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Deidre Woollard: Hello, I'm Deidre Woollard, an editor at Millionacres. Thank you so much for tuning into Millionacres podcast. One of the questions we get a lot is about SDIRAs that's self-directed IRAs. People know that they can be used to invest in real estate, but when they think about the process, it can seem a bit daunting. We're going to dive into that with John Bowens of Equity Trust. John's a Senior Manager at Equity Trust company. He draws from 15 years in the real estate industry. He's got experience as an active real estate investor, and he's traveled all around the country. He's trained over 50,000 investors in how to understand SDIRAs and really building tax-free wealth. Welcome.
John Bowens: Thank you, Deidre. Excited to be here, excited to jump in for our audience today and teach a little bit on self-directed IRAs and how to invest in real estate and other alternatives.
Deidre Woollard: Awesome. Well, let's start with the basics. What are the core benefits of SDIRAs?
John Bowens: Deidre, really, I break it down into three core benefits. The first which I think a lot of your audience can relate to is the ability to diversify beyond the traditional financial markets. Many investors, including myself, how I got involved in the business is I had an appetite to invest with my retirement accounts beyond ETFs, mutual funds in a stock-based portfolio. In fact, many of our clients and many investors that I've worked with including myself, we want to invest in real estate. We want to invest in something that's a little bit more tangible. Now there are varying degrees of real estate investing. I've been plugged into the Millionacres Podcast for quite a bit now. There's a lot of discussion around real estate investment trust, real estate private placements. Those are opportunities with the self-directed IRA, of course. But you could even go beyond that. You can invest in physical real estate where your IRA actually buys a rental property or does a fix and flip transaction. Or maybe you're on the paper side of the business, I'd like to call it, where you are a private lender, where you're loaning money secured by real estate to other investors. In fact, my wife and I were landlords. We own rental property in our self-directed IRAs. Then as we generate cash flow, we have to do something with that cash. We don't want to just sit there and earn little to no interest. We deploy that to real estate investors that we've met in our local marketplace to fund their real estate renovation projects. There's a broad degree, if you will, of real estate investment options that you can participate in with your self-directed IRA or 401(k). The second benefit are the tax advantages. There are some accounts that grow tax-deferred, and there are some accounts like a Roth IRA that grows tax-free. But the core of this is that there's no tax return per se when you have a rental property in your self-directed IRA. It's like investing in a dividend paying stock with your IRA, which most people are familiar with. You buy a stock, your IRA holds that stock, dividend income comes in. You don't have to report any of those gains. You sell the stock. You don't have to report any of those gains. It's all in the tax-exempt, tax-deferred or tax-free account. Same goes for when you own real estate. Less paperwork, I like to say, and of course the benefit of what I call compounding interest in the absence of taxation. Then the last one, Deidre, is pretty simple, but a lot of people underestimate this is that IRAs avoids probate. I don't hear enough people talking about this. This is really powerful. To put it into context for you, Deidre and your audience here, I have a client out in Saint Louis, Missouri, him and his wife in fact. They started at about $100,000 in their Roth IRAs back in 2010. Over the course of the last 10 years, they've bought and sold over 20 houses. They are buy-and-hold investors. They have 14 cash-flowing properties now in their Roth IRAs, generating $139,000 tax-free every single year in cash flow that flows back into the Roth IRAs. They pay zero percent tax, and they're over the age of 59 and-a-half, which is that qualified retirement age, so they have the ability to take tax-free withdrawals. Then beyond that, when they pass away, they're going to leave it to their children or grandchildren. Their children and grandchildren will pay zero percent tax and that IRA will avoid probate. I know there was quite a bit there to unpack, but those are the three core benefits that we find investors are very attracted to with the self-directed IRA or 401(k), whatever type of account they're looking to utilize.
Deidre Woollard: I think that last one is really interesting because you're absolutely right. It's not something that gets talked about a lot. We mostly focus when we're talking about SDIRAs or IRAs in general on the tax benefits. But you mentioned something else that I think is important too, which is the simplicity factor because if you're a rental property investor, the first time you try to file your taxes, it can be a little daunting, but explain a little bit more about how when it's inside an SDIRA, you don't have to deal with as much of that. What about things like depreciation?
John Bowens: That's a great question, and it's a very common question as far as depreciation is concerned. How do I calculate it? Do I lose depreciation? That's usually one of the most common questions I get is, John, I was told at a seminar or online somewhere that it doesn't make sense to own rental properties with a self-directed IRA because I lose depreciation. Here's the way it works. When you own real estate, rental property in particular, outside of an IRA, yes, have the ability to write-off depreciation known as a paper loss, and then obviously have all your expenses, you file a Schedule E. Then in many instances, investors, including myself with my non-IRA properties, show a loss or very little income so we have very little tax exposure. Well, the problem becomes when we eventually sell the property. All of that depreciation gets recaptured and we then have to look at how that adjusts to our total capital gain, and then we have to pay long-term capital gains tax. That's not necessarily a bad thing. But when we look at an IRA, an IRA is a tax-exempt account. If you go to Section 408, 401 of the Internal Revenue Code for anyone that wants to look at this in more detail, you'll see that the IRA is a tax-exempt account. Just like when you invest in a dividend paying stock, you don't have to report that dividend income. It's tax-exempt, gross tax deferred, or tax-free depending on whether you're using a traditional IRA or Roth IRA. Then when you sell the stock, there's no long-term capital gains tax. It works the same way when you have a rental property in your IRA. The rental properties that I have in my self-directed IRAs and my wife's self-directed IRAs, all of the cash flow is tax-exempt. We're using a Roth IRA for as many deals as we can, so that's tax-free.
Then we sell those properties, there's no long-term capital gains tax, and there's no recaptured depreciation. We don't lose depreciation, it's because our IRAs are tax exempt, there's no income that's taxable for us to offset, and so it's important for investors to think about it through the lens of investing their IRAs into rental properties versus investing in the traditional financial markets. For a lot of the investors I work with, they can make a better rate of return and they feel more comfortable investing in rental properties with their IRA compared to a mutual fund, ETF, or other stock-based portfolio investment that they may currently be invested in now. That's a great question Deidre. I'm glad you brought it up. In fact I created a YouTube video on depreciation in real estate because it's come up as such a common question for so many investors across the country.
Deidre Woollard: That makes sense. You've mentioned Roth IRA versus traditional IRAs let's just go over what that is for people, and both of those can exist within the self-directed IRA format?
John Bowens: That's correct. What folks will learn is you can self-direct, just about any retirement plan and even goes beyond retirement accounts, there's also an account called a health savings account or a Coverdell education savings account that could be self-directed into real estate, and I think it's important for everybody to understand that self-directed is just an industry term. It just indicates to investors that they have the ability to use their funds and invest in real estate, mortgage notes, trustees, real estate partnerships, or other alternative investments. They're not forced into only investing in the traditional markets. It's not a matter of legality, but rather a matter of choice. Some financial institutions will allow you to invest in real estate. Many unfortunately, will not allow you to invest in real estate and so that's one of our core competencies at Equity Trust is providing the tools, the resources, the custody solutions, the education for investors to be able to self-direct into real estate. Now where I think you're going to that question Deidre is what's this mean between a traditional IRA and Roth IRA? Well it's really simple? A traditional IRA is tax-deferred, when you put money and you get a tax deduction it gross tax deferred, so you get all those benefits like we talked about when you have a rental property, and you have rental income coming in and then you sell it and there's no capital gains tax. But then what happens with the traditional IRA is when you turn 59 and-a-half year older, which is the qualified retirement age, and you start taking money out of that traditional IRA, that's when you have to pay taxes. Quick example, if I grow a traditional IRA to a million dollars and then at 59 and a half, I take a $100,000 distribution, that $100,000 is going to be added to my 10 40 as ordinary income, and then I'm going to have to pay taxes accordingly. If I'm at a 20 percent tax rate, 20 percent on a 100,000 is 20,000. I keep 80,000, but then I have to pay $20,000 in taxes. In contrast the Roth IRA is funded with what we call after-tax dollars. The analogy we use in the industry is you have to pay taxes on the seed or you pay taxes on the crop, so with a Roth IRA, we put money in after-tax, no deduction. It grows tax-free, leveraging, again what I call compounding interest in the absence of taxation, and then when we take money out, after the qualified retirement age of 59 and-a-half we pay zero percent tax. The Roth IRA is one of the most powerful savings vehicles afforded to us by the federal government. It is an incredibly underestimated tool, especially for real estate investors, and you can even take it one step further because you can also, for real estate investors that are entrepreneurs, there self-employed, they have lots of income, for example, a real estate agent or someone else that maybe they flip a lot of properties. They can actually look at a solo 401K, which has what's called a Roth component, where you can put substantially larger sums of money on an annual basis into that Roth component compared to a Roth IRA. So there are different vehicles here, Roth IRA, solo 401K with a Roth component, you've got the traditional IRA. Everybody is a little different. Some people have 401K's and employer plans and they roll those over into traditional IRAs and grow them tax deferred and they're happy. Other people, they love this concept of tax-free dollars and a tax free lifestyle, and they do their best to get as much money as they can into that Roth IRA or Roth 401K environment.
Deidre Woollard: That makes sense. Now, I know that it's more than real estate that you can invest with in a self-directed IRA. Let's go over some of the other things that you can invest in and what you can't invested in?
John Bowens: Great, question. Real estate, I think we've covered that, but I will mention that I've been using examples of rental properties in mortgage notes and trust deeds. I think it's also important and I've spent a lot of time on the Millionacres content and podcasts. A lot of investors like to invest in real estate syndications or private placement investments, and I think it's important to mention that you can do that as well with your IRA, and we see a lot of that type of activity, and there's a variety of ways in which you can use an IRA or solo 401k to invest in those opportunities. Beyond real estate as an asset class, you can use your self-directed IRA to invest in non-real estate private placements. This is non-publicly traded stock. For example, I had client, many years ago, this is back in 2009 that wanted to invest in a social media platform, and you can imagine what social media platform this was because it was in 2009, and it was before they went public. They use their self-directed IRA to invest in privately-held shares of this social media platform. Beyond that, you can invest in gold and silver. A lot of our investors are what are called hard asset investors. They want physical real estate, they want real estate private placements, they want assets in their own backyard, and they want physical gold and silver. That is an option as well with your self-directed IRA or 401K. Then last but not least, Deidre, I know in preparation you mentioned you want me to touch on this is cryptocurrency. For those that are interested in investing in digital assets like cryptocurrency. You can do that with your IRA. There's a variety of ways in which you can do that. Certainly, this is not all about equity trust, it's more about what you can do with a self-directed IRA with any organization. I will mention that we do have a technology platform that enables investors from point A to point B to be able to acquire cryptocurrency. Some custodians offer a fully integrated technology platform, and then other custodians might offer a system where you got to go out and do everything on your own. You just want to do your due diligence to determine what's going to be the best fit for you. But you can absolutely invest in crypto currency with an IRA, and as you can imagine has been very popular, I would say over the last year-and-a-half, we've seen a lot of activity in that particular marketplace.
Deidre Woollard: What about NFTs does that also come up with people wanting to do that sort of similar?
John Bowens: It is, been getting a lot of questions around NFTs and some of the call it non-big nine to big 10 coins. Pretty limited right now on what coins you can invest in with your IRA. As you can imagine, IRAs with all these unique tax privileges, there's a lot of regulatory oversight, and what comes along with that is some limitations on what coins. For example, like NFTs that will be available. What I will say is we are because of demand from the marketplace, looking at a variety of liquidity providers and a variety of solutions to try to provide a broader array of coins and assets for investors to participate in. It's a constantly evolving marketplace for sure.
Deidre Woollard: Oh yeah, I'm sure. I bet that is only going to increase in interest over the next couple of years because we are still such early days on all of this.
John Bowens: Absolutely.
Deidre Woollard: Someone wants to start an SDIRA. You mentioned earlier the process of the custodian. Can you explain a little bit more about what that is?
John Bowens: Yeah, absolutely. We call ourselves custodians in the industry and there are many out there. Equity Trust were referred to as a directed custodian. Now think of Equity Trust just like any other financial institution. We have many out there. You can have an IRA, you open it up, you put money in. Maybe you have a 401(k) or a 403(b) or thrift savings plan. There's nothing wrong with this. Usually those organizations are only going to allow you to invest in traditional investments. If they do allow you to self-direct, you're only going to be able to self-direct into mutual funds, ETFs, stocks, bonds, traditional assets. What we call true self-directed IRA would be an IRA with a company like Equity Trust, that allows you to invest in all of these unique alternative assets. Really the first step is taking an inventory on what types of retirement plans you currently have and where those retirement plans are. Some people come from occupation where they have a 401(k) or a 403(b) or a thrift savings plan if they work for the federal government and they leave that company and the natural progression is roll it over into an IRA. Because where they're at now, they're not going to able to invest in real estate. They roll it over to a self-directed IRA, no taxes or penalties. That's one of the most common questions, Deidre, is, well, John, if I roll over transferring money into an Equity Trust self-directed IRA, are there going to be taxes and penalties? There are no taxes and penalties as long as you follow the right process. Once the money is over in the self-directed IRA, you can then begin investing in real estate. We work with folks individually to make sure that rolling money over into the appropriate accounts. Some people have Roth IRAs, some people have SEP IRAs are traditional IRAs or 401(k)s. It's a process there to get that money moved over into the self-directed IRA environment properly. Then from there, it's self-direction, it's entirely up to that investor on what they want to invest in, how they want to invest. They can invest in a variety of assets. They might have some real estate holdings and then some crypto currency, and then a private placement investment. They are not forced into one path, they can choose what that path is and ultimately make changes to that path as they progress throughout their investor journey.
Deidre Woollard: Interesting. Let's talk a little bit about those changes. If you start, maybe you start with one rental property and then you want to add more properties or you want to go into crypto. What does that process look like? Can you add as much money as you want at anytime? Can you move properties and assets directly in?
John Bowens: Yes. You would move cash over into the self-directed IRA. Now some people have stocks and mutual funds and they are very loyal to those positions, they don't want to sell them. We do have the platforms to accommodate those assets to be able to be moved over in kind. Then they could be liquidated with Equity Trust and now you have cash and we account to deploy that for your investment. You don't have to move all of your money. That's another common question is, John, can I just move over to Equity Trust what I want to get started to invest in some alternative assets? Absolutely. Then you can transfer more money over at a later date. A lot of investors have IRAs or 401(k)s elsewhere and so they're opening an account and then they're transferring or rolling over their funds to Equity Trust and they can always go back if they want to take their cash from their Equity Trust IRA and move it back to a traditional brokerage that they're currently with, that's fine too. Again, this is for diversification purposes. Then that leads us to contributions. You can contribute to an IRA every year and right now we're in 2021, so we can contribute up to $6,000 when we're under the age of 50 to an IRA. When we're 15 over, we can contribute up to $7,000. Now that's just how much we take out-of-pocket and contribute to the account. But we can earn well beyond that six or $7,000. A great example is a client of mine recently did a real estate option, which I know I'm getting a little ahead of my skis here. But he did a real estate option where he put $2,000 down as an option on a self-storage facility, flipped the contract to an investor buyer, and made a $20,000 profit, all tax rain as Roth IRA. You can go way beyond that six or $7,000 contribution in terms of roll overs or earnings and the plan which I think is important. Then lastly, for someone that is self-employed and they have a solo 401(k) or maybe a SEP IRA, those are small business retirement plans that carry substantially higher contribution limits. For example, a solo 401(k), when you're under the age of 50, you can contribute up to $19,500 a year. When you're 50 and over up to 26,000. It doesn't stop there because there's an employer deferral match which can potentially allow you to get upwards of $58,000 when you're under the age of 50, up to $64,500, when you're 50 and over. There is a possibility of getting that all into that Roth bucket of the plan. That gets into the more finite details, but Deidre, definitely important for folks to understand. Yes, there are contribution limits. There are some plans that will enable people to contribute more compared to other retirement plans.
Deidre Woollard: Excellent. Thank you. In terms of someone's trying to find a great custodian, do you feel like people should interview multiple potential custodians? What should they be looking out for when they're doing this and how are the fees paid?
John Bowens: Yes, I'm representing a custodian here. I am an investor and, of course, just like I would whether I was buying a house or subscribing to whatever type of investor community. I'm going to look at researching a few different companies, 2-3 different companies. I encourage folks to do that, shop around, look at the different custodial providers and determine what their differences are. Some things that I would encourage folks to look at, number 1 is the size and experience of the custodian. Certainly, this is not a commercial for Equity Trust company, but what I will tell you is in my experience, so I've been in the business for now 13 years. I've been in real estate for close to 20 years. What I've learned in the self-directed IRA custodian/administration space, there are administrators and there are custodians. Now custodians are regulated. You'll hear they have a trust charter typically from South Dakota as we do. They're bank regulated, if you will. They have to adhere to some of the same requirements that a bank institution would. That's very important. I have heard countless times where investors setup an IRA or 401(k) with a company that is very small in terms of the number of employees, very small in terms of the assets under custody and the amount of transactions they do. Some of these companies, unfortunately, have failed. They've gone, if you will, into receivership or there has been some insolvency. In some cases, I've even seen fraud before, we've seen that in the industry. Then the customers that have accounts there are left to try to figure out how to get their money and their assets and move it over to another custodian. It creates a lot of problems for those individuals. Size, years of experience, those are very important. Just a couple of facts about Equity Trust. We have $33 billion in assets under custody administration. We have about 400 employees. We'd encourage folks to checkout other custodians, ask about their customer service, the number of employees, and their size. Then the last two items, Deidre, for people to ask about would be technology. Technology is really important today with self-directed IRAs. When I came into the business 13 years ago, it really wasn't. In the last five years, it's becoming more and more important. Do you have a technology platform that allows my renters to pay electronically? Do you have a technology platform that allows me to pay for expenses electronically? Do you have a prepaid debit card or a credit card, if you will, that will allow me to pay for expenses for my rental properties? If I'm going to invest in a real estate syndication, what does that process look like online? You want to find a custodian that has an online technology platform that allows you to do everything from the comfort of your own home without having to manually fax or scan and e-mail documents. Then I would say the last one, Deidre, and I get a lot of feedback when I go out to seminars and conferences and I do our virtual classroom sessions all across the country is education and ongoing training. There aren't a lot of firms out there that provide a lot of education and training to their clients and prospective clients. You're going to want to know what's happening in today's marketplace. What are people investing in? How do I use my self-directed IRA? What's the pipes and plumbing? What are the nuts and bolts of the account and how does it work? That's something we're really proud of here at Equity Trust is providing that ongoing training and education. A good example is I have a client that is doing master leasing with their self-directed IRA, which is really interesting topic. Master leasing has been around for many years, but not so much with the self-directed IRA. Just recently, I was putting together some content for some investors around how they can use their IRA to essentially rent a property and then turnaround and sublease it on a minimum one-month lease, and this Equity Trust client used their Roth IRA with about $22,800 into a deal in Year 1, on a master lease agreement, taking control of real estate without ownership, and made an $8,400 tax-free profit in Year 1. That's the type of education that we like to provide as, what's actually working in today's marketplace?
Deidre Woollard: That's fascinating. Well, let's take a quick break here.
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Deidre Woollard: I'm back with John Bowens and we're talking SDIRAs and real estate. In the first half, you mentioned syndications a bit. We have a service mogul, people invest in real estate crowdfunding deals. They always ask us, can I use SDIRA capital? Some investors take in, some investors don't, but what should people who are doing those type of deals know about SDIRAs?
John Bowens: When investing your self-directed IRA into a real estate syndication, I would say the first most important part of the process is to make sure that the self-directed IRA is set up and funded. Many investments sponsors have very strict requirements on when the money is sent to the investment account, and if you miss that deadline unfortunately you may not receive your official received confirmed subscription. You may fill up the subscription agreement and everything and you have all your Investor documents in line, but if you don't have that money wired to the investment sponsor in time you may not unfortunately be involved in that deal. You have to have the account setup and funded well in advance. What I have found is a lot of 401(k) providers, 403(b) providers, TSP, IRAs, when you're transferring or rolling over from one account to another, equity trust; your custodian is at the mercy of the other financial institution. You can imagine Deidre people aren't willing to overnight send the money at a moment's notice for you to be able to fund your real estate transactions. I've seen it takes sometimes upwards of a month. Number 1 is certainly make sure the account is setup and funded well in advance. From there we really encourage folks to make sure they're doing their own due diligence on the investment promoter, they're reviewing the prospectus or memorandum, they're talking to other investors, and they're doing if you will an overall due diligence review of that investment opportunity because equity trust is a custodian. We don't provide investment options, we don't review investments for merit or risks, and so it's important for that investor to do their own due diligence. That would be the second one. Then last but not least I would say important to look at the overall financial perspectives of the investment to determine if it's a good fit for your IRA, or if maybe you should make that particular investment with your non-IRA funds. My wife and I like to say it's a rising tide for us. We do deals inside of our self-directed IRAs, and we do deals outside of our self-directed IRAs. Some investments make a lot of sense for our self-directed IRAs, and other opportunities make more sense for our non-IRA funds. That is like we talked about depreciation. Maybe an investor wants to take advantage of some depreciation write-offs and so they want to use their non-IRA for a particular deal, but maybe they're using their IRA for some private lending or note investments which throw off interest income and interest income can have a very high tax rate based on your ordinary income tax rate. This is where the fun part comes into play because as investors, we get to design our IRA portfolio and our non-IRA portfolio based on our specific needs and based on our specific tax situation.
Deidre Woollard: I love that you said the fun part right there because I think a lot of people don't think of this as the fun part; they think of this as the most awful part, but you really can't think of it as the fun part because it is a way to think about your future, and your investments, and how you allocate things. Now inside an IRA, there is sometimes a taxable event. I have heard about UBIT and UDFI, can you explain what that is? I know it's something that investors don't know a lot about, and I've heard some things that they might need to be. They might have to pay money or something like that.
John Bowens: So grateful that you're asking me this Deidre because there's not a lot of information on UBIT. For [laughs] audiences, listeners, and viewers that are thinking what is UBIT? UBIT tax stands for Unrelated Business Income Tax, and it's this mysterious tax that no one knows about. Sometimes we like to call it IRA tax, so let's break it down. Unrelated business income tax applies to an IRA investment if one of two conditions are met. The first condition is, if an IRA is engaging in an ongoing trader business that's not substantially related to the primary purpose of the tax-exempt entity. You're probably thinking, what is the primary purpose of the tax-exempt entity? IRAs were really designed for passive investments. Investing in things like rental properties, dividend-paying stocks, dividend-paying mutual funds, mortgage notes or trust deeds that look very close to a bond, so think passive investments. Or we buy an asset, we sell it, we get some long-term gains. Maybe we do an occasional real estate flip where you could cross the line and be viewed as running your IRA as a business, and then incur this unrelated business income tax. Is when you start for example, flipping houses, or you might also hear people talk about flipping contracts, wholesaling, or doing real estate options. These are short-term transactions where we buy, we add value, and then we sell, or maybe we buy and just resell simultaneously, or maybe it's a wholesale contract deal where we actually just put the property under contract and then we assign the contract. Those types of short-term transactions can trigger this unrelated business income tax. Now the question always becomes, well, John, how many can I do? We really can't tell you. Now the rule of thumb; it's a gray area, the rule of thumb that's used in the industry is you wouldn't want to do more than two short-term flips in your IRA because if you do more than two, then there is a strong likelihood that you could be viewed as your IRA is running itself like a business or you're running your IRA like a business, and then you would incur this UBIT tax. I know the question that people are probably thinking right now, what is the tax rate? Well, it follows the estate and trust tax schedule, so get ready for it. If you have income in 2021 and your IRA that's running itself like a business, income over $13,050 you're subject to 37 percent tax rate. Take the ordinary income tax schedule and put a massive accelerator on it, and now you got the estate and trust tax schedule. It sounds really scary, but good news most people aren't doing deals that trigger this UBIT tax. This leads us to the second circumstance which is if our IRA engages in a leveraged real estate transaction, this comes up most importantly when people are investing in real estate syndications which in 98 percent of cases there's going to be debt leverage on those properties. Here's how it works. If our IRA buys a property and we get a loan it has to be what's called a non-recourse loan, which means in the event of a default the only recourse is against the subject property. Why? Because an IRA account holder can't sign a personal guarantee. If you go and get a non-recourse loan, your IRA makes a down payment, you're going to trigger this unrelated business income tax. You will also hear people refer to this as unrelated debt-financed income tax. Quick example for people to really wrap their head around this because I know this is confusing. Let's say I go to a non-recourse lender, and I borrow $50,000, and I do a down payment of 50,000. So I'm buying a house for 100,000, I'm putting down 50,000 with my IRA, I'm borrowing 50,000 from a non-recourse lender. That could be a private lender, it could be one of these bank non-recourse lenders. My debt percentage is 50 percent. What's going to happen is the IRS is going to say, "Hey, you can't take 100 percent of your net profit and put it back into the IRA and not pay any tax because you're leveraged under the provisions of Internal Revenue Code 511 or 514. You're going to have to pay tax on a percentage of that profit, and it's based on the percentage of the property that's debt-financed. Let's say I made $5,000 in net profit. That would be after my depreciation and all my expenses. That's interesting. This is the one instance where you can actually take advantage of depreciation because you have tax liability. After our depreciation, after our expenses, let's say we're at 5,000 in net income. Then we take 50 percent of that amount. 50 percent of 5,000 is $2,500, so now we only have $2,500 in exposure. If we were 30 percent leveraged, then we would only have to use 30 percent as our figure. If we're only 20 percent leveraged, only 20 percent, so on and so forth. In other words as we pay down the debt, our exposure should become less and less. In that example I got $2,500 in exposure, and my first $1,000 is exempt. It's called a special deduction, leaving me about $1,500.
At that tax bracket, I'm actually only at 10 percent, so 1500 times 10 percent, you do the math there. We would pay that amount in taxes for our Unrelated Business Income Tax. Now, last but not least, that was an example of my IRA owning a rental property where my IRA takes on the debt. What if I did a fix and flip deal? If I did a fix and flip deal, obviously, I'm most likely going to be making more than $13,050 in profit, therefore, I'm going to be paying 37 percent. Not always a bad thing. A lot of people think UBIT is scary and I shouldn't do it. Plenty of investors leverage into deals like this because they see the benefit of their IRA even though it's paying taxes, even after the taxes are paid, their return on investment is still quite substantial. A good example of investor that I know, his name is Tim, he is from Texas. He bought a house on owner financing with $5,000 down with his Roth carried $50,000 in financing. He was nearly 100 percent leveraged. He fixed the property up, sold it, made a profit. He ended up making about $28,000 in profit. He had to pay his UBIT tax. At that time, it was actually 39 percent. Now it's a little bit lower, 37 percent. When it was all said and done, he still made about $21,000 tax-free in his Roth IRA, and he only had about $36,000 in the deal. He actually made over 50 percent cash-on-cash return on investment in six months on a fix and flip deal. Sometimes, it still makes sense to pay taxes. Then of course, using that debt leveraged rental property example I mentioned, if your IRA is a partner in an LLC or limited partnership, so think apartment building syndications, IRA is investing in an LLC, LLC with many other investors is coming together to buy an apartment building. The operator is going to a senior debt partners, senior lenders lending money. In that circumstance, the unrelated business income tax actually carries its way through the K-1 reported to the IRA, and then the IRA has UBIT exposure. Now, you might have a lot of expenses and even be able to carry forward a loss. You got to pencil out the deal and see if it makes sense for your IRA. Plenty of investors use their IRAs to invest in real estate syndications. You just want to be aware of potentially having to pay that tax, whether it's during the years of cash flow or during the years where you actually exit the transaction and you're paid off. Tax document that you file is called a 990-T tax return. We encourage folks to get with their CPAs or tax pros to look at filing that 990-T if it is necessary. If they don't have any income or they're showing no income, then they don't have to worry about it, but if they do, they would file a 990-T tax return.
Deidre Woollard: In terms of knowing if you're going to owe UBIT, does it come from your CPA looking at what came in that year and the deals you did or do you find out some other way?
John Bowens: Best way for investors to know is looking at the K-1. Look at the K-1, which is a tax document that is issued by a sponsor of a LLC's real estate syndication. It probably could be their accountant, CPA, or somebody in their finance office, if they're large organization, is going to issue a K-1 to every investor. What you'd want to do when you're analyzing the deal is talk to the investment sponsor, talk to their CPA, accountant, whoever in their office handles this and say, can you tell me what the projected UBIT exposure will be on the K-1. They can give you that information. I'm sure there are a lot of other investors that are asking those questions as well because we do find a large exposure of syndicators who are raising capital from IRA investors.
Deidre Woollard: What I know that sometimes if you've got multiple syndications going at the same time, they may be in different stages, so you could have one that actually has a lot of losses right now as it's maybe before the lease-up stage. Then you might have one that actually has a lot of income because it's in the cash flow generating stage. There is that possibility to play one against another and cancel out some of that, right?
John Bowens: That's a great point. You could absolutely look at it from that perspective. I think that also goes back to our deals that are good for our IRA and deals that are good for our non-IRA investing. If you're a, I call them serial apartment building syndicator investors or serial real estate private placement investors, people that just want to be totally passive, they don't want to own rentals, they don't want to do flips. They just want to invest in real estate partnerships. There's a ton of opportunity there. I think it's just a matter of looking at every deal and determining which ones are right for the IRA and which ones are not, and not having an incredible amount of fear of this UBIT. Many CPAs know about it. They know how to do the 990-Ts. Some custodians will actually help their clients prepare the 990-Ts and then they go and file it. We do provide those services here at Equity Trust Company. There are resources out there. There are ways for folks to handle this. Really what it comes down to is analyzing the deal and saying, what is my return on investment even after the taxes are paid compared to what I might be investing in the traditional financial markets? If that amount is greater, it can still make a lot of sense for investors. One thing that I'll mention, Deidre, and you may have had prepared to ask me this, but I'll jump ahead a little bit, is folks oftentimes ask me, John, how do I avoid it? [laughs] That's usually the question. How do I avoid this UBIT tax? I laugh and I say, well, it's like that there's two things that are certain in life, death and taxes. I think it was Benjamin Franklin that said that. That's the case here. You can't really avoid it, its there. But if you qualify for a Solo 401K, we talked a little bit about Solo 401K, there's some unique advantage of being able to put a lot more money in that plan. With a Solo 401K, there's a little known exemption under the provisions that would actually make you exempt from UBIT as long as the debt is structured properly. In my experience, 99 percent of real estate syndications, the way the debt is structured, your Solo 401K would be exempt from UBIT. Now, that usually brings up from there, John, that means every real estate investor should use open a Solo 401K. Well, I would love if the rules allow that. The problem is, its not every investor qualifies for a Solo 401K, despite what many of these 401K promoters will say. They will tell you, just open up a Solo 401K, don't worry about a business, or income, or anything, just open it up and put money in it. While the IRS guidelines clearly state that you have to make contributions that are recurring and substantial. In fact, three out of the last five years, you have to have made contributions. If you don't have any earned income as a self-employed individual or if you have an LLC or S Corporation, if you don't have earned income, income that you're paying Medicare and Social Security tax on, you can't support contributions, which means you cannot have a Solo 401K. There's a lot to unpack there. I of course don't have time to go into great detail, but what I will tell viewers and audience listeners is, if you want to take advantage of that exemption, look at the Solo 401K, research it. In fact, I have a YouTube video all on the Solo 401K, you can check it out. But there's other resources out there as well. You can talk to your CPA, which I'd encourage you to do so and make sure that you qualify. Maybe you don't qualify today, but you can structure your real estate business and you as an entrepreneur, you can structure things so that you can have a Solo 401K, and then you can rollover your existing retirement money into that Solo 401K, make some healthy contributions, and take advantage of some of this UBIT exemption.
Deidre Woollard: Excellent. You mentioned the word fear. I want to go back to that because people get so afraid of paying taxes and so afraid of dealing with the K-1s that you mentioned that some of them say, I don't want to get involved in real estate investing. I don't want to get involved in an SDIRA. It's too complicated. What do you tell people when they have those fears?
John Bowens: The first one is IRAs, and let's use the example of a non-debt finance type transaction. My rental property is one of my self-directed IRAs. There's no schedulee, there's no tax return, there's no reporting on my personal tax return. All the record-keeping administration is actually handled through my Equity Trust online system. Everything's in a database, all the records. What's interesting is, even though some people look at it as more complicated, administratively I actually do less for my self-directed IRA rentals than I do my non-IRA rentals. Because my non-IRA rentals I got to have a CPA, I do depreciation, not necessarily with a CPA, but I do, you have to do depreciation schedules, you have to do all that calculation in those returns. With the IRA I don't have to worry about any of that. Now if I get involved in a debt leverage real estate transaction, I might have to file a 990-T, but there's resources for that. CPAs know how to do this, you can work with your custodian that oftentimes will prepare a 990-T for you, so there are resources. Although at first glance it may look a little opaque and more complex, what a lot of investors find in my experience, is after they've done their first transaction and they realize how easy it is, at that point, it's okay, when do I get to do my next one, and do a third, and a fourth, and a fifth? I always tell people, if you are brand new to self-directed IRA investing, first transaction that you're going to do, you're going to need some hand-holding. You'll probably need some help from your custodian, like Equity Trust, that's okay, that's what we're here for. We actually encourage people to call us, so [laughs] that we can make it a good experience and we can walk them through that transaction. I think a lot of investors will find, that might be a little fearful of this to start that, hey, it's actually not all that complicated, I just got to do something different and something new that a lot of people find to be a little unorthodox.
Deidre Woollard: I think that's true. It's like anything in life, you have to get used to the new terminology and the new process. Did you have to report fair market valuation inside your SDIRA? How does that work?
John Bowens: What the IRS says is that on an annual basis, you are supposed to provide a valuation to your custodian on your non-standard investments. Non-stock market investments, they call them non-standard investments, sometimes you hear them referred to as alternative investments, the IRS likes to use this term non-standard investment. I think it's a standard investment though, I don't like that nomenclature. I think real estate is the standard, and stocks and mutual funds is the non-standard. That's for me personally and a lot of my clients. But that aside, for your non-standard investments, you have to do some reporting in terms of the valuation. Properties are really easy, I get a broker price opinion for my broker, I send it in to Equity Trust, they update the value. Now once I turn 72 years old and I have to take required minimum distributions from a traditional IRA, or if I convert from a traditional to a Roth, it becomes more important because there's a taxable event. But in the ordinary course of every single year, if we don't get a valuation update, then we just default to whatever the previous year's valuation is, assuming that that's what the current value of that asset is. It's highly encouraged of course to submit valuations on an annual basis, it becomes more important when there's some taxable event. Otherwise year-after-year as you're growing the account, there's no taxable event, you're not taking distributions, you're not converting, it's just income coming into the account, paying for expenses, buying new properties, investing in new assets, so on and so forth. When you're investing in real estate syndications, it's even easier because that syndicator is typically producing a quarterly statement or an annual statement that shows what the value is. In fact, we oftentimes set it up where that syndicator is just sending those statements to equity trust for all the IRA clients that are in our database. Then we get a master sheet that has all those valuations, and then we just populate all the accounts accordingly. Without the investors even knowing it, their values are being updated on an annual basis.
Deidre Woollard: Whoa. That's nice. So you have to do it yearly. This real estate market has been crazy, what happens when the value of your holdings goes up significantly, is there any impact to you?
John Bowens: Great question. Just like a stock increases in value, no impact, the account would be valued according to your direction from your real estate agent or other professional that provides that valuation. No tax implications, obviously the IRA is tax exempt, so no long-term capital gains tax or ordinary income taxes on your general income that's coming in from rents or if it's a loan, interest income, so good news there. If you don't submit evaluation, usually I get that question, what happens if we don't submit evaluation, do you distribute our account, are there taxes, are there penalties, no, there's not. There's no penalties if you don't do it, but it's again one of those things that is very much encouraged for custodians to tell investors to make sure that they submit valuation updates on an annual basis.
Deidre Woollard: Fantastic. Last question for you. One of the things that we keep hearing in the news is potential for tax changes, wondering how you and the team at Equity Trust are thinking about some of those. I know there's been talk about the 1031 exchange, maybe some talk about IRA shifts, what are you hearing and what are you advising people to think about?
John Bowens: Great question. I know it's on everybody's mind. Self-directed IRAs, there was some threatening legislation, if you will, and this was in the infrastructure part, actually it's part of the Build Back Better Act. The infrastructure was just passed recently as many people know. The Build Back Better had some self-directed IRA provisions, let's call it, that could've been catastrophic for self-directed IRAs. Now rentals in IRAs, mortgage notes, trustees, 95 percent of what I worked with investors on was not being threatened or impacted. The reason why this all came about was because there was this Silicon Valley technology giant that used his Roth IRA with like $5,000 and grew into billions of dollars. This then kicked into gear the government to say, ''Hey, we need to do something about this.'' By the way, what that person did was pretty much a prohibited transaction. The law doesn't need to change to stop that. It was a self-dealing prohibited transaction. That being said, the reaction was, we need to stop these people from abusing the IRA law, not the person that's buying rentals, not the person that's investing in real estate syndication. There was some language that was put in this IRA provision proposal that could've been really bad for real estate investors. But again, for people that want to invest in rentals or make loans, there wasn't any problems. Here's where the problem came into play, the legislation proposed said that it would be a prohibited transaction, which means your IRA would be essentially distributed. If you invested in a syndication or a private security where the promoter would ask about your financial situation, your education, in other words, you hear of this term, accredited investor or sophisticated investor. If you are investing in a real estate private placement, and that sponsor was reviewing you to determine whether you're credited or not to then determine whether you can invest or not, that would be considered a prohibited transaction. That's what they put into the law. Now Deidre, good news, all of those IRA provisions were taken out. They were taken out of the Build Back Better, and this happened a couple of weeks ago, really good news. I can tell you, Equity Trust, many industry professionals went to congressmen and women, went to the senators, went to the legislative folks, and said, ''You need to get this out of here because you are going to create a massive vacuum with liquidity in the real estate investor marketplace.'' Fortunately they took that all out. That being said, there were a couple of things that snuck their way back in recently, and at the time of recording this at least, we don't know whether this will stay or not. So you want to make sure, depending on when you're listening to this, you read up further. But a couple of things that snuck back into the Build Back Better, which will be up for a vote here coming soon, is IRAs, once they get to $10 million, the person will have to take out 50 percent of the value. Once they get to 20 million, they'll have to start taking all of it out, and starting with Roth IRA money. Really going after the Roth IRA, again, they don't like the fact that millionaire, billionaires are using Roth IRAs to invest in companies with little tiny amounts of money and then growing it very large. That's what they're trying to stop. They're not trying to stop me, or you, or a lot of people on today's call, from just simply growing their retirement plan at a inappropriate pace, a pace beyond the stock market returns maybe, but a pace that's not the, one day it's 5,000 and the next day it's a billion dollars. Then lastly Deidre, and this gets into an entire different [laughs] seminar, but there's some rules around Roth conversions. You can take money from your tax-deferred traditional IRA and convert it over to your Roth IRA, getting the taxes out of the way now so you don't have to pay it later. What they're going to shut off is, if you make too much money you won't be able to convert from a traditional to a Roth starting next year. It's actually 400,000, and then 450,000 merit filing jointly. There's some of those nuances around Roth conversions that could change. Like I always say, I'm just trying to get to 10 million, and 20 million, once I get the 10 million, I'll deal with it when I get there and when we cross that bridge. Really good news, self-directed IRAs are not going away, but there are some of those items that snuck their way back in the legislation that we'll see what happens.
Deidre Woollard: Well John, thank you so much for your time today, this was fantastic. Reminder for listeners, you can learn more at Trustetc.com, to learn more about Equity Trust. Stay well and stay invested.
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