Tax Free Real Estate Investing

In todays email:

🤑 How to buy real estate and not pay taxes.

• SDIRA - self directed IRA explained

• Solo 401K - history, eligibility and rules

What is a self directed IRA or Solo 401K?

Self Directed IRAs are not special types of IRAs but follow the same set of rules and regulations as normal IRAs. Many people hear the term “self directed” and start to think that this is a special new plan by the government. In reality, the IRS does not even recognize the self directed IRA as a separate type of IRA but instead considers it just an IRA. Any IRA, whether it be a Traditional, Roth, SEP, SIMPLE can be “self directed”. The term “self directed” is used to signify the ability of that IRA owner to make 100% of the investment decisions and not be limited to the typical employer type asset classes such as stocks, bonds and mutual funds. Instead, a properly setup self directed IRA with an appropriate custodian can invest in any of the IRS allowed investments of which there are numerous.

Typically, when dealing with traditional securities brokers like the Vanguard, Fidelity and Charles Schwab types, they can handle the administration as well as the purchase of stocks, bonds and mutual funds. However, when we talk about investing in other alternative assets (i.e. real estate, notes, gold, etc) these traditional brokers are not setup to handle such transactions. This is where the self directed custodian is important (see the resources area for a list of some custodians).

Now there are a few different types of IRAs. The most common are traditional or the Roth. For most people, I recommend a Roth but you should discuss with a qualified CPA. I will discuss only the Roth IRA plan today in this newsletter.

ROTH IRA EXPLAINED:

History

Senator William Roth of Delaware was the chief legislative sponsor and the Roth IRA was established in 1997 by the Taxpayer Relief Act. Only the Traditional IRA existed before 1997 which was focused on granting tax breaks for money put into the plan. The Roth IRA focuses on tax breaks on the money withdrawn from the plan during retirement. This is a very important distinction. In a Roth IRA, you pay taxes on the “seed” and not the “crop”. For example, let’s say you invested $1 and grew it to a million dollars. In a Traditional IRA, you would pay taxes on the million dollars – the crop. In a Roth IRA, you would pay taxes on the $1 - the seed (and NOT on the one million dollars).

Imagine only paying taxes on the money going into the plan and leveraging this money to make $40,000 from a real estate transaction and not having to pay any taxes and being able to use all the money again on the next great deal. This is the greatest government gift but most people don’t take advantage of these plans.

Eligibility Requirements for Roth IRA 

· No age requirement as long as your MAGI (Modified Adjusted Gross Income) is within allowable limits.

· You must meet the income limit requirements in order to contribute. The income limits change almost every year and not discussed in detail here (just Google “Roth IRA income limits”).

Roth Withdrawals

Unlike the Traditional IRA, the Roth IRA has an advantage that there are no required withdrawals at any age. You can wait to pull your money out at 90 years old if you like or never pull it out at all. The contributions can be withdrawn at any age - tax and penalty free! Finally, the earnings portion in the account may be withdrawn tax and penalty free as long as it has been open for at least 5 years and you are over 59 ½ years of age.

SOLO 401K EXPLAINED:

The Solo 401k plan is for self employed individuals and many times referred to as Individual K or Solo K. Just to give you a historical perspective, in 1974 the IRA was created from a federal law called ERISA (Employee Retirement Income Security Act) which sets the standards for retirement accounts. Then in 1981 the 401k was introduced formally by the IRS. The Solo 401k plan is simply a traditional 401k plan covering only one employee and has become more popular as a result of the EGTRRA (Economic Growth and Tax Relief Reconciliation Act) tax law change that became effective in 2001. Essentially, EGTRRA law changed how salary deferral contributions are treated when calculating the maximum deduction limits for contributions to a 401k plan. This change created an opportunity for some people to put away additional amounts toward their retirement.

A Solo 401k is perfect for the sole proprietor such an independent contractor, consultant, real estate investor or any small business with no full time employees. The business can be a LLC, C-Corp, partnership or sole proprietorship. The solo 401k is a cost effective and tax efficient plan with more benefits than a Self Directed IRA.

Finally, you can have a Roth Solo 401k or a traditional Solo 401k. The biggest difference between a Roth 401k and a traditional 401k is how the money you put in and take out is taxed.

Solo 401k Eligibility

To be eligible to benefit from a Solo 401k you need to have self employment activity and no full time employees.

· Self Employment Activity – This includes ownership and operation of a LLC, C-Corp, S Corp, partnership or sole proprietor where the business intends to turn a profit and contribute to the plan.

· Profit – There is no written number for how much profit the business must make or how much money must be contributed to the plan or even the timing. If you have a legitimate business and you intend to make profits you should be OK. The self employment activity does not have to be full time, in fact you can work another full time job with another employer and participate in their 401k plan at the same time. However, you cannot “double dip” and the contribution limit is from both elective deferral plans combined.

· No Full Time Employees – You must not have full time employees. You can have independent contractors, employees under 21 years old and employees that work less than 1000 hours.

Solo 401k Advantages:

· Higher Contribution Limits. $66,000 for 2023 Solo 401k versus $7,500 for 2023 IRA (both based on 50 or older). If less than 50 then the amounts drop a small amount. For example, an IRA would be $6,500 in 2023.

· Loan Feature. You can borrow funds from your Solo 401k up to $50,000 or 50% of the balance (whichever is smaller) for any reason and pay your 401k back at a low interest rate typically prime rate or prime plus 1%. The funds can be used for any purpose. In contrast, in an IRA you cannot borrow funds.

· Total Control of Allowable Investment Choices. Since you are trustee of the Solo 401k plan, you will be able to invest in almost any type of investment that suits you as long as it is allowed. Making an investment with your Solo 401k Plan is as simple as writing a check. As trustee of the Solo 401k Plan, you will have total control over your retirement assets to make real estate and other investments without custodian consent.

· Reduced Fees. Making an investment in your Solo 401k is as easy as writing a check and does not require you to get permission or have funds wired or mailed from a custodian which allows you to eliminate the expenses associated with this type of activity. This also allows you to act quickly when you find a great investment and need to move fast to take advantage of the opportunity. There also is a checkbook IRA with similar features.

· UDFI Exemption. If you buy real estate in an IRA and use some funds from your IRA and the remaining portion of the funds from non-recourse debt financing, typically you would incur UDFI (Unrelated Debt Financed Income) which is a type of UBIT (Unrelated Business Income Tax) on which taxes must be paid. In a Solo 401k, you are not subject to the UDFI rules and the UBIT tax (which is high since it is based on trust tax rates).

A Solo 401K can be have a Roth portion which means that portion will be tax free when you pull out the money in retirement.

EXAMPLE 1: You buy property in your Roth IRA or Solo 401(k) for $200,000 and sell it for $250,000. The initial investment of $200,000 would go back to the IRA as well as the profit of $50,000 all tax free as long as you wait until 59.5 years old and had the IRA for at least 5 years.

EXAMPLE 2: You buy a $100,000 mortgage note that is paying you 8% for 180 months (15 years). The total interest received is around $72,000 and it is ALL TAX FREE! Only in America!

For more details you can buy my book on Amazon.

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