing non-IRA, we have depreciation, which of course is a paper loss. Now, maybe you do a cost segregation study, or you’re just taking it as 27 and a half years straight line. Either way, the depreciation loss every year that offsets your taxable income, that’s a paper loss, and that depreciation is going to add up over time, and then eventually when you sell the property, unless you do like a 1031 exchange, or you pass away and take advantage of step up in basis for your heirs, ultimately that depreciation is going to be recaptured. Now, of course, there’s, you know, the cost basis, capital improvements being added to increase your cost basis. So there’s some other strategies that can be discussed there for maybe a different, different, uh, seminar or a different podcast. What’s important to understand is that depreciation eventually recaptures. In a IRA environment, you are in a tax exempt environment. So think of the IRA just like investing in stocks, bonds and mutual funds. So when you’re investing in stocks, bonds, and mutual funds compared to real estate from a tax perspective, it’s the same. If you have a capital gain from a stock sale, that goes back into your IRA and it’s exempt from taxes in that year. If it’s a traditional IRA, eventually you’re going to pay taxes when you take the money out. If it’s a Roth IRA, no taxes when you eventually distribute from the account. And we can talk more about the Roth IRA. So now looking at rental property specifically. If I own a rental property in my self-directed IRA, I have rental income flowing back into the self-direct IRA, which is not subject to taxes, because there’s no taxes, I don’t have depreciation to try and offset any taxable income. And then in a Roth IRA, as I have rental income flowing back in, no taxes. When I eventually distribute money from that Roth IRA later on in my retirement years, I pay 0% tax. When I own a rental property in my self-directed IRA and I sell that property, there’s no capital gains tax because, remember, along the way, there was no depreciation because there was no taxable income to be offset by depreciation. I didn’t need to worry about it. I didn’t need to file a schedule E, there was no complex tax reporting of it. It was all in my tax exempt IRA.

Host:
My dear listeners, are you ready to take action today? Maybe buy your first or next rental property. Our Bigger Pockets concier team is standing by to help connect you with the exact resources you need. Whether you’re looking for an experienced agent, reliable lender, trustworthy property manager or specialized tax professional, simply call or text 720-902-8552 during business hours. Don’t waste time searching blindly. Let our team help you build your perfect investing network. Again, that’s 720-902-8552, your direct line to the Bigger Pockets community of experts.

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Host:
Welcome back to the show.

Guest:
Now let’s confuse everybody and introduce taxes, because there’s no taxes, but then there is, there there could be UBIT or UDFI. Can you define UBIT and UDFI and when they apply to a rental property investor who is buying a property in a self-directed IRA.

Guest:
Yes, so first, a traditional IRA, that means money went into the traditional IRA, you got a tax deduction for it. It grows tax deferred and then when you take the money out, you have to pay taxes based on the amount you pull out and based on your effective tax rate at that time. So if you distributed let’s say a million dollars at 60 years old, which most people aren’t going to do, but let’s say they did, and they’re at a 20% tax rate, they’re going to pay $200,000, right, on that $1 million distribution. That’s how a traditional IRA works. And a lot of Americans, their money is in 401Ks, 403Bs, TSPs, traditional IRAs, SEP IRAs, so it’s pretax, but there are some folks that have Roth IRAs. So then the Roth IRA, that is money goes in after tax, whether that’s through a conversion or through just direct contribution. It grows tax-free and then when you take the money out, you pay 0% tax. So if you think about it, owning rental property in a traditional IRA, you sell, no capital gains tax, tax exempt in the traditional IRA, but yes, you eventually pay taxes when you distribute money from the traditional IRA. But what about a Roth IRA? What if you own rental property in a Roth IRA? All of your growth is tax-free. Your appreciation is tax-free. You don’t have to worry about depreciation. You don’t have to worry about recapturing depreciation. And then when you distribute money from the Roth IRA after the age of 59 and a half, 0% tax. As a quick example, and then I’ll get to your question about Ubibit. Kevin and Cynthy are are two investors I started working with in 2011 and 12. And they had 401Ks from their old jobs and they referred to themselves at that time as stock market refugees. They rolled over their 401ks into traditional IRAs, and then they did a Roth conversion to their Roth IRAs. They started with about $150,000. So they paid taxes over two years, and then they started buying rental properties. Now, they’re very good at finding opportunities, so they find motivated sellers. They find opportunities that have significant opportunity for appreciation. They buy these houses, they fix them up. These are all in their Roth IRAs. The Roth IRAs are paying for these expenses, of course. And then they sell these properties on owner financing, lease option to purchase, and some rent to own. And they still have 14 cash flowing properties across their two Roth IRAs, seven in Kevin’s Roth IRA and seven in Cynthia’s Roth IRA. And through these activities, they’ve actually grown their Roth IRAs to over $2 million in property value and cash that they’ve been able to accumulate. Now, they’re over the age of 59 and a half, the qualified retirement age of 59 and a half. So they can distribute money from those Roth IRAs 100% tax free. But they actually don’t plan on using the money in their Roth IRAs. They plan on leaving it to their children or their grandchildren, because you’ll learn a Roth IRA can be a great legacy or a state planning tool. So those children or grandchildren will inherit those Roth IRAs, be able to continue to grow the Roth IRAs for 10 years, and distribute all of the cash and all of the assets 100% tax-free. Along the way, Scott Mindy, I should mention that they’re also private money lenders. So when they have uninvested cash, they actually lend money to house flippers. So other investors within their community, they’re lending money out of their self-directed Roth IRAs secured by property. So they have a first lien mortgage on these properties. And then all of their interest income flows back into their Roth IRAs tax-free. Now, with respect to unrelated business income tax, that’s a great question. If your IRA buys real estate with debt, if your IRA buys real estate with a loan, or takes on a loan for improvements, there’s a special tax called unrelated business income tax. Some people call it unrelated debt financed income tax. This will occur with your IRA, your Roth IRA, your SEP IRA, your simple IRA, even your HSA. There is one account, this is interesting, and we can talk about this in more detail if you want Scott. There is one type of retirement account where you can be exempt from unrelated business income tax as it relates to debt finance real estate, and that is a 401K, specifically a solo 401K for the real estate solopreneur. It’s a super powerful account that we can dive into more detail of. If you go to section 514C9A, there’s actually an exemption for qualified plans including solo 401Ks when doing debt finance real estate transactions. You do have to meet certain criteria. In my experience, in most cases, individuals meet that criteria. For those of you that are thinking, what in the world is Ubiit? Let me just give a quick explanation. If you buy a property for $200,000 with your IRA, and you borrow 100,000, you’re 50% leveraged, right? And so what happens is that means that 50% of your net profit is going to be subject to unrelated business income tax. Now, here’s the deal, and this is interesting. We talked about how you can’t get depreciation in your IRA. When your IRA owns properties free and clear, remember, you have no taxable income because you’re an exempt account. So there’s no taxable income to offset with depreciation. But when you have debt, and therefore a taxable event, you can actually take advantage of depreciation. So using my example of buying a property for $200,000, borrowing 100,000, let’s assume it’s a buy and hold rental property. We take 50% of our gross rents minus 50% of our operating expenses, minus 50% of our depreciation. So we can actually depreciate in this case. And often times I see where with the depreciation and the operating expense write-offs, the unrelated business income tax exposure is minimal, or the investor is actually showing a loss. That loss can carry forward, can stack up and offset future gains up to 80%. And guess what? The Ubi tax rate long-term gains is only 20%, not the often times generalized, advertised 37% ordinary Ubi income tax that a lot of people talk about. So there’s some interesting nuances that you need to know about with respect to Ubi. I often times tell folks just like I said before, where complexity lives, opportunity thrives. Don’t be afraid of Ubitt. You should run towards Ubitt because in some cases, the opportunity can still make a lot of sense. Just pencil out the opportunity, net of the Ubitt tax, are your returns still substantial?

Host:
Okay, I have a question for you. If you had the option, you were going to invest in real estate and you were going to open up either the self-directed IRA or the self-directed 401k, which one would you choose?

Guest:
So the way I would determine self-directed IRA versus self-directed solo 401k is first understand the individual’s specific circumstances with respect to are they self-employed, are they not? Are they a business owner, are they not? Do they have W2 employees across their various businesses? There’s a few things that we need to know about first. Here’s a short answer of it. Solo 401K. If the investor is interested in self-directing into real estate transactions where there’s debt financing involved and they want to take advantage of the Ubi exemption, there’s two primary criteria for a solo 401K. A, they have to have earned income as a solopreneur. That could be they’re a self-employed person, just filing as a self-employed person, that could be an LLC, that could be an LLC taxes in S corporation. They just have to have earned income, meaning income that they’re paying Medicare and social security tax on. Meaning if I have an LLC and I just have a bunch of rental properties and it’s all pass through passive income, that’s not going to qualify. I need to find a way to get earned income. It might only be a little bit, but I need to work on that with my CPA. Let’s assume that the person does have some earned income. The second criteria would be they have no W2 employees with the exception of their spouse and themselves. So, if someone has a business and they have their spouse as a W2 employee, great. They can open a solo 401k and then their spouse can also take advantage of those benefits. The great thing about a solo 401K if the person qualifies, if they have pre tax money from an old 401k, traditional IRA, SEP IRA or simple IRA, they can simply roll that over into what we call the pre tax bucket of the solo 401K. Solo 401Ks have two buckets, pre tax and Roth bucket. So they roll it over to the pre tax bucket and then they can convert it to the Roth bucket paying the taxes now. so that way all of their profits going forward are 100% tax free. Then they use that Roth component of the solo 401k to do for example, a a debt finance real estate deal directly, rental property or fix and flip transaction maybe. Maybe they invest in a real estate syndication, which could also have you bet. But you do that with a solo 401k and they’re likely going to be exempt from that. Now, let’s say the solo 401k is just too complex for someone. They don’t qualify, they don’t want to go through the efforts of setting it up. Well, in that case, just use the self-directed IRA, roll over your money, transfer your money and invest through that type of account. Might you have you bet? You might, but in many cases, folks find when they pencil it out that it still makes sense.

Guest:
Mindy is trying to get you to agree with her strong stance that the self-directed 401K is just better than a self-directed IRA for real estate investors.

Host:
If you have the self-employment income that allows you to qualify and no employees over a thousand hours a year or something.

Guest:
Yes, so here’s what I would say. The solo 401K is, yes, superior to the self-directed IRA, providing that those various circumstances were met. It’s superior, especially for a real estate investor. And in addition to what I just mentioned about the unrelated business income tax exemption, you can make much larger contributions to a solo 401K. Here’s a quick example. I’m working with a a real estate agent in fact, and their business is actually set up as an escort, which is interesting. They’re trying to pay themselves right, lower amount of self-employment income, so they can lower their Medicare social security tax. So they have about $100,000 in W2 from their escort. Well, you can contribute in 2025 up to $70,000 to the solo 401k when you’re under the age of 50. And there’s actually three different buckets to get you there. There’s a Roth bucket, so they can put 23,500 directly into the Roth bucket as an employee. Then they can make an employer contribution, which is 25% of their 100,000, which is 25,000. Then there’s a post tax bucket that we like to call the mega back door bucket and they make that contribution. At the end of the day, they’re going to have $70,000 in the Roth bucket of the solo 401k from their $100,000 W2 escort salary. And then that $70,000 they’re going to be able to plow into real estate syndications and be exempt from unrelated business income tax. Because see, that’s their strategy. They’re a real estate agent. They’re really good at selling real estate. They have some rental properties and then they are going to use their self-directed solo 401k specifically to invest as an LP, as a passive investor into real estate syndication opportunities.

Host:
We have to take one final ad break, but more from John Bowens when we’re back.

Host:
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Guest:
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Guest:
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Host:
Thanks for sticking with us.

Guest:
I love it. So I’m I’m a I’m a high income earning with W2 with a million and a half of my my 401k in my 40s and I’m thinking about retiring early. I go get my rental property, my agent license and uh I stink at it for the first year. I get no income. I begin rolling over my 401k dollars into my Roth Roth 401k. and by year three, I’m starting to earn a big income, but now I’m a real estate professional. Um I am able to create the self-directed yeah, we can get going on this this this fun stuff, but that’s that’s what the power of this this tool is is there’s a large number of people out there specifically that overlap with the Bigger Pockets, you know, real estate investor, you know, persona out there. The people who do a lot of have a couple of properties, a a 401k, good job uh out there and they have this concept of the middle class trap where folks are worth two two and a half million bucks and it’s all in their home equity, their 401K and a couple of rental properties that are, you know, 50/50 debt to equity ratios and they just don’t generate cash flow. They feel stuck despite the fact that they’ve done everything right and built up a multi-million dollar net worth. And I believe that the tools, you know, forgetting even before we get to self-directed IRAs, just the toolss of 72T, um, substantial equal periodic payments and distributions uh uh tools to access the funds early for your to spend in your personal life, the tools for the Roth conversion ladder, for example, um, and and strategies like that that allow folks to roll over money from the 401K to a Roth, um without paying penalties and then begin withdrawing principle from the Roth several years down the road. Those tools are super powerful, but when you lay them in with a at least a portion of that those 401k or those IRA dollars with the just knowledge that you can use one of these self-directed IRA tools to provide access to different uh asset classes to uh debt fundsIndications or traditional regular old-fashioned real estate. I mean it just it becomes a very powerful dynamic. It’s advanced, like there’s a lot of jargon that we’re using here. You’re going to have to do your homework on this one and it’s going to be complex um in there and I I I I’m a little bit more cautious. when I hear the word complex where I’m I’m a little bit more scared than you are. I don’t run towards complexity. I like to run towards simplicity personally, but I think that the complexity here is worth it because you can it may free you um mentally um or much earlier in life. it may it may mean your 40s are spent doing what you want um if you can if you can just think about all the tools that are available to you and and and create the right strategy to access that money in the retirement account. so.

Guest:
And Scott, I’ll add, you you reminded me of something. I was just talking to a husband and wife couple earlier today, and they’re in their early 30s. Uh one is 32, the other one’s, uh, I think 33 or 34. And they drained all of their money out of their retirement accounts. They had high-paying corporate jobs, they had large 401ks, and they knew nothing about self-directed IRAs, unfortunately. And they actually drained all the money out of their accounts, paid a lot of money in taxes. And I’m talking 45 to 50% of their accounts wiped out just to get access to the money to be able to go out and invest in real estate because they didn’t know about this concept of self-directing into real estate with their retirement accounts. So now they’re sort of in this rebuilding mode. Well, these investors, they’re very good at finding motivated sellers, and they’re very good at finding opportunities and they have a network of private money lenders and private investors. So I shared with them a story earlier today that was encouraging for them where I have a client that only had about $13,000 and some change in his Roth IRA. So he had two years of contribution. So for example, you could contribute $7,000 to a Roth IRA. So he was between two years where he was able to contribute for two years. He had about $13,000 and some change. He’s in Dayton, Ohio. He found an opportunity, three bedroom, one bath, fix, fix and flip deal. He needed about $106,000 for the deal. He didn’t have $106,000. He only had about $13,000 and some change. So he only had about 10% from the Roth IRA to be able to put in the deal. He worked with, uh, call it an investor teammate. So this is someone that’s not related to him. You will learn there are disqualified persons to your IRA, so you can’t do transactions like this with people like your spouse or yourself, or your children, or your parents, known as disqualified persons under 4975 of the tax code. But this happened to be a non- disqualified person. So this individual partnered their Roth IRA with this other investor, they did the $106,000 fix and flip deal, and the investor with their Roth wasn’t the one swinging the hammer to the nail. He was the one just overseeing the transaction. They sold the property and they made $68,000 in profit and they had a joint venture agreement that spelled out that 50% of the profit goes back to the Roth IRA and 50% goes back to the other investor. So this Roth IRA investor with only $13,000 and some change in the transaction, made $34,000 tax-free. So he grew his Roth IRA from about $13,000 and some changee to over $47,000 tax-free. Now, of course, there’s always caveats with this. How many of those types of transactions can you do a year in your Roth IRA? Well you got to be careful. If you do too many, now your IRA looks as if it’s running as a business and ongoing trader business that’s regularly carried on and you actually have a different form of U. So in this case, he’s just doing one transaction. But hey, 34,000 tax free, had he done that deal outside of his RO IRA at about a 30% tax rate, he would have been paying over $10,000 in taxes.

Guest:
Okay, so let another one of the components of my you know, if if I came in with with here are the five things I don’t like about self-directed IRAs and real estate and traditional real estate investing. Again, they were, you lose the depreciation and tax benefits that are inherent to real estate investing outside of the accounts. Two, you may be subject to Ubit or UDFI, whichever term you prefer in there. Three, it’s going to be harder to get a 30-year fixed-rate Fannie May insured mortgage. We haven’t covered that one yet. And then fourth, what we’re starting to cover here and there’s a fifth one here as well. but the fourth one is you cannot materially participate in the deal and there are clear restrictions about who or how you work with the properties, right? So can you give us a a broader overview besides these prohibited persons that can be associated with the with any any business activity inside the self-directed IRA? What are these prohibited like how do I think about what I can and can’t do? Can I can I negotiate the deal? Can I manage the property? Can I change the locks? Can I sign a lease with the tenant? What are the rules that I that that I need to be aware of going in in terms of managing and participating in our rental property management?

Guest:
Absolutely. I always like to use the rule of thumb. This is an easy rule of thumb to think about when you’re going to start doing self-directed IRA transactions or even solo 401K transactions because all these accounts, the rules are the same under 4975 of the tax code. You can do the desk work, you need to stay away from the physical sweat equity within the tax code 4975, it states that a disqualified person cannot furnish services to the IRA or to the plan. Okay? Who is a disqualified person? That would be your yourself, you’re the account owner. That would be your spouse, that would be your children, that would be your parents, your grandchildren, your grandparents. And then businesses that you own or contra control 50% or greater of. So your property management company, your other LLCs and entities, your trust, your living trust, those are also disqualified persons. So what is services? Well it’s not clearly defined within the tax code, it’s not clearly defined by the IRS. Could swinging the hammer to the nail be considered a service? It could be. And so that’s why the rule of thumb is used in the industry that you can do the desk work, but you need to stay away from the physical sweat equity. One of the questions I get very routinely Scott is, well, can I be the property manager? Well, to what extent are you the property manager? Are you physically doing work on the property? Or are you administratively overseeing the transaction? I’m using administrative oversight very specifically here. So it’s an optics, it’s an optics thing. There’s going to be no clear, this is absolutely right or this is absolutely wrong. For somebody that is very concerned with respect to the prebited transaction rules, they hire a property manager. For people that understand the optics component of it, and they’re very good at keeping good records and maintaining the transactions and not going over to the property and doing the physical work on the property themselves, those are generally the people that are going to self-manage if you will. They’re not going to compensate themselves. That’s a big part of this. So you cannot take compensation from your IRA. If you were to do that, there’s a good argument under 4975 of the tax code, it’s a prohibited transaction.

Guest:
What happens if you do that? What is the penalty for getting this wrong?

Guest:
Well, I think Mindy’s going to like this one. Okay? So IRAs, Roth IRAs, HSAs, the consequences can be severe. The consequences could be the entire account is distributed January 1 in the year in which the transaction occurs. There are some investors that are overly concerned by this that will have separate IRAs for their separate transactions. So maybe they do a lot of private money lending, you had brought that up, Scott. Maybe they do a lot of private money lending, so they do that in this Roth IRA or IRA, and then they have rental properties and they do it in this IRA over here. But guess what, a solo 401K doesn’t have as severe of consequences. If you do a private transaction in a solo 401k, you only have a 15% penalty on the amount that’s engaged in the private transaction that compounds year over year until you correct it. So you can correct the mistake and you don’t entirely lose the status of the solo 401k. That is another if you will, maybe benefit to the solo one K. It’s not something that I lead with because we don’t want to be going out and doing private transactions, right? We want to follow the rules.

Guest:
We are not going to get to number my my my all the questions I have outside of the rental property piece. but let’s make sure we finish that one for the traditional rental here because this is really, John, you’re absolutely fantastic wealth of knowledge on this on this uh on this subject matter. This is awesome. I’m learning so much right here. Okay, so going going back to my framework on rental properties. Self-directed IRA, I again came with the bias of depreciation benefits are loss. Self-directed IRA, um uh, can create problems with uh or or subject properties to forms of taxation like Ubit or UDFI. We discussed the how the solo 401K, subject to solo 401k can uh resolve that problem to a large degree and how in your opinion, in many cases it’s really not that big of a deal um depending on how much income you’re going to generate. Third, I said you’re not going to be able to get a 30-year fixed rate Fanny May insured mortgage on there. That is surely true, but I bet you that there are work arounds and loan products that are reasonably uh that are reasonable for folks in this space. Could you tell us about the different types of financing available and what you see folks doing for single family rentals or or small multi-family?

Guest:
Yeah, and you’re you’re right, Scott. So if you’re looking at a rental property and you say, should I do this with my IRA or should I do it with non IRA funds. If you can’t get financing for the IRA, depending on the opportunity, it might make sense to not do it with the IRA. And that’s something as an investor to look at. Don’t use broad generalizations like we started with here, Oh, never do rental properties in an IRA. It just never makes sense. You lose all the depreciation. Well, again, we already talked about, you’re not losing depreciation. There’s no taxable income to offset. And so, when, when it comes to, IRAs borrowing money, the type of loan that you have to obtain is called a non-recourse loan, meaning in the event of a default, the only recourse is against the subject property. Now, why is that? Why can’t your IRA borrow with a conventional loan? The reason why is because conventional lending requires the individual borrower to sign a personal guarantee. Under 4975C1B of the tax code, it would be a prohibited transaction. Oh, look at that, just building it off the top of your head. Yes, though we live this all day every day, Scott. Yeah, it’d be a private transaction. So you have to get a non- recourse loan. Now, I will tell you, Scott, there are non-recourse loan products out there. We have hundreds of clients that buy real estate with their IRA with a non-recourse loan. So there are lenders out there. Uh there are more and more lenders emerging into this market. And I think a lot of it has to do with they see the opportunity. They see that there’s over 14 trillion in IRAs and back when I started nearly 20 years ago, there was only like 4 trillion. So because the market has grown and more and more people have an appetite to buy rental properties with their self-directed IRAs and solo 401Ks, there’s more available for non-recourse loan products. The rates of course are going to be a little bit higher than your 30-year fixed mortgage, but not unreasonably higher. The idea is is these folks are doing it because the cash flow is still good. If they’re in a decent appreciating market, and ultimately their renter is paying for their mortgage, eventually they’re going to own a free and clear asset. And you know, Scott, I should have mentioned this before when you asked me about Ubi. Here’s one of the, the beauties of UBIT. So you might have a little bit of taxable exposure if you’re doing this with your IRA, not your solo one K paying the Ubi tax, but let’s say you pay off the debt in its entirety. You own the property now free and clear in your IRA. As long as you wait 12 months and a day from the time that you pay off the debt, no U tax, no recapture appreciation, no U tax. So imagine a Roth IRA. I know someone that bought 20 houses with a Roth IRA on owner financing. They had an aging landlord that was willing to sell on owner financing. They borrowed money from a private money lender to rehab the units. They were nearly 100% leveraged. Well, guess what? He’s got over a million dollar portfolio now in his Roth IRA of rental properties that he owns free and clear. Eventually, when he starts distributing those, or selling them to distribute the money from the Roth IRA, he pays no tax. So there’s some interesting really longer- term strategies that can be discussed with respect to these Roth IRAs and even while someone might have some Ubi exposure.

Guest:
Awesome. Okay, and then that brings me to my last question here around fees and headaches because so again, I think these two things kind of go together with with the the questions about prohibited persons and prohibited you know, the the prohibited activities uh with respect to managing or providing services to properties or businesses inside of the self-directed IRA. Can you give us an overview of what the costs look like to set up a self-directed IRA or self-directed 401K and the you know, if I want to buy a property, what am I looking at in terms of transaction expenses, paperwork, fees to specialists, what are those specialists called in order to facilitate a transaction or changes to the property, sale, signing the property manager, those types of things. How do how do I think about the costs that will that that I’ll incur above and beyond um, you know, an outside of the IRA uh transaction if I’m doing it inside of one of these accounts?

Guest:
Yeah, yeah, so the first place I would start is there’s a fee to pay a custodiann or trust company or an administrator for if it’s like a 401K. So you’re you’re going to pay a company, if it’s going to be an IRA, it’s going to be a trust company, or often times referred to as a custodian. And that fee is going to often times be dependent on the portfolio value of the account. So, for example, uh, at this moment in time, if you had an account with equity trust company and let’s say it was um, around $100,000 that you started with, you’d be looking at a maintenance fee of $500. But it’s a sliding tier scale. As the portfolio value increases, your annual maintenance fee is generally going to be a little bit higher. Now you look at it on a percentage basis, so often times it’s less than a half a percent. So when you compare that to managed money, if you had someone managing your money for you, you could be one, one and a half, maybe even 2%. Keep in mind it’s a self-directed IRA. So when you go out and you make profit, you get to keep 100% of that profit in your IRA. You don’t have to share that with your trust company or custodian. Do you have to pay an annual fee to your custodian? Yes. and they’re going to give you exactly what that fee is. Solo 401Ks to touch on that, uh it depends comparing a solo to an IRA on the portfolio value of your account. Sometimes it’s a little bit less, sometimes it’s a little bit more. Generally a solo 401K is going to be anywhere between $1,300 to $1,700 on an annual basis is what I see. Solo 401Ks do carry a little bit more burden in terms of the administration of the actual plan because it is a solo 401K. For example, if you have over $250,000 in the solo 401k, you have to file what’s called the 5500 on an annual basis. And for example, the way we do this is we have systems and pipes and plumbing to make it easy and accommodating for that individual to be able to accomplish all of that. So to answer your question, Scott, first piece is, what are your annual maintenance fees to your custodian or trust company? Uh, some firms do pay like, or I should say charge, they will charge a per transaction fee or per asset fee. And then some firms just charge you one fee regardless of how many assets and how many transactions you have in the account. So you just want to have a conversation with them with respect to what that’s going to look like for your specific circumstances. And then outside of that, in terms of like, you you ask about um, specialists. Uh, so we always encourage folks to work with their CPAs, their tax attorneys, their other professionals as they engage in transactions. Equity Trust is one member of their financial team. So we’re not endorsing or recommending investment opportunities. We don’t give tax legal or financial advice. And that goes for pretty much all trust companies and custodians out there. They’re not going to give you that degree of advice. A lot of it can be done by the individual account owner in terms of educating themselves and learning about the system, asking their trust company or custodian, who often times has a lot of education and information that they can share with them. And then when needed, especially if they’re going to do something a little bit more complex, that’s where they would bring their tax account and CPA or other professional into the equation. In terms of closing on like rental properties or maybe doing a fix and flip property investment, often times we do see folks will form an LLC where their IRA will be the owner of the LLC and then that LLC acquires the property. So you would want to factor in some additional fees for that. Those types of LLCs are generally going to range between 1,000 to $16 to $1,700. Keep in mind, it’s not a go online to one of these online LLC formation companies and set up an LLC. When you create an LLC for your IRA, it has to be a specially crafted operating agreement. You have to have language in there specific to the private transaction rules under 4975. And if you don’t do it properly, you could create implications for yourself.

Guest:
Okay, so so if I want to, if I want to take $250,000, let’s say I have a million bucks in my 401k. If I want to take $250,000 out of it and move that into a self-directed IRA or a solo solo 401k. I’m looking at a couple hundred bucks for the self-directed IRA and maybe up to 1300 to 1700 for the solo 401k. Just to form the thing. I’m going to pay it every year in a recurring fee um in most cases. Then I’m going to have a transaction fee related uh that that that the custodian or the the the provider will then charge to help me facilitate that transactions. And I will likely have to crat pay other specialists, perhaps including that that custodian, some fees to set up the LLC and the and form the operating agreement with that to make sure that they adhere to the rules that are are specific to self-directed IRAs or solo 401Ks, self-directed solo 401ks. And is that and and so that that can be those can be certainly added expenses that will go into buying that rental property and should be should be known to folks. And I will be prohibited from providing many types of services to that property for the life of that investment. So those are real real considerations people need to go in eyes wide openen if they’re going to use this tool.

Guest:
You absolutely hit the nail on the head, Scott. I always relate this akin to when you start getting into real estate and and I can speak from experience and and you’re an entrepreneur and you’re starting businesses and I know Scott, you’ve done this over the years and I’m sure Mindy, you as well. And and what happens is eventually you get to a point where, you know, you have maybe partnership LLCs and you have extra tax returns like 1065 partnership returns that have to be filed. So the best way to think about it is your self-directed IRA, it’s like a separate entity and you have to maintain that entity. And there’s some extra costs associated with the maintenance of that entity. And you always want to analyze. I’m glad you brought it up Scott because it’s important to analyze the benefits and the burdens if you will. What are the benefits with the self-directed IRA, Roth IRA, solo 401K? Well we talked a lot about the tax advantages, and then of course, there’s the ability to diversity. So you brought up, well what if someone has a lot of money in a retirement account? That may be all of their wealth that they have. Instead of paying a bunch of taxes to take the money out to invest in real estate, they can do it inside of their self-directed IRA, and invest in a hard asset. A lot of people want to invest in these types of real estate transactions because they want their money to be diversified beyond the traditional public markets. And that’s the self-directed IRA or solo one K allows them to do that. So, is it, is it beneficial and then look at the burden. I’ll give you a quick example. I have a client when we talk about a UBIT, this is this is a good example. I have a client in 2021 that invested in a real estate partnership. It was an apartment building syndication, value add deal, $100,000 with their self-directed IRA. They didn’t use a solo 401K, was an IRA. and the property sold in 2023 and they had two about 231 flow back into their self-directed IRA. So their capital gain was about $164,000. Now the property was only 70% leveraged. So they didn’t have to pay taxes on 100% of the profit. That’s the beauty of UBIT is you don’t pay taxes on 100% of the profit, just the percentage that’s debt financed. So they were 70% leveraged, they paid 70%, they paid taxes on 70% of the profit, which came out to be about $23,000 in Ubi tax. So some people look at that they’re like, wow, that is a lot of money in taxes to be paid for from the IRA, 23,000. But when you net it out, they made 140,000 in their IRA, which it all will continue to grow tax, tax exempt. Their annualized return was still a 47% annualized return. So that that’s a good example of hey, are the are the burdens worth the benefit? Was the extra $300 to file the 990T tax return worth it? Yes. Was the extra $500 to $600 in annual maintenance fees to equity Trust worth it? I would argue that it was worth it.

Guest:
Love it. Yeah, and and I what I think is awesome about this conversation here and and again, we didn’t even get to my two through six uh of discussion topics here, right? With with like, hey, here’s where this how do we think about syndications in here? We kind of you you lightly sprinkle that in with great examples here. But I think what what I what I hope we accomplished here for folks that are are listening and this is a very dense conversation. It’s very technical, there’s a lot of complex topics. You got to know it before you go into this and understand what you’re doing. is I think we just discussed the self-directed IRA for what it is, right? Itwarts and all. This is a great tool for a lot of people out there to potentially use to potentially access those funds um in there. It’s not free. There’s no free lunch uh in investing anywhere for but it’s way better for your for your example than just taking the funds out and paying the 10% penalty and your marginal taxes for so many people. There’s a lot of really good use cases for this tool and again, I think that it’s something that we’re going to be exploring a lot over the course of the year in the context of this middle class trap dilemma um for this. And so I I love it. I think you’ve done a really fantastic job here of of describing it for what it is and where it can be used and highlighting really good examples here. Yeah, obviously do this all day long every day and are ready for everything I can throw at you um in terms of questions.

Guest:
Yeah, and Scott, you know, you brought up some really good points around, hey, for somebody that wants path of least resistance, for somebody that they they don’t want to bother with some of the burdens of Ubi tax and trying to understand it and some of the complexities. We find some people they just want to simply use their self-directed IRAs to make a loan secured by real estate. For example, I have a client that recently made a $193,000 loan on a fix and flip deal. He’s just a passive lender. and he actually partnered his Roth, his traditional and his HSA because you’ll learn you can partner multiple accounts together. So you made $193,000 loan and all the interest income is flowing back into those accounts tax free. So interest income, that’s passive income. That’s going back into your accounts tax free. Or I think you brought up a private credit fund. So sometimes people don’t want to invest in real estate syndications where there’s actual реальy real estate with debt because they have Ubi. So they look to invest in different types of funds. For example, like a private credit fund where they have interest income and that interest income passes through on the K1 as interest income into the IRA and they don’t have to worry about Ubittax. So that goes into every investor is different. They’re they can self-direct their account and make all of their own decisions. They determine how they want to invest, where they want to invest, and ultimately they’re the manager of their self-directed IRA. They’re their own wealth manager.

Guest:
Can you use an example of that person who went into an apartment value addd deal with 70% leverage and how that generated taxable income on 70% of the gain but it was still a huge win overall? And so that tax the tax consequences, the tax concern is real, but it’s also like you only get the tax consequence if you win on there and on a percentage of the gain is is as I think John’s argument. Is that is that right, John? That’s correct, yep.

Host:
One last question I had, you said you have a certain number of transactions that you can do before your uh IRA becomes running a business. What is there a specific number?

Guest:
Yeah, so in terms of if your IRA was and let’s say you, on behalf of your IRA, you’re using your IRA to flip houses. If you flip too many houses and that number is not clearly defined within the tax code or within any IRS guidance. The IRS says that if there is a trader business that’s regularly carried on, that’s in your IRA, if you will, and you’re not paying corporate tax, then you have unrelated business income tax, which isn’t necessarily a bad thing. Maybe you do four flips and you pay 37% tax, but the rest is all tax-free in your RA. The rule of thumb that people use in the industry is they don’t do more than two short-term flips in their IRA.

Guest:
In a year.

Guest:
A year, correct, a year. And if they’re an active real estate investor, generally they’re going to limit that to one. So there’s no clearly defined guidelines on this. We always encourage folks to talk to their own CPA about what do they feel most comfortable with, but again, that’s the rule of thumb that’s used. Rental properties are different. That’s passive income. So I mentioned a client of mine that has 14 rental properties between their Roth and their spouse’s Roth or private money lending, lending money secured by real estate. So that’s passive income. It’s just a the short-term flipping that someone needs to be wise of. And then of course, there’s some really advanced strategies such as a blocker corporation where you set up an LLC taxes is a corporation, so you pay a more favorable 21% corporate tax instead of the higher 37% Ubit tax. But that’s a whole another podcast in of itself.

Guest:
We’re definitely going to have to come back and discuss a lot of advanced strategies. Like I want to think through how can I use the HSA to subsidize healthcare costs in early retirement or traditional retirement using a self-directed IRA and some of these strategies, right? Um, I I I I’ve been on a kick about debt funds here, which I think are a very niche product, small use case, small portion of one’s net worth, but particularly attractive with these tools in order to provide certain, you know, can you can you match mix and match that with the Roth conversion ladder or a self or a 72T rule um inside of a self-directed IRA. I think there’s a lot of advanced and a complex topics here that begin to solve this problem of all my wealth is in my 401k and I’m going to have 7 million dollars at traditional retirement age in real inflation-adjusted 2025 dollars if I just keep leave it in there and let it compound. I want my 40s. how do I access it? and I think I think the answer is in this um, with more discussions like this like this one here that get into those these more advanced concepts and the all the world’s alternatives.

Guest:
And and a quick one, Scott. If you contribute directly to a Roth IRA, 7,000, and then you make 10,000, you can take out that original 7,000 at anytime you want tax and penalty free. You referenced 72T withdrawal, that’s a strategy. Higher education being able to distribute and be exempt from the 10% premature withdrawal penalty. So yeah, there are ways to look at it. And of course, like I tell everybody, worst case scenario, if you take money out of your IRA, which you can do anytime you want, you just have a 10% premature withdrawal penalty and an ordinary income taxes. But hey, if you did really really well in that IRA, it might be worth it to to do that in order to be able to enjoy some of the benefits now.

Guest:
Well, thank you so much for the the partnership, and thank you for bringing this incredible depth of knowledge here. I can tell I’m not the first person to ask any of these questions to you to the point where you’ve literally memorized which pages, almost all of the pages uh that the source material from the IRS tax code is is uh is on there. We’ve got we’ve found one that you weren’t sure which which quite which page it was on.

Guest:
Right back at you guys. Um, I’ve been dialed into your podcast and it’s so interesting almost all of my friends growing up are now in real estate including myself now. And, um, a good, probably 75% of them are part of the Bigger Pockets community. And that wasn’t because I turned them on to the community. They they found it on their own. So when they found out I was working with bigger pockets and and passive pockets, they were like, really, I’ve been doing that for for years. That’s actually how I got involved in real estate. What one of my best friends, he um he read the, you know, Robert Kiyosaki, Rich Dad, poor dad book and then he got dialed in the bigger pockets and he’s got 10 to 11 properties now. He’s invested in some real estate syndications. And um, you know, he’s he’s got two kids. He’s over 40 and or about 40 and you know, he’s um he’s he’s he’s on his way to, you know, creating creating a lot of wealth and you know, that’s a that’s a big thank you to you guys.

Guest:
Awesome. Well, thank you so much, John, for for coming on this. I’m excited maybe to get a get another one on here talking about the uh some of these more advanced strategies now that we’ve covered the basics. Woof, that was the basics. Um of investing in a a rental property with a uh a self-directed IRA.

Guest:
Happy to do it.

Host:
All right, Scott, that was John Boa and that was a lot. And while I think this is a really great episode, John was throwing so much information at us. I know I’m going to have to go back and listen to it again so I can pause and take notes because I can’t pause him when he’s talking and then by the time I take a note, I’m like, oh crud, he just said 15 more things that I want to research. So I’m super excited for all of these rabbit holes. Thanks a lot, John. I’ve got so many rabbit holes to dive down. But what did you think of the show, Scott?

Guest:
I love it, right? This is not, this is not like an entry level topic. So there’s no way to discuss the material without using the language that is appropriate to self-directed IRAs and the specific language that is listed in the IRS tax code. So he didn’t shy away from it. We didn’t shy away from it. It’s going to take you probably three or four listens uh to this one to really digest all the material and you’re still going to understand about 80% of it, but you really got to know what you’re doing if you’re going to use these tools. This is not a tool you should use if you don’t understand it, right? It’s just a option you should know at the highest level, there is an option for you to take money inside of a 401K, a Roth or even an HSA and set up a self-directed account and invest in real estate. There’s some problems with that. They can be overcomeable, they they and they can even be worthwhile um for the investor, but you really got to know what you’re doing and you got to dive into the complexity of it. And if the complexity scares you, stay away. But if it doesn’t, um there is an opportunity here to potentially begin solving some of the problems of the middle class tract.

Host:
What did John say where there’s complexity, that’s where opportunity lies?

Guest:
I’m a big fan of personally, but if I was sitting there in the middle class trap with a million and a half in a 401K, I’d be really seriously interested in exploring the complexity here and seeing how that can actually free up some of that capital earlier in life.

Host:
I like a little bit of complexity and a little bit of risk because, or you know, depending on what account I’m in more than a little bit of risk because there’s so much opportunity for growth, but uh, yeah, you know what, you know what makes money so fantastic, Scott? Is it’s personal. You can do your own thing, I can do my own thing, and the only thing that the only people that your money has to work for and your plans for your money has to work for is you and your partner and your family and for me and my family, it’s uh a little bit different, but that’s okay.

Guest:
Absolutely.

Host:
Well, shall we get out of here, Mindy?

Host:
We should. Scott, that wraps up this episode of the Bigger Pockets Money podcast. You are Scott Tredt, I am Midy Gensen, saying, see you soon, Silver Moon.

Host:
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