Wish you could keep more of what you earned? Self-Directed Retirement accounts are a powerful way to minimize your tax bill, and John Hyre, tax attorney and retirement account expert, joins us to share how you can benefit. He also shares an example of how someone put 50 rentals into a self directed IRA account, paid them all off very rapidly, now has a completely tax free cash flow machine where all revenue and eventual sales are tax free! Keep more of what you earn, and watch this episode!
Highlights of this show
- Meet John Hyre, a premier expert and advisor on self-directed retirement accounts (and tax attorney).
- Learn some powerful ways that you can shelter your earnings and build long-term wealth
- Listen in as John shares a story about how someone built up 50 rentals into a self-directed IRA, how they rapidly paid them off, and how the income from these rentals is now 100% tax free.
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Listen to the Audio Version of this Episode
FlipNerd Show Transcript:
Mike: Hey, everyone. It’s Mike Hambright of FlipNerd.com. Thanks for joining us for this episode of the Expert Interview Show where I interview leaders and entrepreneurs from across the real estate investing industry. If you’re a member of FlipNerd.com already, thanks for joining us again today. If you’re not a member, go check out FlipNerd.com. You can get a free membership in literally about 15 seconds. We’ve got a lot of awesome stuff going on, lots of access to properties. And given that this is episode number 294, we have hundreds of hours of great content, of interviews with experts in our space.
So again, this is episode number 294 with John Hyre. John has been on the show before, almost 200 episodes ago. So hard to believe that it’s been that long. But John has got great information. He’s a real estate investor, a tax attorney, he’s an accountant that has just a tremendous amount of experience helping real estate investors. And as we sit here this time of year, a lot of people are feeling the pinch with the taxman. I know we’re working hard to get our taxes done, and it’s kind of a messy time. And all along you’re thinking, “I can’t believe that I give up this much of the pie.”
And actually, a friend of mine just recently said, just two weeks ago we were in Nevada, and he said if you’re not spending as much time keeping the money you made as you are making it, then you’re probably paying too much in taxes. So pretty insightful, and John’s going to talk to us a lot about that today. In fact, we’re going to talk a lot about self-directed IRAs and 401(k)s, and how you can really minimize your tax bill and some tools that are out there for everybody listening to the show today.
So as you know, we break the show up into two parts now. The first part, we’re going to talk about self-directed IRAs and 401(k)s. And then, in the second part, the taking action segment of the show, John is going to share his favorite technique of somebody that recently put . . . or not recently. Probably over time, but 50 rentals in a self-directed IRA account where the earnings and the eventual sale is completely tax-free. How does that sound out there? So, John, how are you today, my friend?
John: Very good. Very good.
Mike: I’m excited. I just told you right before this that I wasn’t blowing smoke. I really love talking to people about minimizing taxes because I have paid a ton of taxes. And it’s just painful. I’m all for doing my fair share, but it certainly feels like I’ve done well more than that over the years.
John: Yeah, it’s going to get worse. Socialism’s very expensive. And now that the bill’s coming due, the government and the IRS are pushing heavy. So it’s going to get interesting.
Mike: Yeah, yeah. Awesome. Well, why don’t you take a few minutes and introduce yourself and tell us a little bit more about you?
John: Sure. I’m a lawyer, accountant, and investor. And that’s probably in order of competence. For example, I’m very good at spotting deals with real estate. I’m a terrible manager. I’ve had several mobile home parks that I just don’t manage them very well. We do much better with single-family houses. We bought some during the crash. We’ve done pretty well with them. We want more of those. So I do invest. Mostly low income. So blue-collar, single-family rentals. We’ve done a few flips. And like I said, the mobile home parks but just not my shtick.
I’m also an accountant. I did sell my accounting and return practice about a year ago, mainly because I was doing too much. Just spread too thin, needed to have a life. But I’ve done tax returns for about just shy of 20 years. So I have a lot of experience with it. Sold the practice to my best employee. We do refer her a lot of work because whatever we come up with on the planning side, she’s able to implement on the return and bookkeeping side. And she does serve people all over the country. She’s great.
So now I spend most of my time as a tax lawyer, focused really on self-directed IRAs and 401(k)s, real estate investors and small businesses. And roughly in that order. And most, I would say most of the 401(k), IRA people, are in some sort of real estate. We find a few of them that aren’t, but for the most part, we’ve found that they are. And I would say my claim to fame on that is, unlike a great many lawyers, I mean A, I understand and get into self-directed accounts. It’s very rare to find a planner who gets into it.
But I’ve also now gone to tax court twice to defend clients. They got audited. Thankfully, I dealt with the audit, which allows us to set the stage for a victory later. And we eventually won right before trial. The IRS pushed it. I mean, we had to actually stand up and present in front of the judge in one case. Then, the IRS decided they wanted to settle. And the settlement was really good. My client owed zero.
Mike: Wow. That sounds like a good settlement.
John: And the second time around, the same one. The IRS started off by saying he owed $400,000 and he ended up owing zero. And by the way, these people were all over the country because the tax court is a circuit court. So they meet in all the cities. We always file in Columbus. That way the clients don’t have to pay for me to go somewhere. But the bottom line is between the planning side, but also solving IRS problems: audits, collections, that kind of thing, I’ve got a lot of experience. And what I can say that very few can is that I’ve gone to tax court twice now on IRA issues. So I have a much better idea of how the IRS looks at things from having had to do with them almost up to the highest level on that.
Mike: Yeah, that’s powerful. I can tell you I’ve given advice before, and this is advice I’ve learned over time because, unfortunately, I’ve been through an IRS audit. It was painful, they found out wrongdoing, it was just a painful process. But I can tell you, and I know that you don’t run your accounting practice anymore. But for those that are listening, when you’re looking for an attorney or somebody that knows what they’re doing, a CPA, it’s not a bad thing.
You want to find somebody that is not afraid to be audited. I’ve had accountants before that have massive practices and they will do everything they can to . . . I mean, they’ve never been through an audit. And they do everything they can to not be audited, which means they’re probably not taking it close enough to the line to save you money.
John: Yeah, they pay a lot more than they need to because they’re . . . look, it’s the personalities. Think of the people you went to school with. The ones who became lawyers, the one who became accountants, the screwed up ones who did both. Attorneys tend to be more creative and aggressive. Accountants tend to be more in the box, they don’t want trouble. They can be a little timid. We get a lot of audit referrals from accountants for that very reason. They’re terrified.
Mike: Yeah. If you think of the average accountant, I mean, or any accountant, they’re not typically paid more if they save you more money. So why would they go through the trouble of taking it too far to the line if they can just stay safe?
John: And I’ll take it to another level. The IRS expressly tries to intimidate them. I went through a very special audit as a professional. They said, “We think as a professional, not just a regular audit but as a professional, you’re giving bogus advice. And we’d like to put you away.” And it was because a client . . . I didn’t know this at the time. I didn’t find out until much later. A client of mine committed fraud. And so they audited everybody who had any connection to him.
We came out of it clean as a whistle. And I mean it got to the point in the audit where I turned it around and started asking them questions. And very, of course, politely. But firmly. And so I wasn’t intimidated because it’s what I do. I’m a lawyer. I fight. But a lot of these accountants, in order to avoid that, they’ll do anything, including have you pay a lot more.
Mike: Sure. Absolutely. Well, John, let’s dive in. Let’s start talking about at this time of year, people are preparing their taxes and maybe paying big tax bills and maybe thinking about, “Man, I’ve got to find a way to minimize my tax bill as a real estate investor.” And fortunately, for real estate investors, there’s a lot of ways to do that if you have the right advisor. Is that right?
John: Oh yeah. Yeah, I think there are a ton of ways to do it. Now you know my favorite is to make it so the income is not taxable to begin with. But it depends on where you’re at in life and how realistic is that. So there’s, of course, structuring entities, there’s making sure you write off everything possible without going overboard and overdoing it. Because I’ve seen some investors who are so aggressive, they go to the opposite extreme and they’re sort of begging for an audit.
There’s a sweet spot. You want to be aggressive, you want to write things off, but you don’t want to do things that might trigger an audit. Or if it gets triggered, you still want to win. You want to be . . . how do I put this? If it’s gray, which is okay, you want to make sure your batting average is really good. So if I take, let’s say, 20 aggressive deductions, if I pay on one or two, I’m not really worried about it. Even if I pay some penalties, so what? If I do the math, I’m way ahead for having done it.
So a good example of that, before we dive into the IRAs, because that is my favorite area, but a good example of that is just writing off daily things. And a lot of people are aware of it but they don’t track it. So writing off your meals, writing off . . . I’ll give you, here’s a great quick example. How to write off really nice furniture for your personal home. It’s not that hard. What you do is, in my case, my business as a lawyer, I have an office. I have nice furniture.
I buy furniture for my office that I would like to have in my home. I depreciate it or write it off right away, but I hold it for five years. Once I’ve had it for five years and it’s at zero for tax purposes, there’s a rule that says I can distribute it from a non-corporate LLC. So a regular LLC. There’s no tax on doing that. So chairs and desks and leather sofas, after five years, go to my house, but it was after I got the write-off. And there’s a way to do that.
Mike: Okay. So let’s jump into IRAs and 401(k)s. Where do you want to start?
John: First of all, high risk, but also high opportunity. We’ll talk later in my favorite techniques how one guy makes $250,000 a year, 100% tax-free. He doesn’t pay state tax, he doesn’t pay federal tax, he doesn’t pay Social Security tax. And it’s so brilliant how he did it and it’s so simple the way he did it.
Mike: Yeah, I’m looking forward to that.
John: So we’ll talk about that. I’ll tell you. The high risk is because of prohibited transactions. So there’s a code section, 49-75, that talks about prohibited transactions and what can and can’t you do. And most people think they know what’s a prohibited transaction. “Hey, I can’t lend money to my dad because he’s an ancestor, but I can lend money to my uncle.” Not necessarily.
There is another set of rules that talk about using the IRA for your personal benefit. And if you structure the loan to your uncle in a certain way, are you really trying to benefit him and indirectly yourself and your family versus benefit your IRA? So you can lend money to your uncle and it could still be a prohibited transaction. That’s just one example.
The bottom line is if you do a prohibited transaction in an IRA, the IRA dies. All the money gets distributed, you pay a bunch of penalties. What we tell people is if your IRA has a prohibited transaction, you should expect about 50 to 60% of it to go to the government. So that’s the high-risk side. You’ve got to structure around prohibited transactions. You need good advice, good education, and good advice to structure around those issues. And there are a lot of subtle ones.
Mike: Yeah. So the risk is you could be aggressively putting things away in your self-directed IRA for a long period of time, 20, 30 years. And then, right before you’re going to retire or whatever is going to happen, you do one transaction, you screw one thing up, and it could blow the whole thing up.
John: That’s exactly right. Let me give you an example. And this illustrates, as you and I were chitchatting, I like 401(k)s, all things being equal. I like 401(k)s a lot more than I like IRAs. I prefer a self-directed 401(k) if you’re eligible to a self-directed IRA. Now, if you’re not eligible for the 401(k), still do the IRA. And maybe one day you’ll be eligible for 401(k) and you can roll over into it.
Here’s one reason why I like 401(k)s more. We’re going to make up a prohibited transaction for a dollar. You lend your mother a dollar. Now we all know that’s a prohibited transaction. She’s an ancestor, your IRA cannot do business with her; you cannot lend her money. Let’s say that we have an IRA and 401(k). Each one of them has $1.6 million in it. That’s not an accidental number. You’ll see why I picked that in a minute. So it each has $1.6 mil. You lend your mother a dollar out of each account. Now, on the IRA, it destroys the IRA. So all that $1.6 is distributed, and obviously, you’re in the highest tax bracket, plus you pay a bunch of penalties. You’re probably going to pay about 60% of that money. Well, what 60% of $1.6 mil? One mil. So a one-dollar transaction in an IRA that’s done wrong can cost you $1 million. And people say, “Well, the IRS would never do that.” What?
Mike: Yeah, right. They’re hungry.
John: Yeah, absolutely they’re hungry. If you did the same thing in a 401(k), prohibited transactions are penalized at a much lower level. In a 401(k), specifically, it’s 15% of the transaction and it doesn’t blow up the account. So what was the transaction here? A dollar. Well, what’s 15% of a dollar? $.15. Big difference. That’s one reason I really like 401(k)s. And there are other reasons. You know, the ability to contribute more, you can borrow some from them, better asset protection in terms of protecting the account from your personal creditors. So those are all good reasons as well.
Mike: Yeah. I know we’re not going to be able to cover a whole lot of this, but maybe at a high level, John, why don’t you talk why you would do . . . I know there’s a lot of benefits to a solo 401(k) versus a self-directed IRA. A self-directed solo 401(k) . . . that’s a mouthful, right, versus a self-directed IRA. Maybe just at a real high level, just take a minute or two and talk about, even though there are all these benefits, here’s why those that don’t do it, can’t do it.
John: I’ll give you two instances I see. One, you just don’t qualify for a 401(k), for whatever reason. Usually, you don’t have a business that brings in earned active income. You just don’t qualify for the 401(k). So the IRA is better than nothing, a lot better than nothing. The other one is this. With Roths, the Roth 401(k), and the Roth IRA, rules are a little bit different. With a Roth 401(k), when I hit 70 1/2 years of age, I have mandatorily to start distributing money from the 401(k) Roth. Where with a Roth IRA, I’m not forced to distribute.
So we do see people at age 70 1/2 roll their Roth 401(k) into a Roth IRA to keep from being forced to distribute. Maybe they don’t need the money. Maybe because passing on a Roth IRA is very powerful because whoever inherits it gets tax-free income for life, even if they’re not retirement age. That’s huge. So that’s another reason that we see Roth 401(k)s rolled into Roth IRAs.
Mike: Okay. And some of it too, just to clarify, is whether you have employees in your company or not, right?
John: Well, you can have a 401(k) if you have employees, you just can’t have a 401(k) solo. So you can have a self-directed 401(k) Roth and have employees. What’s the difference between a regular 401(k) Roth, and a solo 401(k) Roth? Administration. You should plan on spending an extra, I don’t know, $2000, $2500 a year on administering the 401(k) where there are employees versus the 401(k) solo where you don’t have employees. It’s cheaper, simpler, easier to run.
Mike: Yeah. I see. Okay, okay. Awesome. Well, what are maybe . . . before we kind of dive into sharing your example here, maybe you can tell us this time of year I guess here, we’re coming out, this show’s going to be coming out in March. And so it’s really kind of late for people to be doing things. We’re going to be coming out the end of March here. But talk about what folks should start . . . if they miss the boat on some things in maybe how they can make sure that for 2016 they take advantage of some of the things that are in place, if they’re not already, to kind of minimize their tax bill?
John: That’s a long list. One, where entrepreneurs fall down is record keeping. Some of them research, listen to the show, read books, buy courses, pay for education, and learn how to save taxes, and never properly implement it. Why? Because their records are horrible. Same thing with maintaining entities. So, A, learn how to maintain records. And, B, if you’re no good at it and you make enough, delegate it. I would say to learn general tax savings techniques, talk to people who are more aggressive, more creative, who know your industry.
If you don’t have an IRA or 401(k), and by the way, the same rules that apply to IRAs apply to health savings accounts and Coverdale educational savings accounts. If your kids are going to private school, you can pay for K-12 tax-free through a Coverdale educational savings account. It works a lot like a Roth IRA. Your health care costs should be paid through a health saving account. Those work a lot like Roth IRAs. So the planning techniques that work for IRAs, work for 401(k)s, work for HSA’s, work for CESAs. But if you procrastinate, which is an entrepreneurial disease, you procrastinate, you don’t do what you’re supposed to do, you don’t set it up, then it’s going to be a problem. I apologize. I had my phone on not mute. Let me turn it down.
Mike: No problem.
John: There we go.
Mike: So would you say that some of the process . . . of course, people have to keep good records for all of this. Would you say that if people are listening to this today, where they start is just to get with a good custodian and get an account set up to at least kind of get that process moving?
John: I would say act, first of all. Yeah, get with a good custodian, set up an account, get some education. Some of it out there . . . see, for 401(k)s and IRAs, there’s some written material out there. But not a lot of it’s very good. So that, in that industry, there’s still a lag. Now, for real estate investors, on non-401(k) tax savings issues, there are some decent books out there that give you a decent idea.
But I’d say to get a good custodian, get a good advisor. If people are going to be cheap and not pay the advisor, understand I’m going to get your money one way or another. I’m going to get it now ahead of time and a lot less of it planning ahead, or I’m going to get more a lot later when you run into problems. Or I won’t get any of it, it’s just the government will get a bunch of it.
Mike: Yeah. Who would you rather have? It’s a little bit to your tax advisor in the grand scheme of things or a lot to the IRS, right?
John: Yeah, no matter what, you’re going to pay. The question is how much, when, and to whom. All right? But one way or another, you’re going to pay. So take the time, do the planning, even if you’re a brand-newbie. I mean we take clients of all sizes. We’ll get brand-newbies. Now knowing that they’re on a limited budget, we try to limit the call to an hour, we try to give them as much homework to do because their time isn’t worth as much, typically, because they’re getting started. Then you get someone older, more experienced, with a bigger portfolio, a bigger business, they pay us to do more because their time is worth so much more.
So there’s a spectrum. But get a good advisor. And if you don’t mind the shameless plug, we’re at IRAlawyer.com. We are taking clients, hint. There. That was shameless. But there’s plenty out there in terms of advisors. Make sure they’re in real estate, they’ve got the experience, and that they’re aggressive. As you started saying, don’t get some wet noodle who just basically asks you to cut the biggest check possible to the IRS to minimize their risk.
Mike: Right, right. And in terms of an advisor’s job, maybe you could just tell us one last thing before we jump into the taking action segment here is differentiate between a custodian . . . there’s a lot . . . I know you work with all the major custodians. So they’re prohibited from giving legal advice, right? So they can give you some general information. Maybe you could kind of differentiate an advisor in this space versus an actual custodian.
John: The custodians will provide some educational content. But that content is not custom designed to serve you. They haven’t been in audits. They’re not going to take on the liability of giving you legal advice. And if they did, the Supreme Court in their state would spank them. So they can’t give advice. They do give some education that gives you a basic understanding.
I would not act just on that education. It’s too general. You need something directed at your specific circumstances. Remember what I said. This is both high-reward, hey no taxes, but also high risk. Oops, prohibited transaction, sort of activity. So the custodians can give you a heck of a start, but they’re not the end-all-be-all. And they’ll be the first ones to tell you that. That’s why you sign something that says they’re not liable if you take their advice.
Mike: Right, right. Awesome, great. Okay, John, let’s jump into the taking actions segment of the show here. You ready to share your story with us?
John: Yeah, yeah. Let me tell you how I stumbled on this, by the way. In order to be a better servant to my clients, and also to find techniques that work for me, I go to a lot of training classes. I pay to go to seminars and sit in the audience and listen to what people do. So I went to a seminar put on by a guy named Jeff Watson, a fellow attorney. I don’t usually say nice things about lawyers. He’s actually a good guy and a good attorney. Very rare for me to say that.
And somebody in his audience described in great detail, and we had a lot of Q and A, his technique. And it has become my favorite way to just ridiculously expand a 401(k) or a Roth IRA. He did it with a Roth IRA. He’s now in his early 60s so the income is coming on to him completely tax-free.
He has over 50 rentals, mostly low-income stuff in the Midwest, free and clear, in a Roth. So he’s over 60, he’s had the Roth for more than five years, he makes about $250,000 net after management and everything. That is $250,000 net of any tax. So how did he get 50 properties free and clear into a Roth on only $5000 a year in contributions? And he did it fairly quickly. I think it was only over about 10, 11 years he did it. Leverage. Very careful, very intelligent use of leverage.
The IRA or 401(k) can borrow, but you have to meet certain criteria for the borrowing. He uses private money, which is way more flexible than banks. Even the banks that’ll do IRA loans aren’t that flexible. He knows a lot of people. The loans had to be nonrecourse. What does that mean? It means that all the lender can do if there’s a default is seize the property. Now, he bought deals that were sweet enough that the lenders would hope that he would default. They would get a very nice property for the amount of money they put into it. He bought a lot of stuff during the crash at the bottom, a lot of low-income stuff for like $15,000, $20,000 grand a house that has rents of $600 to $700. Do the math.
He would have a loan that would amortize very quickly. Because here’s the catch. When you have debt on property owned by an IRA, it’s a little different with a 401(k). When you have debt on rental properties owned by an IRA, you pay tax. The IRA is not tax-exempt to the extent it’s leveraged. You pay a tax called U-V-I-T, UVIT. But these loans amortized so quickly, I mean, these properties cash flowed like monsters given the prices he had. He got the tax paid . . . I mean, he paid off the loan within four to five years. And the amount of UVIT he paid every year declined very quickly.
So he paid the man upfront. He got nonrecourse loans, very carefully drafted. He did his research and made sure none of his lenders were what’s called a disqualified party so that we didn’t have any prohibited transactions. He was very careful about that. And then today, let me ask you this. In today’s market where people are making 1 or 2% on their money market, do you think 7% on secured real estate might be attractive? It can be out of other people’s IRAs. It doesn’t even have to be their money money; it could be their IRA money. So he borrowed . . . go ahead, go ahead.
Mike: I was going ask you, specifically for disqualified partners as your lender. So is it the same criteria? Can it be direct descendants and things like that? Is it the same criteria for a nonrecourse private lender? Is it the same kind of criteria?
John: It’s the same criteria, but let me tell you this. There are subtle . . . how do I put this? Most people think, “Hey look, as long as it’s not my parents or my descendants or my spouse and her descendants, we’re fine.” There’s a much larger list of disqualified parties than that. For example, anyone who works for the accountant that does my tax return, that’s a problem. Anybody who is a JV with me, that could be a problem. There are some subtle disqualified parties that people don’t hear about. So the research has to be meticulous and careful.
So he borrowed, he paid off the debt very quickly. Most of his money was kept high and dry. In other words, most of the money in the IRA that he contributed was kept as a reserve for rehab or vacancies and paying on the debt, that kind of thing.
Let me add one nice kicker. In a 401(k), you wouldn’t even pay the UVIT. Most rental property loans in a 401(k) do not pay the UVIT tax. Now, what do I like about paying the UVIT? What do I like about the structure? Why is it my favorite? It’s simple. Even the IRS understands loans. You start getting into assignments, you start getting into options, lease options, trusts, IRS agents get confused. What does a confused mind say? No. You’ve got a lot harder fight ahead of you. It doesn’t mean that you’re going to lose but you should count on a fight.
So the IRS understands debt. It’s explicitly permitted. And there’s this sort of sense that if you paid some UVIT, maybe it’s not a lot. But you paid some, that they got something out of you. They threw the dog a bone. And I’m telling you psychologically, in audits, that makes a huge difference.
Now, let’s take this a step further not just with low-income rentals, but any type of asset that could quickly pay off underlying debt. For example, I’ve seen some people buy discounted notes. And if you buy right and you know what you’re doing with discounted notes, could one discounted note that you do a . . . I always think of it in my head as rehabbing a note, but you do a loan mod . . .
Mike: Sure, yeah.
John: Could it pay off . . .
Mike: Take it from nonperforming to reperforming or something like that?
John: Yeah. Could that pay off two or three notes in a lot of leverage? Yeah.
John: So you eat the UVIT on the initial hit, but then you’ve got this big war chest you didn’t have before. There are other thoughts, but I think the leverage concept, done correctly, that how you take an account. I’ll give you an example. Coverdale educational savings account are like Roth IRAs for education. You can pay K through 12 private education for your kids tax-free through one of those. The biggest complaint I hear: “I can only put $2000 a year in there.” Well, now we’ve got an answer to that. How do you balloon these accounts? That’s the answer. I love this technique.
Mike: Yeah. So talk about other ways that you could essentially get a bunch of cash then to pay down rentals, let’s say. So I know like some folks, and correct me if I’m wrong. You’re the attorney here. I’m not going to give legal advice, but I want to run some things past you because I know people are listening and saying, “Hey, can you do this or can you do that?” So I want to ask you specifically about rehabs and about assignments, kind of running assignments through this.
So let’s start with rehabs. So you could essentially use nonrecourse loans to lever up a rehab. You may ultimately put close to nothing down if you can get nonrecourse loans to cover the rest of that. Rehab a house, make, let’s just say, $20,000 or $30,000, gets put back into your account, and you could use that to effectively pay down debt on your rentals in there, right?
John: Yeah. The only problem with that is the entire profit or most of the profit, depending on how much you borrowed on the flip, would be taxable at UVIT rates. And after the first 12,000 in income, the UVIT’s very high, 40% plus.
Mike: Oh wow, okay.
John: So now, first of all, let’s say your account doesn’t have much in it. Do you do one or two rehabs and eat the tax, but now you’ve got a war chest that can grow tax-free? Sure. Is it a strategy I would use to pay down debt? Probably not because of the UVIT issue.
Mike: But if it’s in a Roth 401(k), are you avoiding that?
John: No, because . . . and there are different types of UVIT. So the type of UVIT that a 401(k) avoids is the UVIT on a leveraged rental.
Mike: Ah, I see.
John: But on a flip, it’s a different kind of UVIT. Whether or not it’s a trade or business, which you pay UVIT on, or it’s just because of the leverage, either way, you would pay UVIT. But I have seen people suck it up, eat the UVIT on one or two flips, but now they’ve got $40-, $50-, $60,000 to go do something with tax-free completely.
Mike: Right, right. And so how about an assignment? So I don’t know whether this is allowed or not, but I know people that will run an assignment through there, maybe they have an $8- or a $10,000 assignment fee that the contract the house in the name of their . . . go ahead.
John: Yeah, I’m very familiar with assignments. And you just said the word that leads to where I’m going to go. You said fee. They’re charging an assignment fee. Now one of the prohibited transactions is you’re not allowed to provide services. What the IRS is going to say, and I get arguments from people all the time that are kind of, “You don’t know what you’re doing. You’re just an attorney, you don’t know anything.” Oh, okay. What they say is, “John, you don’t understand. This isn’t a fee, I’m not being paid for a service. I own an option or I own a contract. That’s property, John, you dumb lawyer. Do you understand? Do I need to use little words?” I mean, people get really upset when I tell them this.
The problem is this. The assignment is functionally the same as brokering. You’re finding the property, you’re putting the deal together, you’re finding the customer, you’re getting paid a fee. It’s being restructured in the form of a sale of a small piece of property in which you have a very tiny investment. The IRS has more power than the normal government when it comes to reclassifying something and saying, “No, no, no. You say that’s a dog and I see the sign on it. You could put a sign on it with crayon that says dog, but it’s got a bill and feathers and it quacks. That, my friend, is a duck.” And so the substance over form doctrine, I am convinced that on assignments, the IRS will successfully argue that it’s a prohibited service.
Mike: Okay. Now if [inaudible 00:30:29] if you double close on a wholesale deal, let’s say that? Do you actually take ownership even if it’s just . . .
John: I like it better . . . here’s where I really like it. Hold it for at least a few days. You actually close. The longer you hold it, the better. If you can stomach holding it for 30 days, oh, that’s much better. Because then it looks more like what? What the IRS is used to seeing. They’re used to seeing people, for example, buy stock and sell stock. Now they’re not really used to seeing . . . well, I guess there is an argument. Now you’ve talked me into it. Day traders will buy a stock and sell it very quickly because they’re looking for patterns. And as long as it covers the fees and they see a pattern, maybe a quick spike, they might do the equivalent of a double close.
The bottom line is I think the double close is better than an assignment. But I would really feel more comfortable if the property were held for a little bit. This is why I like rehabs. By definition, you buy it. It takes a certain amount of time for the rehab to get done. You bought a piece of property, you paid other people to do all this stuff to it. Then you sold it. I love that model from a tax standpoint.
Mike: Yeah. Well, I want to ask you a question out of left field here now. So talk a little bit about . . . do you know anybody doing . . . I’ve heard of some folks doing options on deals where they basically have an option price that’s low. And once they rehab a house, basically all that . . . let’s just say your retirement account may own an option to purchase a house that all they put in was the option fee essentially. Let’s just say, as an investor, I bought the house, my retirement account has an option to purchase it for $5000 above what I paid for it. And then it simultaneously buys it and sells it for $20,000 more than what I paid for it.
John: With options, it depends on how you structure them. If you don’t mind me dropping a name, when you do what Pete Fortunado calls a strategic long-term option, that’ll work. When you do what he would call a tactical option, which is what you just described, and more to the point, you’ve structured it with a friend to dump a bunch of money into your IRA, and we both know you’re going to do your friend a favorite at some point. Because what I would do is go to the friend, if I were an IRS agent and say, “You know, you just did a deal with this guy where all the profit from your flip went into his IRA. I’d like you to do five of those with me.” You know, we all know what he’s going to say. “No, I’m not doing that for you.” Right.
So here’s the problem: that’s an artificial transaction designed to stuff the IRA. Usually, if they dig hard enough, there’s some sort of backscratching on the other end, a favor of some sort. And that’s why that won’t fly. Now can we structure options that’ll work? A long-term option that exists for a reason that’s on there for 15 years, that there’s a pattern that some of the options go up and some go down. And there was an organic reason, not an artificial reason, but a reason organic to the deal that the option was included up front in the deal, sure.
A lot of times for me, an option is just a synonym for assignment. Okay, I have an option on the house and I assign the option. And I know that’s not . . . you were talking about something a little different. But, and I can even give you the law right off the top of my head. The IRS is actually aware of this kind of technique. So they put out a letter called . . . it was letter 2004-A. And they talk about stuffing your Roth. They’re all over it. Sorry.
Mike: Hey, well, some of it was not necessarily me asking these questions. There are . . . as investors, we hear things, I hope folks that are listening to this right now, there are things that we hear that you’re like, “Huh, I wonder if . . .” you know, we’re all creative and like trying to figure out some creative ways to minimize taxes and do it . . . I’m not saying doing anything illegal, but there clearly are some creative ways and it comes about by having a great advisor to kind of bounce questions off of.
John: And that’s what happens. A good conversation with an investor is we take 20 of these ideas and throw them up against the wall. And I keep going, “No.” And here’s why I keep going, “No, no.” Because the IRS has now been around for over 100 years. And what they do is when somebody like you does what you just suggested, creative investor, great idea, and they get away with it, then the IRS goes to Congress and says, “Would you write a law saying you can’t do that?”
And so they’ve had 100 years to write laws and regulations blocking a lot of the fun stuff. But if you throw enough stuff against the wall, you talk to your advisor, you brainstorm, he’s going to go, “No,” nine times out of 10. But that one time out of then where he’s like, “You know, I think that might work.” And that’s where we got into more of the long-term options or using the leverage.
And there are some techniques I haven’t talked about. There are ways to expand your IRAs, but they’re not as simple as an assignment or an option with financial friends. That’s a term . . . as soon as I hear financial friends, I say, “Okay. Now, you know what you’ve told me? The guy’s doing you a favor.” It’s an artificial transaction that the IRS can say that’s not real.
Mike: Right, right. Well, John, any kind of final words of wisdom you want to share? We’ve been talking for a while here. A lot of great information. I know it’s a lot to absorb for those of you listening. Any kind of final words of wisdom on where folks should take what they just heard here and go do something with it?
John: Take action. Plan. People talk about, “What should I do in my IRA?” The first thing I’d say is, “What do you normally do?” It’s not always doable in an IRA. I can’t have my law practice run through an IRA. It just doesn’t work. But a lot of the time it is, especially with real estate. Do what you’re good at. Do what you know. Get a good advisor. Brainstorm some ideas. And most of all, stop dreaming about it. Follow through.
My favorite clients are the ones who can live off of, I don’t know. Let’s make up a number. I’m in the Midwest. If you live in Ohio and you make $100,000 a year, and you’re not happy, there’s something terribly wrong with you. I’m not saying there’s anything wrong with making more money. I’m not Obama. It’s okay to make more. But a lot of these guys that I like a lot, they’ll make $100,000 and say, “John, how can I make the rest of it? I don’t need more than that. How can I make the rest of it through a combination of 401(k)s, health savings accounts, and CESAs?”
And we structure the rest of their business through those accounts, totally legitimately. I like that. So what would I say? Take action, dream a little bit, talk to an advisor, throw things up against the wall and see if it’s going to stick. And I’d love to work with people. I take clients nationwide. The federal tax law’s pretty much the same everywhere.
Mike: Yeah. Tell us one more time, John. Where do folks go to connect with you?
John: IRAlawyer.com. And it’s a primitive little website. It’s really just a “here’s how to reach John’s page.” But IRAlawyer.com. I’d love to find ways to legally and ethically keep the socialists from taking your money.
Mike: Well, on that note, John, thanks so much for spending time with us today. I look forward to talking to you again soon. And if you’ve got some good information out of this, you can reach John at IRAlawyer.com. And I think all of us work so hard. It’s so hard to be a successful real estate investor. It’s not as easy. The gurus say you just lay on the beach and collect checks. It’s not quite that easy. But it can be that easy someday if you put enough of it away in your retirement accounts, right?
John: The things I’ve seen people do through these accounts, the amount of time they’ve saved . . . because that’s what you’re losing. When you pay taxes, you’re not losing money. You’re losing a piece of your life that they took from you that you earned and was seized. And if you can win it back, that’s when you get to go to the beach.
Mike: Awesome. John, thanks again. Everybody, thanks for joining us today and we’ll see you soon on another upcoming episode. Have a great day.
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