Today’s REI Classroom Lesson
Today, Clint Coons goes over the risks of SDIRAs this year and an alternative for real estate investors to take advantage of.
REI Classroom Summary
Due to changes and statements from the IRS, Clint comments on how SDIRAs with investments in real estate can be targeted and how a qualified retirement plan can be a good option to look into.
Listen to this REI Classroom Lesson
Real Estate Investing Classroom Show Transcripts:
Mike: Welcome back to the FlipNerd.com REI Classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. Now, let’s meet today’s expert host.
Clint: Hi, everyone. This is Clint Coons, host of the REI Classroom and managing partner of Anderson Business Advisors and Law Group. Today, I want to talk to you about self-directed IRAs.
Mike: This REI Classroom real estate lesson is sponsored by VirtualStaffNow.com.
Clint: This is a very popular topic out there. A lot of people talk about investing with their self-directed IRA. But people are not getting the straight information here. That is, they’re not aware that the IRS has specifically targeted self-directed IRAs to make them a target in 2016.
In 2014, the IRS came out with a new form, what is called 5498. That is for the IRA custodian or third-party administrator to report on your investing. That is, they have to tell the IRS if you’re investing in very specific types of assets. Previously, this was not requested. What they’re looking for right now is whether or not your IRA is investing in real estate or closely held business interest.
Now, this form is mandatory beginning in 2015. So if you had an IRA or self-directed IRA in 2015, you may have already been reported. On top of that, last year the IRS came out, the General Accounting Office, and they specifically stated that the IRS will target people that have hard to value assets, more specifically real estate and limited liability company interest. Because I know a lot of people out there that set up self-directed IRAs are using those checkbook LLCs to gain control.
Well, this is a real problem. If you want to know what the IRS is looking at and why they’re probably coming after your self-directed IRA, number one, it’s taxes. I run into hundreds of people that are using self-directed IRAs to invest in real estate and they don’t understand the ramifications of their actions, that they actually are going to result in taxable events. If your IRA is taxed, you’re paying tax at 40% on that income.
Now, it’s easy enough for me to say that your IRA is going to be taxed. But let me give you some concrete examples of what causes taxation. Number one, if you have a self-directed IRA and you’re actually borrowing money, xo you’re using debt financing, which is okay as long as it’s on a non-recourse basis. What you may not realize is that debt is taxable to your IRA on the income that’s generated from it.
Now, take this example. I met an individual. They were investing and invested in a house, a rental property. It was $200,000. Their IRA had $100,000 in it. So they got a non-recourse loan for $100,000, so they were able to buy this property. This property throws off $30,000 a year in positive cash flow to their IRA. Now, I asked them because they’d had this set up for five years, I said, “Have you been paying any tax on that income?” They said, “No. I wouldn’t have to. This is a Roth IRA. It’s tax-exempt.”
Well, it’s not because 50% of the acquisition cost was debt. That is, the IRA put in $100,000. The IRA had to borrow $100,000. That makes $15,000 of that income subject to taxation, and that IRA needs to file form 990-T each and every year to pay that tax. Huge problem right there.
Secondly, I run into people who flip property, and I know a lot of people who are listening to this are probably flippers in and of themselves. So flipping property is considered to be a trade or business if you’re a real estate investor. There have been a couple tax court cases last year where they found people who buy and sell property on a short-term basis are considered to be in the business of flipping real estate.
Now, you cannot run a trader business through your self-directed IRA or it’s taxable. So that’s a huge problem right there. That if you’re flipping real estate in your own name and you’re flipping real estate in your self-directed IRA, you’re creating a taxable event for that.
Last but not least, I want to cover because, I mean, there’s so many issues out there regarding self-directed IRAs that could create problems for you, is asset protection. You know that if you create one prohibited transaction, one mistake, your IRA loses all of its asset protection benefits. You’ve seen right now an uptick in cases in bankruptcy courts where real estate investors are losing their IRAs because they entered into a prohibited transaction. From that point forward they no longer have the asset protection benefits of the IRA.
Here’s a solution. These are the problems that individuals who use self-directed IRAs face, and I often tell them, get out of the self-directed IRA. Set up a qualified retirement plan. Roll your IRA monies into the qualified retirement plan, and those problems will go away.
For example, when you set up a qualified retirement plan and you roll your money into it, did you know that you can now borrow from it? Yes. You personally can borrow up to $50,000 from your plan. You cannot do that with a self-directed IRA. Asset protection, like I just finished with, with the self-directed IRA, if you engage in a prohibited transaction, well you invalidate your IRA. But with a qualified retirement plan, we have no such restrictions.
If you screw up and you do something you shouldn’t, with a qualified retirement plan, the only penalty is you have to pay a tax on that particular transaction. It doesn’t invalidate your qualified retirement plan. I’ve seen situations where people have adopted qualified retirement plans, rolled their IRA money into them, and then bought a boat and cruised around on a lake. They used it personally. Try to do that with your IRA, you know what’s going to happen. It’s going to be disqualified.
Not with a qualified retirement plan. The court upheld it and said they could not pierce the plan. You want to use debt to invest in real estate? Go right ahead inside of the QRP. It’s nontaxable. There are so many other benefits inside of qualified retirement plans, like paying contributions of Roth. You can throw in $18,000. Heck, I’ve even got a strategy where you can put $53,000 away into a Roth IRA. You just need a qualified retirement plan.
These are the strategies that sophisticated real estate investors are using right now for their retirement funds. The question is, are you going to continue on with your self-directed IRA and become a target? Or are you going to step out of the mold and find other options that are available to you to put you on the path to greater success? My name is Clint Coons, and I hope to see you next time on this show.
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