How to Choose the Right Legal Entity for Your Real Estate Investing Business

Mike Hambrey: Welcome to the flipnerd.com podcast. This is your host, Mike Hambrey, and on this show, I will introduce you to VIPs in the real estate investing industry as well as other interesting entrepreneurs whose stories and experiences can help you take your business to the next level. We have three new shows each week which are available in the iTunes store, or by visiting flipnerd.com. So without further ado, let’s get started.
Hey, this is Mike Hambrey with flipnerd.com. Welcome back for another video opinion review, where I introduce some of the most successful and interesting real estate investing experts and entrepreneurs in the industry to help you learn and grow.
Today, I’m joined by John Hyre who is an active real estate investor himself, but a tax attorney and accountant by trade, focused purely on real estate investing. All of his clients are real estate investors, so we’re going to learn a lot today.
So taxes, and accounting and bookkeeping is an area that most real estate investors love to hate, but I can tell you from personal experience, being strategic from a tax perspective can help put a lot more money in your pocket and help you avoid some massive headaches down the road.
Today we’re going to pack this interview with all kinds of stuff. We’re going to talk about choosing the right legal entities for your business, building wealth in your IRA, because John does a lot of IRA work, and we’re going to talk about bookkeeping, an area that real estate investors generally hate, but John is going to give us maybe some tips on how to make it a little bit easier for us.
Before we get started, though, let’s take a moment to recognize our featured sponsors.
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Please note, the views and opinions expressed by the individuals in this program do not necessarily reflect those of FlipNerd.com or any of its partners, advertisers or affiliates. Please consult professionals before making any investment or tax decisions as real estate investing can be risky.
Hey, John, welcome to the show.
John Hyre: Glad to be here.
Mike Hambrey: Yeah, yeah. So we’re going to pack this interview with you today full of great content. Right?
John Hyre: Hey, I’m not billing, so take advantage.
Mike Hambrey: Oh, that’s good, that’s good. But I forgot to ask you if we were on the clock, so I’m glad we’re not. Awesome, awesome.
Well, before we get started we’re going to talk about some stuff here, IRAs, choosing legal entities, which is always an interesting question, everybody always asks that and a lot of times it’s hard to get a solid answer out of attorney, so I know you’ve got some answers for us, though, in building wealth in your IRA. A whole bunch of stuff. Before we get started though, why don’t you introduce yourself and tell everybody a little bit about you?
John Hyre: Sure. My name is John Hyre. I’m a lawyer and an accountant. All my clients are real estate investors, and we get a lot of the sort of exotic clients who are doing something a little different, so we’re very used to dealing with subjects who lease auctions, signing and buying parcels, selling parcels, selling notes, buying notes at a discount, you name it. Whatever technique that most people would consider different or exotic, we’ve probably seen it and dealt with it. And we get above the accounting side, particularly the tax returns, and we also do a lot of planning, and if you need it, we hope you don’t, but if you need it, audit representation or collection representation.
So a small firm in Ohio, nationwide client base, mainly because our expertise is so rare. It’s taught me… a lot of people end up paying our accountant to learn from them. You’ve not, you know, you’ve never lived until you’ve watched somebody pay an accountant for hours to sit and explain how certain types of deals work.
Mike Hambrey: Yeah.
John Hyre: We’ve never had to have that with clients. It’s usually about a five-minute process. I’ve usually heard of it, and if I haven’t, I can research it and figure it out.
Mike Hambrey: Yep. Yep, that’s great, that’s great. Well, why don’t we start with choosing the right legal entity? So it’s a question that every investor asks, in fact, I mentoring coach a lot of new real estate investors that come into the industry, and that’s always one of the first questions they ask, is “Should I set up an LLC, or S-Corp, or what’s the right legal entity,” and I usually just dodge that question a little bit, and say, you know, “Here’s a couple of attorneys you can talk to.” and I know historically, what’s interesting because you’re an accountant and an attorney, historically my accountant has always said something like different from my attorney.
John Hyre: Yeah.
Mike Hambrey: Because they’re looking at it from how to minimize taxes, and the attorney is looking at it from how to, how to kind of minimize legal liabilities. So what are your thoughts on what the right legal entity is for a real estate investor?
John Hyre: It’s funny. The lawyers always tell you, “Go talk to your tax guy,” and the tax guy says, “Always go talk to your lawyer”, and as you said, they disagree. Fortunately, if I disagreed on film, it would be, and disagreed with myself, it would be really amusing. Help send me to a shrink. So we try to synthesize the ideas. Let me give you some guidelines. Let me give you the usual lawyer caveat of, “This isn’t legal advice. You really should talk to someone about your circumstances,” but these are some really useful guidelines to incorporate. When it comes to buying and selling, I call “flipping” generically a number of things. For me, assigning is flipping, retail deals where you rehab them is flipping, and wholesale deals where you take title and then sell it off quickly is flipping. So for me, those three things are pretty much the same.
Mike Hambrey: What are we looking at:
John Hyre: If you’re not taking title, you probably have a Social Security tax issue right away. Or a self-employment tax. It’s the same thing. So if you’re assigning, it’s an issue right away, because IRS looks at that as “services” income, and you pay that extra 15% on that, so we want to minimize the tax. If you’re actually taking title, you’ve got the famous “dealer” issue. Whenever you’re considered a dealer, that’s when you pay the self-employment
Social Security tax, so if people who take title, the first few that they do, we can often put them on Schedule D, as in “dog”, treat them as a short term capital gain, and there’s no Social Security tax on that. But you can only do that for so long. What the IRS looks for is a pattern. So once you’ve got a pattern of buying and selling, or if you’re doing assignments at all, because it’s a little bit different technique, you’ve got Social Security issues. How do you minimize that?
There are two primary ways to minimize it; a) You convert Social Security taxable income into non-Social Security taxable income. So to give you an example, classic for my business. I have a service business. Right? And we do tax advising and lawyering for a living, just like you’re flipping. It’s the same kind of income. Now, that is taxable for Social Security tax.
What do we do, how do we convert it into non-taxable income? Well, I might buy a building and rent it to my tax practice. Well, rental income is not Social Security taxable, so let’s say I’m paying two grand a month from my lawyer company, or my flipping company in your case, to my rental company. That’s converting two grand a month to non-Social Security taxable, because my income on my flip side goes down two grand an month, my rental income goes up two grand a month, so income tax-wise, it evens out. But Social Security tax-wise, this is not taxable here.
Mike Hambrey: Now John, when you say Social Security taxable, are you referring to entities which are passed through entities?
John Hyre: Yeah. The default is, if you have no entity, you pay self- employment or Social Security tax. If you have a regular LLC that makes no election, you pay Social Security or self-employment tax, and there are certain types of entities that limit that. So we’re going to get into that next.
Mike Hambrey: OK.
John Hyre: So now tax step one is you convert Social Security taxable into not. It usually involves paying an outside company that you own. Another example would be debt. You fund a company with debt, maybe the interest rate is on the high side, you know, more towards 12% or something, that’s a deduction for my company, for one thing, its income for interest, but interest is not Social Security taxable. So that’s rule one.
Two is choice of entity. There are three types of entities that can help protect you from Social Security, oh, I lied, I’m a lawyer, it’s what I do. Really, four types of entities that can help protect you from Social Security tax. So which one do you use? I have to know a lot more about you. But I can give you some guidelines. For newbies, we usually use an LLC that is taxed like an S corporation, so when you set it up with the state, it’s an LLC, but then you tell the IRS on a special form, we want you to pretend that that’s an S corporation, and they will.
Now what’s nice about an S corporation is income that passes through the S is not taxed for Social Security purposes. But, the IRS requires you to pay a “reasonable salary”, we want to debate what’s “reasonable”, but they want a “reasonable salary”. That salary, you do pay Social Security tax on. Our goal is to keep the salary as small as possible. The IRS’s goal is to argue for the biggest salary possible. It’s a subjective thing. It’s like, what’s a house worth? Well, you know, it depends. Am I buying or selling? I’m going to give you two different numbers.
Mike Hambrey: Right.
John Hyre: There’s a subjective range. Even an appraiser will sometimes give you a range, of here’s what its worth.
Mike Hambrey: Sure.
John Hyre: Same thing with the salary. So our goal when we do planning is to figure out, what is the smallest salary we reasonably think we can get away with? Such that if we get audited, maybe the IRS will take it and maybe they won’t, but if they impose a different number, at least we don’t pay penalties. That’s our goal. And that’s huge, because the Social Security tax is 15% up to the first $110,000 if flipping income. After that, it actually goes down.
Now, the S corporations have an advantage. They’re cheap and easy to set up. They have a disadvantage. The get audited hard. The IRS is all over them. They know this technique. They know why you set up an S-Corp, and they audit aggressively. So what we say for newbies, maybe in the beginning when you’re new you don’t want to spend a whole ton of money on entities. For example, all this stuff about setting up an entity in Nevada. If we have time, we’ll talk about it.
For newbies, a big waste of time and money. They should be spending it on marketing, and on education, and getting deals, not having 15 entities in Nevada or Wyoming. But we like LLCs taxed as S-Corps because they are simple, but high audit percentage. Once you start to get a little bigger, once you start to get a little more sophisticated, or once you have a partner that’s not your spouse, because the other disadvantage of an S-Corp is that they’re not real flexible.
Mike Hambrey: Mm-hmm.
John Hyre: So if you have a partner in an S-Corp and anything changes, it can be a problem. S corporations are just not flexible. So what we try and do then is, if you start off with a partner that’s not your spouse, or as you get larger and being audited becomes much more of a concern, we tend to go in one of several directions. It kind of depends on the client. We like limited partnerships. They have the same law as S corporations, they have the same Social Security tax advantage, but they’re not audited nearly as much. They’re audited far less, and they are specifically audited on the Social Security tax issue a lot less.
What’s the downside? More complicated. If you set up a limited partnership, you have to have an entity that’s a general partner, so you’ve got two entities you’re really dealing with. The law for limited partnerships is more complex, more old- fashioned than LLCs because, remember, I suggested before an LLC tax was an S-Corp, and LLC laws are pretty simple in a lot of ways.
Mike Hambrey: Yeah.
John Hyre: You’re dealing with more complexity and more moving parts, and that’s the trade-off. You get more flexibility, less likelihood of an audit, Sometimes, and this is fairly new, we suggest an LLC with partners. There is some really gray law that says LLCs with partners may not have to pay self-employment tax. It’s very, very gray law. We like it more than the L.P., because it’s simpler. LLCs are simpler and easier to run than limited partnerships. But it gets you the same benefit, lower chance of an audit, and way more flexibility.
Last but not lease, entity number four, C corporations. When do we use those? Most of the time, we find that C corporations are over-sold. We see a lot of people set them up, and they either don’t get any use out of them, they just sit and they pay the fees, . . .
Mike Hambrey: Yep.
John Hyre: . . . or they actually get hammered. They don’t use them right, because the accountant gave them a “Boom” type of recommendation, instead of looking at their circumstances, looking at their books and records, their returns, but also where they want to go. So playing a little bit “Miss Cleo,” trying to see where they think the future is going to go, and trying to make it fit for what the client is going to do. I’ll tell you that C-Corps make the most sense when we’re dealing with high-bracket people. The number one benefit of a C corporation is that the first $50,000, 50K, is taxed at 15, 1 to 5 percent.
Mike Hambrey: Right.
John Hyre: Well, if you’re in a 35% bracket, 20% on 50 grand a year savings, that’s 10 grand a year in net savings.
Mike Hambrey: Right.
John Hyre: We always remember that the C-Corp almost invariably is a satellite, never the main business. So I probably have my big flipping business here, that makes the money, that’s getting me into that high bracket, and then maybe I take this little C-Corp moon that revolves around my entity, and we throw a few deals to it, enough to get it up to that 50,000 bucks a year.
Mike Hambrey: Hmm.
John Hyre: Maybe enough to get a few of the C corporation perks, but again the C corporation perks that you hear all of the promoters talk about, those are grossly over-sold and overdone.
Mike Hambrey: OK.
John Hyre: I’ll give you one example that really just lights my fuse. They say that if you have a C corporation, you can deduct up to $50,000 of term life insurance. Well, it sounds great, but how much does 50 grand of term life cost you? Maybe a hundred bucks a year, maybe?
Mike Hambrey: Right, right.
John Hyre: But it’s a silly deduction. Why would I even consider a hundred dollar deduction when deciding if I’m going to have a separate entity? It’s immaterial and irrelevant, but it sounds good when we’re marketing. A lot of sizzle, no steak. So very, fast talking, I hope everybody understood what I said, because I accelerated to get the answer in, because I don’t like to just give an answer. I want you to have an understanding of why, because you see all of this stuff on the internet of which entity to use. People are like, “Well, who do we listen to? We don’t know.”
Mike Hambrey: Right.
John Hyre: The guy who tells you why and why not and tries to explain it so that you get it.
Mike Hambrey: Right, right. Yeah. And I think, like you said, it’s a case- by-case basis, it can partly depend on it you have partners, why type of business you’re going to operate, and things like that. So I think the key is just to talk to you, or talk to a professional that knows what they’re doing.
John Hyre: You know, it’s usually a quick discussion for us, unless you’ve got some seriously large business already existing, it’s usually for a newbie an hour-long conversation of which entities should be used. Maybe two hours. It just depends on how organized they are and how much they’ve got going on. Now, if it’s a little more substantial, you’re still only looking at three to four hours. That’s not a lot of time to spend to make a very fundamental business decision, because we’ve seen people pick the wrong entity, and it’s a nightmare.
Mike Hambrey: Yeah. You can regret that for sure. Right, well, OK, John, that’s great. That’s great information. So talk a little bit about, we’ll go next into the bookkeeping stuff, just some of the, some tips there. I know bookkeeping is, I know, I mean, I know a lot of real estate investors, and they do some terrible things, like they, you know, just have a box full of receipts sitting somewhere, or you know, the do their bookkeeping once a quarter or something like that, which would be a nightmare, um, we’ve hired that out, we have a bookkeeper that’s on our staff just because we don’t like to do it, I mean, it’s just one of those things that is a necessary evil, but if you don’t keep your books clean, it can become a nightmare, I know that. So talk a little bit about some of the mistakes you see, and give some advice on how to keep cleaner books for real estate investors.
John Hyre: There are a number of reasons the books have got to be clean. One, it makes the returns cheaper, and easier and more accurate. It makes a big difference in what we charge to do a return if you’ve got a clean set of books. If you ever get audited, having a clean set of books makes all the difference. All the difference. We have seen so many people who are entitled to deductions, but they wouldn’t do what it took to back them up, which is mostly bookkeeping. Also, it makes the audit go a lot faster. When you’re paying somebody on the clock to represent you, that makes a difference.
Mike Hambrey: True.
John Hyre: I’ll tell you the number one reason. Let me get one more, and then I’ll give you number one. One more reason to have a good set of books — entity maintenance. You know, entities are cheap and easy to create, I always joke that an entity is like a child. The process of creating one is fun and easy …
Mike Hambrey: [Laughs] John Hyre: Maintaining it, generally cheap, …
Mike Hambrey: Generally cheap, it depends on … [laughs}
John Hyre: … Yeah, as long as you’re not in California or Illinois or some, some silly state. They’re easy to make, but maintaining the entities takes effort and time, and part of that maintenance is a good set of books. But the number one reason to have a good set of books, here’s why they call them “the books”. It tells the story of your business.
Mike Hambrey: Yep.
John Hyre: And if you don’t know the story of your business, people guess. “Oh, I think I made money on this deal.” And then they look later, and it turns out they didn’t, or they didn’t make as much as they thought, but they kept doing the same type of deal because they thought they made money. Oops. So that’s the number one reason. It tells the story of your business.
Mike Hambrey: Absolutely.
John Hyre: It’s not that hard to do, and I think you can farm it out at an early threshold. In other words, what most of the people listening to this call are good at is making deals, buying and selling houses. A lot of them are either not good at bookkeeping, or are good at it, but they don’t want to be.
Mike Hambrey: Right.
John Hyre: I would say once your time is worth more than 20 bucks an hour, it’s time to farm that out. What we do, now we don’t like to do bookkeeping in our office, because we think it can be done very cheaply, and we don’t like doing things cheap. I don’t like billing 20 bucks an hour. That makes me very sad.
Mike Hambrey: Yeah.
John Hyre: But what we can do is find local bookkeepers, my favorite are maybe a stay-at-home mom, or somebody who is retired, but someone who has experience and wants flexibility, and in exchange, they maybe aren’t going to charge you 50 bucks an hour. Those are the best. Sometimes you have to train them. We do a lot of that work. We will consult with investors that are farming out their bookkeeping. We explain to the bookkeeper, which is a lot easier than explaining it to the investor, how to do things, and then we might look at their books every month, every quarter, something like that, and then once it’s clear that they get it, we might only look during planning season, which is about now. Starting to come up on the latter half of the year when you start your planning. We’ll see the books, and if there are issues, that’s when we’ll pick them up. And we also do teach people how to do their own books. So there are some options out there for that. We found that we had so many bookkeeping issues and questions, we just finally wrote a home study course that we sell, …
Mike Hambrey: OK.
John Hyre: … and that gets people out of the way, but I don’t want to be, you said don’t be pushy, so I’m not going to be pushy.
Mike Hambrey: Yeah, well, I’ll link to it. I think it’s a great, I mean, in all honesty, like you said, a lot of, most real estate investors I know are not good at bookkeeping, and they, it’s just their necessary evil, but, I mean, this is such a cash-intensive business, that you’ve got to know where you stand at any given time, I mean, you’re going to wind up in trouble if you don’t.
John Hyre: And especially in the world that we’re living in. We live in a different world than ten years ago. Certainly different than twenty years ago. The world, like it or not, is getting more bureaucratic, more socialized, the government and the regulators are sticking their nose in more, and demanding more. Like it or not, you’re going to spend more of your time, instead of producing wealth, tracking the wealth. And I don’t like it, and I’ll try and minimize it, but here’s the reality. And if you run things like a cowboy, I’ve seen it, where you didn’t really do anything wrong, but it allows an IRS agent or some other regulator to nail you, even though you didn’t really do anything wrong. Unfortunately, you really do have to track what you do.
Mike Hambrey: Yeah, yeah. I mean, having been through an audit myself, it’s no fun, but I can tell you, my wife is extremely organized, I mean, when they wanted something, it’s like, boom, here you go, we just had it, and you’ve got to believe that that makes a difference, rather than saying, “I don’t know, I don’t have the information you’re asking for, it’s going to take me four months to get it,” or “Here’s a box or receipts”, or whatever. You’ve got, I mean, at the end of the day, these IRS auditors are people, too, and if they see that you’re buttoned up, they’ll probably be more, you would expect an auditor to be more respectful of that, like, wow, they’ve got, you know, if they’re this organized, things are probably better than we thought, you know, maybe…
John Hyre: Those audits tend to get dropped sooner, and have a better result. And either one of those things is a good thing. If you have to get audited, even if it doesn’t go well, shorter is better. And if you’ve got the books, it’s likely to go better. And we have had auditors where we’ve done before, for example, because on audits, I’m very proactive, and ask questions, and push things. I get away with stuff that really isn’t part of the law, it’s just what the agent will allow. Well, that’s a whole different thing, if you ask questions. A good example would be, my client has a hundred rentals. They wanted to see a profit and loss for each month. That’s a lot of work. Come on. Let’s do 20. And to make sure that we’re not pulling the wool over your eyes, you pick which 20. And if you want to see more properties after the first 20 we’ve shown, let’s just start with a sample. I’ll tell you what, when you put it that way, nine out of ten IRS auditors will take that approach. If 20 look good, they’re not going to look any further. Look. They’ve got quotas.
Mike Hambrey: Right.
John Hyre: You’ve heard the story about the guy and his buddy, and the bear in the woods, and the bear comes after the guy, and the guy puts on his tennis shoes, …
Mike Hambrey: Yeah, yeah.
John Hyre: … and the answer is, his buddy says, “Why are you putting on tennis shoes? You can’t outrun a bear.”, and he says, “I can’t outrun the bear, I can outrun you.”
Mike Hambrey: Right. Right.
John Hyre: The same thing with the IRS. Right? If you have a hard case, the auditor is going to go look for something else, most of the time.
Mike Hambrey: Right. Right. Absolutely. Awesome. Some good information. We’ll add a link. I know you’ve got a home study course for people that maybe want to buy it for themselves or even train their bookkeeper. So that’s great. You know, we went through that process where we had to teach our bookkeeper, somebody that had no experience in real estate, we had to teach them, but once that was set, it’s pretty much on autopilot now for the most part, and it makes your life a lot easier.
John Hyre: You can focus on what you enjoy doing, and what makes you the most money.
Mike Hambrey: You’ve got it. And it’s not bookkeeping. [Laughs] John Hyre: Yeah. Do what you’re good at, and do what you like, and for all that I’m a tax guy, and a lawyer and an accountant, I don’t like doing bookkeeping, either. I know how to do it, how to teach it, I would rather drink probably gasoline mixed in with ground glass to do my own.
Mike Hambrey: Don’t do that, man. So let’s move on to the next item we’re going to talk about. I know you do a lot of work with IRAs, and you know, there are some people that that’s all they do, some real estate investors I know, that’s all they do. They swear by it. There are some that don’t do any of it, like me, in fact. I do none of it. But I’m very intrigued by it, and I don’t know why I’m not doing it, I just am so busy that I can’t change gears at this point, but that will change soon. But let’s talk about kind of building wealth with IRAs.
John Hyre: And let’s include in that, everything I say about IRAs more or less applies to 401ks, HSAs, also known as health savings accounts, and CESAs, Coverdale Educational Savings Accounts. Everything I say about an IRA, you can take and do, put your kid through private school, and I don’t mean just college, I mean private school. You can get enough money in a CESA, you can do it tax-free. My health care, I just went a few months ago to South America to get my health care done. The dentist up here wanted four grand. I got it done down there for about a grand by an American- trained doctor. It was great service, paid for the trip twice over. I paid for it out of my health savings account. I showed up with a debit card, presented the debit card, boom, done.
Mike Hambrey: Wow. Say that again, where did you go?
John Hyre: I went, my wife is from Chile, in South America, and I grew up speaking Spanish, so I have no trouble getting along. So I needed some dental work done, well, I just went down there and got the work done. Paid for it out of my HSA. I’ve gotten minor surgery, like sinus surgeries, done down there. You get better service, don’t even get me started, because the system is so messed up. If you know which doctors to use overseas, you don’t just use a random one.
Mike Hambrey: Right.
John Hyre: It’s a great relationship. You give them little green pieces of paper, and they give you advice. It’s wonderful.
Mike Hambrey: Yeah.
John Hyre: None of these lawyers or government. But I digress. What can you do with an IRA? First of all, you can do flips in an IRA. I’m not a big fan, I’ve got to say, and if we have time we’ll talk about it, I’m not a big fan of assignments in IRAs. And let me just give you that, look, if you do what is called a Prohibited Transaction in an IRA, and this is 70% of my IRA discussions are how to avoid a Prohibited Transaction ..
Mike Hambrey: Yeah.
John Hyre: A Prohibited Transaction, with a capital P and a capital T are bad. If you do one Prohibited Transaction, even a tiny one, if you do a 10 dollar Prohibited Transaction, in your million-dollar IRA, it dissolves your IRA. All of the money comes out and gets taxed, you pay penalties. We tell people that if you do a Prohibited Transaction in your IRA, you should count on paying 50-to-60% of it to the government. So we want to avoid that at all costs. Frankly, we’re a little bit conservative on that, because the penalty is so high. So on regular taxes, we’re very aggressive. The penalty for being wrong on regular taxes is much, much lower. So it’s OK to be aggressive, and play the gray in the law. But with IRAs, we’re careful. With that said, what can you do in your IRA? Rentals? Easily. I know a guy 60 years old, he’s got 50 free and clear rentals in his IRA. Think about that.
Mike Hambrey: Wow.
John Hyre: It’s a [??] IRA, he pays no tax on the money he pulls out of it, because he’s 60 and he’s had it for more than five years, he has got 50- plus free-and-clear rentals that he’s not paying any tax on. That’s wealth- building. [SS] Mike Hambrey: Yeah. [SS] So I think one of the challenges with an IRA is getting a whole lot of money in there, I mean, you’re restricted by how much you can put in. Talk about how people will build up that kind of wealth. Is it from doing other real estate transactions inside of there and building it up, or how, because a lot of folks that are listening now, even if you’ve been maxing it out for 10 years, you may not have enough to even buy one house yet.
John Hyre: Here’s one example. And we don’t have the time to go into hyper- detail, but I like simple. All things being equal, if simple works better than complex, you do simple. Occam’s razor. Here is one example. Very simple. You can borrow in your IRA. Now there are some rules you have to follow in terms of how the debt is structured, and who the lender can be. That’s where I get involved. We structure that. Well, your IRA can borrow. The way this gentleman I’m talking about got 50 free-and-clear rentals in his Roth, he put 5 grand a year in his Roth, just like you and me, not a lot. He never touched that money. That was his reserve on the side. He would go buy 100% leveraged property using private money, which you flipper guys are already familiar with, private money, …
Mike Hambrey: Yep.
John Hyre: … Now he negotiates some pretty good rates. He didn’t tend to pay hard money rates. He went after more like 5-to-8% private stuff, and he paid the rentals quickly. The key was, he amortized the loans quickly. Why is that important? Because in an IRA, if you borrow, you pay tax to the extent you borrowed. For example, let’s say I buy a property for 100 grand, my IRA puts down 10 and borrows 90. We look at the rental income at the end of the year, 90% of the rental income is taxable. So you pay a tax called UBIT, U-B-I-T. Unrelated Business Income Tax, in English, just IRA tax. What you do, is if you pay the loan down fast, every year that percentage drops really fast, so the amount of tax you’re paying drops really fast, until it’s free and clear. Well, this guy amortized those things over four years.
Mike Hambrey: Hmm.
John Hyre: Now here’s the beauty. It’s simple. Even the IRS gets debt. And there’s a psychological advantage. IRS auditors, because I’m like most people, I’ve been in IRS audits or IRAs, and I’ve been in a tax court and done quite well, IRS auditors hate Roths. It bothers them that you’re not paying any tax. It really bugs them. If you pay a little bit of UBIT, over the years, maybe those four years where you’re amortizing the property, you pay the little bit of tax every year, you would not believe the difference that makes in their attitudes. It’s purely psychological, like you’re paying something, it wasn’t a lot, but you paid something, so it’s a great way to balloon it. So how do you put a kid through private school? All right. Maybe you borrow the same way you guys do with private money, you do some flips in your IRA, maybe if you’re borrowing there’s going to be some tax paid, so on the new deals you pay tax, but once you’ve got this big chunk in your IRA, enough to fund its own flips, now it does a periodic flip, and doesn’t pay tax. Now I say periodic. If you do too many flips in an IRA, it becomes taxable, separate issue. But if you do one of two flips a year, maybe three flips a year, once the IRA has got its own money that it got from the leverage on the earlier flips, you can do that in a Coverdale Educational Savings Account, and pay your kid’s private school when he’s three years old. You could do that in your health savings account, and have a big nut for health care costs as you need them. And in the meantime, it’s growing tax-free. You could … [SS] Mike Hambrey: So the, the education account you mentioned, that’s a separate vehicle from an IRA?
John Hyre: It’s a separate vehicle, but it follows the same rules, and I get the same complaint that you kind of alluded to. People say, “Look, we can only put$2000 a year in there, and it’s not worth it.” Well, you think, and you structure how to do it, you can turn that 2000, just like they guy I was telling you about. You don’t touch the 2000. You put it to the side. It’s a reserve. You borrow the money you need for the deal. You guys are already used to doing that. You do the deal, and like I said, on the first few that you borrowed, you eat the tax. But at some point, that CESA is going to have a nice, rich balance in it. Or, you do the rentals instead of the flips. You borrow on those, and you just pay the debt down fast, so don’t pay a lot of tax, eventually it’s tax-free, and the cash flow pays for your child’s education.
Mike Hambrey: Yep.
John Hyre: I just want people to understand. You can tell I’m into it. I don’t like what the government does with your money. Most of what they do with it, let’s not even get me started, because you’ll have to bleep me, and it will be horrible.
Mike Hambrey: [Laughs] John Hyre: But if we can use their own rules legally and creatively to get around it, to pay your kid’s tuition, to pay their private school, to pay all of your health care, and keep in mind, some of the stuff that’s health care, and I’m sure we’ve all heard of the case where if a doctor prescribes a swimming pool for whatever condition you’ve got, it’s tax deductible and can be run through an HSA, that’s true.
Mike Hambrey: Hmm.
John Hyre: That’s not even gray law. That’s black letter law. So there are things we can do to add to it then, building up your retirement, because, I mean, nobody who is rational is counting on Social Security.
Mike Hambrey: Right.
John Hyre: I think Lindsay Lohan will invent, she’ll invent cold fusion before you and I see any significant Social Security money.
Mike Hambrey: All right. All right.
John Hyre: So just some thoughts, and I’m throwing them out machine-gun, as fast as I can, hopefully they’re understandable to people. Some of the things you can do, now why don’t you hear about this? There are very few people that know about IRAs in the tax world. And the reason is, there has been very little, until recently, IRS activity in terms of auditing and going after it. So there’s been no money in learning it, and it’s been a pretty obscure area. I got lucky in that somebody years ago brought an audit to me that we did really well with on an IRA. I did my homework, and so now I start getting more of that, whenever somebody has issue. As a consequence, I’m well-equipped to plan. Let me give you one more piece of advice on the IRAs, because a lot of people use what’s called a “checkbook LLC” It’s an LLC that your IRA owns 100% of.
Mike Hambrey: Hmm.
John Hyre: Just like anything else, there are ways to do that correctly, and there are ways to do that incorrectly. What I’m seeing is most of the checkbook LLC documents we review in our office are templates. There is no training of the investor how to run it, and they get themselves in trouble quick. The IRS is now focused on it, because they figured this out. Give you an example. You should not manage your own IRA LLC if your IRA owns an LLC, you shouldn’t manage it. The IRS says, and the code says, you’re not allowed to provide a service. Well, is managing an LLC a service? Well, we don’t know. There’s no definition in the code, so someday a court is going to tell us if it is or if it isn’t. My guess is they are going to say it is. So you want someone else to manage it. Now, you still tell them what to do, and there are procedures and ways to do that. So exciting stuff, a lot of opportunities, a lot of ways when you’re starting to make real wealth and you’re just sick and tired of paying 45% and 50% to the government, start running your business, I’ve got clients that that’s what they do, they make this much a year, let’s say 200 grand in the Midwest, which, 200 grand, live like a king.
Mike Hambrey: Mm-hmm.
John Hyre: Everything else gets run through the IRA or the HSA. I’ve got clients who structure their lives that way because they refuse to pay 40%- plus tax rates.
Mike Hambrey: Yep.
John Hyre: But just some thoughts. You’ve got to interrupt me … [SS] Mike Hambrey: It’s great… [SS] John Hyre: … or I’ll keep going.
Mike Hambrey: No, that’s great, man. We’re kind of winding down on time here, but that’s a lot of information packed into one show. I definitely appreciate that. For folks that want to learn more, John, and I know a number of folks who have recommended you in the past, so I know you do great work, the people who are interested in learning more about the services you provide, well, who should they contact? Where should they go?
John Hyre: I would give them two places. Realestatetaxlaw.com, and just fair warning, I’m so busy, the web site is horribly obsolete. It gives you an idea, there are some articles, but if the website looks like it hasn’t been updated in six years, it’s because it hasn’t.
Mike Hambrey: [Laughs] All right.
John Hyre: Just telling you. And the other one you can just call the office. 800-762-3290. That’s 800-762-3290. And our clients are from all over the country, and increasingly from out of the country. I’m sure you’ve seen that in your business, that there’s a lot more buyers from overseas.
Mike Hambrey: Absolutely.
John Hyre: We’re getting a lot more buyers, especially from the Anglosphere, and from Southeast Asia buying buy-and-hold properties for the cash flow and the currency advantages that they have right now. So we’re seeing a lot of that as well. So bottom line is we can do this virtually.
Mike Hambrey: Yeah. Yeah. Absolutely. Absolutely. Well, John, thanks for sharing all of that great information. I know it was a ton to pack into just a little over a half hour here, but great stuff, for sure. Maybe we’ll have to have you back on, and take some deep dives into some of these topics.
John Hyre: You want to have some fun, tell people what are their questions, get me a list of questions a week or two before a show, and we’ll answer them one at a time. It’ll be fun.
Mike Hambrey: There we go, there we go. Awesome. Awesome. Well, John, thanks so much for joining us today. Appreciate it.
John Hyre: Pleasure. Take care.
Mike Hambrey: All right. Bye-bye.