IRA or Individual Retirement Arrangement is a way of saving your money for retirement in a tax-advantaged way. However, you can encounter a problem if you are not sufficiently knowledgeable about your IRA. Bernard Reisz of 401kCheckbook.com helps with this as he shares the many forms IRA takes, discussing how those can be used either for real estate or debt, when to use them, and what are the things you need to be aware of when using them for real estate. Moreover, Bernard also talks about the various structures you can use your IRA as the Tax Code incentivizes you to get the highest return for your long-term investing.
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Bernard Reisz: What You Need To Know About IRA
Our guest is Bernard Reisz. Thanks for being on the show again, Bernard.
Thanks for having me, Whitney. It’s great to be here. I’m excited about being able to provide this integrated series that should hopefully address all the questions that people have, make people educated consumers with more knowledge, more education and more power. When people come to us, we want them to be educated. We want them to be asking the right questions. It makes things efficient for us. When they’re educated this way, they know immediately, “This is for me, this isn’t for me.” We can get right to business rather than having to start them from the ground up or correct a lot of misinformation that may have absorbed elsewhere on the internet.
I know I’m thankful to know somebody like Bernard because when people start throwing out these acronyms and terms like QRP, 401(k), SDIRA, UDFI, all those things, I’m like, “Where’s Bernard?” I want to tell the guest I’m thankful to have him on the show. We’re doing this little series. If you want to know more about Bernard, you should go back to show, WS11. He was one of our first guests and also on WS181. I would encourage you to go back and read those and then also this episode so you can read all these together and hear Bernard explain these things. I’ve had tons of questions and I know the audience too as well. Bernard, let’s jump right in.
Our topic is primarily going to focus on the IRA space and those are Individual Retirement Arrangements. They come in lots of different flavors. How can those be used for real estate equity or debt? When those should be used, how they’re used and what are some of the things you’ve got to be aware of when using them for real estate? Broadly speaking, tax-sheltered accounts can be used for about any investment. The Tax Code, IRS has never dictated what you should or shouldn’t invest in. There are very few restrictions what the Tax Code allows you to use within IRAs, 401(k)s and QRPs. The Tax Code wants to incentivize you to get the highest return for your long-term investing. There are various structures that we can use. We’ll talk about IRAs. In IRAs, there are SEP IRAs, Simple IRAs, Traditional IRAs or Roth IRAs. With regard to real estate investing, they’re governed by the same rules. They fall into one category based on your particular scenario, your financial profile or your long-term expectations or the deal you’re trying to do. You may choose to use one over the other. The rules that apply to them are generally the same.
At a very high level, when you use an IRA, there are a couple of different structures that you can use. For my company, our focus is on Checkbook IRAs. If you look in the Tax Code for Checkbook IRA, you won’t find it. It’s not a Tax Code term. It’s not an IRS term. In general, if anybody in the space tells you they’re providing something that’s IRS-patented or IRS-reviewed, you should be a little skeptical. We’ve got the Tax Code, there are certain things that are in there. There are certain structures that have been reviewed by the IRS. There’s no such thing as an IRS patent. There’s no such thing as an IRS Code. The Tax Code is from Congress. The Congress is the legislator. The IRS is the enforcer. They interpret some of the code. They may provide some regulations. Beware if anybody tells you something is IRS-patented.
When you want to get money into real estate using an IRA, how would you do that? Should you do that? The way you would have to do it is you need an IRA custodian, somebody that’s qualified to be a custodian of IRAs. In contrast with QRPs, an IRA requires a custodian. It’s there in Section 408 of the Tax Code. You’ve got to have a financial institution that’s the custodian of the assets. You’ve got to find somebody that’s qualified from the IRS’ perspective to hold these assets. If you go to Fidelity or Schwab, Vanguard, E*Trade, wonderful institutions, and you say, “Can you hold my real estate?” They can’t do that for you. They don’t want to do it for you. They are primarily investment exchanges. Their business model is to make money off investments. Even if there were no such thing as an IRA or a 401(k), they would be there so people can trade stocks.If you get something for free, you should take a step back to figure out how you're paying for it because you're paying for it somewhere. Click To Tweet
They make money on trades. They make money from the funds that they provide whether it’s funds that their business sponsors or some kickback. They are in the business of making money off investments. They did realize that we can’t offer IRAs and 401(k)s as a way to funnel money to our investment platform. They’re in the business of providing investments. They’re not in the IRA business. They do those as a marketing strategy to get money onto their platform. They’ll give you an IRA for free. It’s never free. If you ever think you’re getting something for free, you should take a couple of steps back and try to figure out how you’re paying for it because you’re definitely paying for it somewhere.
It’s okay, it’s just if you don’t know where you’re paying for it, you’ve got to be wary because who knows how much you’re paying for it because there’s got to be a catch somewhere. You’re going to pay for it through your investments. If you wanted to hold real estate, they’re not set up to do that and it will make money on that. They’re not going to be your IRA custodian for your illiquid real estate deal. How can you do that? There is an industry called IRA Custodians. They’re in the business of custodying IRA assets. They do not provide investments. Those kinds of custodians can be used to get an IRA into real estate.
You mentioned that the custodian has to be qualified. How do we know that they’re qualified?
The Tax Code does define who qualifies. They’ve got to be a state-regulated or a federally regulated financial institution or a trust company. You can do your due diligence and say, “Let me see your state charter or your federal charter.” We’ve got a great list on our website of 50 custodians and administrators that are active in this space.
You can ask them for those documents or you have that information on your website?
We don’t have those documents, but you can request it from them. Within that space, as you can imagine, they’re doing heavy administrative work. The assets are illiquid, whereas the stock market if these exchanges are completely automated. Some people’s investment strategy is all bots and high-frequency trading. Running that is relatively easy at least. Whereas if you’re dealing with the custodian in the alternative space, every deal is unique. It’s not like you’ve got this finite world of New York Stock Exchange, NASDAQ traded investments. You’ve got your property in Ohio, somebody has got a property in Texas, Africa and somewhere in Asia. You can do just about anything. Every investment has its own set of paperwork that’s got to be manually reviewed and manually processed. That can get to be very cumbersome and costly.
These custodians are there to make a business. They want to make a profit. They’re providing a service and making a profit on that. If you’re going to have a one-off passive investment, you go that route. That’s the best route for you. You choose which of the 50 is best for you and go for it. If you’re going to be doing multiple investments or you have substantial assets within an IRA, then you want to explore what we call the Checkbook IRA or IRA LLC. There were a lot of benefits to that. It’s first best to outline what that structure is. We’ll talk about why you would want to use it.
One of the investments that you can do within an IRA is private equity. You can say, “I’ve got a startup company. It’s not publicly traded.” There’s huge upside potential here. This has been done in some very well-known cases. Peter Thiel, Max Levchin and Mitt Romney are well-known and documented instances. People took advantage, put a few thousand dollars into some startup company, and those now are worth hundreds of millions of dollars. That’s a unique opportunity that you can capitalize on inside of an IRA, preferably a Roth IRA in that case.
As you can put it into some company that we all recognize as an investment and many of now are PayPal. You could put your money to PayPal at the IPO stage. We can create a company for you and have the custodian move your money into that company, and you control that company. You direct all the activities of that company. Let’s say you’re somebody who’s going to get into multiple syndications or you want to do tax liens and hard money loans. You want to buy some gold and silver. You want to do a range of deals. If you did that through the custodian, every single deal would be new fees, new paperwork and a couple of weeks of waiting to get the paperwork approved to make sure everything was signed and the T’s crossed and I’s dotted exactly as they need it to process the investment.
It’s much more efficient for you to get direct control of the money, eliminate all those fees and be able to write the check for each investment by yourself. That’s instantaneous investing. There are no weeks of waiting and no paperwork. You do the deal yourself. That’s one of the key benefits of using the IRA LLC structure. It doesn’t have to be an LLC, but that’s the way we generally do it. What we do is we set up a business entity inside of the IRA and tell the custodian, “We’re making a private equity investment inside of this business.” Once the money is in the business bank account, you have control and you can manage the investments directly. That’s the key benefit.
If I had that set up already, I could invest in numerous opportunities. There would be no wait time. Is that correct?
There are no fees and no wait time. Ironically, you’ll have the lowest fee structure and the greatest flexibility. You usually think, “To get something better, you’ve got to pay more.” Ironically, you’ll pay less and have better outcomes.People often think that in order to get something better, you've got to pay more. Click To Tweet
That’s always an issue that sometimes we run into when somebody wants to invest, but they’ve never used their IRA before for any investing in real estate. They’ve got a few days to make the investment before the deal is either funded or we can’t accept funding anymore. If they had it set up ahead of time or maybe if they could write the checks like you’re talking about that would help them be able to participate quicker or make a decision faster.
Numerous syndicators that we worked with have expressed this frustration with working with IRAs. The next segment that we’ve got planned, we’ll talk about exactly how we help syndicators and help individuals. They’ll definitely have the most streamlined and speediest investment processing if they use the structures that we set up and provide the turnkey service that we give our clients to take them from 0 to 60 at the fastest rate possible. The key benefit is getting that control. There are other reasons to use this structure. Those are some of the asset protection benefits. There are two components to that. There’s the asset protection component whereas your personal liability that you may incur, “Can they go after the IRA?” or if you’ve got a liability within the IRA, “Can they go after your personal assets?”
While there’s a distinction between yourself and the IRA, the IRA is a trust. Without getting too much of the nitty gritty, the protections that are afforded IRAs are state-based. There definitely is the potential for liability to cross between yourself and your IRA. If you’re holding Amazon stock or an S&P 500 Index Fund, then there’s no concern about liability. If you’re buying properties, then you’ve got the potential for liability. There’s an enhanced benefit of having a property within an LLC if you’re doing it inside of your IRA to keep any cross-contamination between yourself and your IRA. Beyond that, putting aside the potential for any liability to cross one way or the other, your IRA is an investor, just so you are. All real estate investors know that limited liability companies are a key part of their asset protection strategy.
Asset protection is a highfaluting term. I’m not a big advocate of getting too carried away with that certainly when somebody is building a portfolio. LLCs themselves are inexpensive. You’ve got to have your insurance in place. In most states, LLCs are an inexpensive way to get enhanced protection so you do it. If you don’t do it from the get-go, then you can have trouble moving it in. If you’re in a state that’s got a property transfer tax or real estate transfer tax, in some states, even if you’re going to be moving it out of your personal name into an LLC that you own, you can get hit with the transfer tax. You can have problems with the lender. If you want an LLC and in most cases you should, you want to put it in there from the get-go.
An LLC provides segregation of liabilities. It means if you’ve got multiple properties and they’re in separate LLCs, then liability can’t travel from one to the other because they’re distinct legal entities. If you’ve got ten properties in a single LLC, they’re all exposed to the liability of any other asset that’s within that LLC. You’re looking for segregation of assets to have segregation of liabilities. As you would do it for yourself, if you’re going to bolt multiple properties, you’re going to have multiple LLCs. The same holds true for your IRA. If the IRA is going to hold multiple assets, it should have multiple LLCs. Let’s say you’ve got $500,000 in your IRA, you’ve got $400,000 in cash and you’ve got a property that you put $400,000 into. If something happens in that property, you don’t want them going after your cash. You want that property, your IRA to own that through an LLC. When you get into real estate, your IRA is an investor like you would be. It should employ all the same strategies that you would employ and you do employ when you invest in your own name.
Help me with that structure a little bit. It’s going to own numerous LLCs. It might be different states to segregate the liability. My IRA can own many entities that are owning many properties, is that correct?
Yeah, the IRA is an investor. It’s very much the same way as any other real estate investor. You’ve got to make the decision. Some people put multiple properties to an LLC. What level of equity do you want? It’s the same considerations that you would have any time you invest in real estate. It’s a lot to think about. When people invest through their IRA, sometimes they overlook the fact that the IRAs and investor just as they are and all the same considerations would apply. Let’s talk about who should use an IRA. What do we use to determine who should use an IRA, who should use a QRP and some of the rules that got to be aware of?
Our first line if we can, we want people to use a QRP 401(k). How do we determine if the QRP or IRA is for them? It’s two simple questions. First is, do you have an owner-only business? If you have that, you’re a candidate for a QRP. We’re not there yet, but we’re almost there. The second question is going to be and we see lots of people getting tripped up with this. “Is your money after-tax IRA or Roth IRA?” After-tax IRAs and Roth IRAs cannot be rolled over to a QRP. We’re dealing with people that have accumulated funds in your regular plain vanilla IRA and they want to move it into real estate. If it’s in a Roth or it’s after-tax IRA money, they’re locked out of using the QRP for those funds. We see lots and lots of people encountering this pitfall. Those are the two things you want to think about. If you’re not a candidate for the QRP, then the Checkbook IRA is the way to go. We set up people with IRA LLC, they get direct control of the funds and they can put it into as many deals and as many assets as they’d like.
QRP first, if I have an owner-only business and it’s not after-tax IRA or Roth IRA money. If I don’t qualify, then I’m going to go to the Checkbook IRA.
Let’s talk about why we use a Checkbook IRA as opposed to taking a distribution because we’re seeing lots of people that are saying, “I’m going to take a taxable distribution rather than use an IRA to invest.” There’s been misinformation there about using an IRA for real estate investing. What are some of the compliance burdens or some of the catches that you may encounter? The key consideration why we prefer QRP 401(k) over an IRA-based structure is UDFI. That’s the Unrelated Debt-Financed Income that we spoke about in the prior episode. We’ve got to put that in perspective. What exactly is that? Why is that better than a taxable distribution? Why shouldn’t that deter you from using an IRA for real estate?
Broadly speaking, UDFI is the income within a tax-free account that can be taxable ironically. These accounts that we think of as tax-free can occasionally be taxed. The tax is called Unrelated Business Income Tax. That was put in place by Congress in order to ensure that tax-free entities don’t abuse their preferred status. It’s a thing that applies to non for profits. Your 501(c)(3), your non for profits, tax-free charitable organizations, they can encounter this tax. IRAs and 401(k)s that are also tax advantage can have this tax.
It’s slightly off topic, but I wanted to hit what you said, a nonprofit if they have a business inside the nonprofit. I heard the example of a church having a very successful coffee shop within the church or something like that. It’s an unrelated business income.When people are educated, they know immediately whether something is for them or not. Click To Tweet
This was prompted back in the ‘50s which New York Columbia University or somebody owned Mueller Macaroni Company. They were running the company tax-free. All the other food manufacturers are paying this huge tax. Everybody’s biggest expense is tax. You can imagine if you don’t have to pay tax and tax rates were far higher back then, you’ve got a huge competitive advantage. Anytime you’ve got an active business inside of the QRP or IRA, you’ve got the potential for this Unrelated Business Income Tax. The Unrelated Business Income Tax can be incurred in a couple of different ways. One way is what we’re discussing right now is that active business. If you run a coffee shop inside of your IRA, that can become taxable. We’ve got strategies to mitigate that for those of our clients that have active businesses inside an IRA.
What’s more commonly encountered is where you use debt. Even if you’ve got a more passive investment in say real estate and you borrowed money to finance the deals. Your IRA put down some of the equity and you’ve got the rest of funding from a lender. That’s called Unrelated Debt-Financed Income and can result in some measure of tax to an IRA. As we said for real estate within a QRP 401(k), you’ve got carve out, an exemption. A great advantage of the 401(k) vis-à-vis an IRA is that it does not have the UDFI. However, if you do not qualify for the QRP, I can’t emphasize this enough, QRP is not the way to go. IRA is the way to go. There’s still incredible benefit even if you encounter UDFI. You can sidestep UDFI completely, a couple of strategies for that depending on your investment strategy or your investment approach. Let’s focus on people that are doing real estate syndications or your regular real estate deal, which is going to be leveraged.
Some people are doing all-cash deals than an IRA, but if there’s no reason to go all cash, why shouldn’t we get the benefit of the OPM, using Other People’s Money within an IRA? It’s important to talk about how UDFI is calculated and what’s the alternative? The alternative is QRP doesn’t qualify for much worse results or taking a taxable distribution from an IRA, which has also very unfavorable results. The best bet is still going to be to go the Checkbook IRA route and get into that deal. UDFI, Unrelated Debt-Financed Income, the first thing you’ve got to notice is you’ve got to have income.
As we all know, in real estate, you can make money without having income. That’s one of the great enigmas of real estate. You can be making money, getting cash and have no taxable income. That holds true for your IRA as well. If there’s no taxable income because you’ve got interest, you’ve got depreciation, you’ve got all the real estate deductions, you’ve got no Unrelated Debt-Financed Income. You’re very likely to never encounter it in the first couple of years of a real estate investment where you’re showing a loss. That’s the first thing you’ve got to be aware of. The second component, in UDFI, you get $1,000 freebie. The first $1,000 of UDFI is exempt. There is no tax on it. If you’ve got less than $1,000 of UDFI, you can ignore it.
The third thing is, what are the UDFI tax rates? The UDFI tax rates are not favorable. You very easily, very quickly get to the highest income tax brackets within UDFI. That is on the rental income, which you probably won’t have in the first couple of years. You’ll also have all those deductions. That’s likely to be minimal. Where you’re most likely to encounter the UDFI is upon the sale of the property. At the sale, the rates that apply are the capital gains tax rates. That can be anywhere between 0% and 20%. It’s those low-income tax rates. You’re not going to get the UDFI rates. I’ve seen time and time again misinformation about this concept, talking people out of using IRAs for real estate. It’s a shame because on the sale, even if the UDFI will apply, and again there are always strategies to sidestep it. It’s capital gains tax rates, which are low rates.
To get into how it’s calculated and to see why it should never be deterrent. When you’ve put equity into the deal and then use a portion that’s leveraged, the UDFI tax only applies to the extent that there is leverage. If it’s $1 million deal and you put in $250,000 from your IRA, $750,000 or 75% of the money is borrowed. It’s a bit of an oversimplification of how UDFI is calculated. It is proportionate to the amount of money that is borrowed. 25% is tax-free forever. It’s not forever, it depends if it’s Roth or traditional. Your equity portion, the amount that you put into the deal, the amount that you had in your IRA for the equity, it does not get taxed. That remains tax-free.
You can have $25,000 of mutual funds or you’re going to have 25% of whatever that may be, $250,000 of mutual funds or you can get $1 million of real estate using the same $250,000 and pay tax on the $750,000 and that 75%, which is OPM. It’s a no brainer, go for the real estate. You get the OPM, you get the bank’s money and you get all the real estate deductions, so you probably have no taxable income at all, even with the UDFI first couple of years. If and when you do encounter it, it’s taxed on the OPM. It’s on the leveraged portion. You take as much leverage as you can. If you’ve got income on that, that’s free money anyway because it’s the banks. It should never be a deterrent.
Are there a few things that you need to let the audience know about?
Let’s talk for a moment about the alternative, taxable distribution. What happens there? Let’s say you’ve got this money in the IRA and you’re thinking, “I want to pull it out.” If you take a distribution from the IRA, here’s what happens. It becomes ordinary income to you. Depending on your marginal income tax rate, you’re going to pay that as a base, to begin with. If you’ve got a substantial IRA, you’ve got to think about not the income tax bracket that you’re currently in. You’ve got to think about which bracket is going to push you into. If you’ve got a $500,000 IRA and you take a distribution, you’re likely going to be paying between state and federal off the bat depending on what state you’re in. You’re going to pay close to 50% because it becomes ordinary income. You can lose all other tax deductions that you have. You may have certain credits and all sorts of stuff. They can do all sorts of wonky things to your tax return if you’ve got an unexpected windfall of $500,000. Beyond that, you’re going to pay an additional 10% penalty.
If you take a taxable distribution from your IRA, you’re likely to give, depending on where you fall, in terms of taxable income, between 30% to 60% of that to the taxing authorities. You’re starting off if you had $500,000 to invest, what you’re going to end up with is somewhere between $200,000 to $250,000 of investible assets. Think about the difference initially and overtime of investing $500,000 or investing $250,000. The difference over time is worth millions of dollars. You could begin with your principal and it compounds over time. If you do that, if you start with a much lower principal amount and if each year thereafter you’re paying tax on your gains, compared to starting off with $500,000 and invest in that tax-free, you’re tax-deferred for a couple of decades, that is worth millions and millions of dollars. To recap, preferred structure, QRP if you qualify. Secondary, get into the Checkbook IRA. Last resort, which nobody should ever have to resort to because you can always use either the QRP 401(k) or the IRA is a taxable penalty laid in distribution.
Thank you so much, Bernard. This show has proved to me again why a team is so important and why having somebody like yourself as an expert in these matters that seem complicated. We’re not in that every day. It seems complicated but I appreciate someone like you that can lay it out in layman’s terms or where somebody like me can say, “I know Bernard said this and I should be thinking about this.” Ultimately, it’s going to lead to calling you to confirm maybe what I think or pointing me in a different direction.
What we like to say is we’ll give people all the time in the world that it takes. We like working with clients. We’re committed to getting you into the plan that’s best suited to you. It sometimes takes some time and discussion to sort that out. We like saying, “We know we’re going to put your interest first. We get started on an engagement. Our pricing is transparent. It’s low. It’s super competitive. If you’re committed to working with us, we’re committed to giving you all the time it takes or potentially even to restructure you if you’d like to go that route to fit you into the plan that will get you the best outcomes.”
Bernard, tell the audience how they can get in touch with you.
Check us out at 401KCheckbook.com. I love to see you there. You can click and schedule a meeting with us. You can go through all the info we’ve got there. There are lots of helpful info. We want everybody to be educated. We look forward to assisting you.
I hope the audience will go to Bernard and ask these questions to him. Make sure you’re setting this up correctly with an expert like him. Go to Life Bridge Capital and connect with me. I’d love to have a phone call with you if you were looking at investing in real estate and partnering with us in many ways you can do that. You can go to the Real Estate Syndication Show on Facebook so you can discuss and ask questions with other experts like Bernard and people in the industry and we can all grow our business together. I look forward to seeing you there and talking to you soon.
Whitney, thanks for having me.
- Bernard Reisz
- WS11– Previous episode with Bernard Reisz
- Real Estate Syndication Show Facebook group
About Bernard Reisz
Bernard Reisz CPA, empowers individuals to optimize their finances, using proactive and innovative strategies. He provides an integrated approach to tax and financial planning for real estate pros, focusing on their unique profiles and opportunities.
Bernard is the founder of 401kCheckbook.com, which gives investors direct control of their tax-sheltered funds for real estate equity and debt opportunities using Checkbook Control IRAs, Solo 401(k)s, and Checkbook Life Insurance. He is also the founder of AgentFinancial.com, which provides tax and financial services to real estate professionals, including real estate agents and mortgage brokers.
Prior to founding ReSure, Bernard served as Director of CoMetrics Partners, managing an array of engagements involving financial consulting and due diligence. Bernard advised owners of closely-held middle-market companies on advanced tax mitigation strategies.