April 1, 2021

JF2403: Self Directed IRA's | Actively Passive Investing Show with Theo Hicks & Travis Watts


Today, Theo and Travis are going to be talking about self-directed IRAs. What is a self-directed IRA? How does that differ from IRA or 401k you may currently have? Many investors use self-directed IRAs and there’s almost $20 trillion of IRA money in the United States. The purpose of this episode is to provide insights obtained by one of our contributors.

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Theo Hicks: Hello Best Ever listeners and welcome back to another episode of the Actively Passive Investing Show. As always, I’m Theo Hicks, here today with Travis Watts. Travis, how are you doing?

Travis Watts: Hey, doing great, Theo. Good to be here.

Theo Hicks: Today we’re going to be talking about self-directed IRAs. Now, a disclaimer, I’m not a self-directed IRA expert, Travis is not a self-directed IRA expert. The whole purpose of this episode is to provide some insights that we receive from a blog post from one of our contributors. His name’s Brian Boyd; he is a real estate attorney who specializes in taxes. He wrote a detailed blog post for us entitled How to Invest in Real Estate With a Self-Directed IRA. Travis and I wanted to hop on a show, Travis will talk about his experiences with the self-directed IRA, I can talk about my very limited understanding of the self-directed IRA, but at least extract the best advice from Brian’s blog post. So before we hop in, as always, Travis is going to introduce the topic a little bit more, and why we’re talking about it today.

Travis Watts: Thanks, Theo. I think that this is just a really good topic in general; it’s something we haven’t covered on our show. It certainly pertains to passive investors; it can pertain to active investors as well, it just kind of depends, but probably more of a passive topic. So it’s a very common strategy. A lot of investors use self-directed IRAs; I used to as well, I’ll share a little bit of experience later in this episode on that. Basically, if you prefer to park your money into private real estate, and there are other things you can invest in, too – private businesses, or physical gold, or silver, and oil, and all these different things – then you should have the choice to do that. And you do have the choice to do that. So that’s what we’re going to cover, is what is a self-directed IRA? How does that differ from maybe the IRA or the 401K that you currently have.

The other thing I thought was pretty interesting as I was doing a little bit of research here, is there are almost 20 trillion dollars of IRA money in the United States. That’s T, trillion, a little less than our national debt, I guess. So that’s a tremendous amount of money. A huge pool. So yeah, rightfully so, to my point earlier, that a lot of people use this strategy, there’s a lot of IRA money out there. So folks looking to do syndications, private placements, etc, this can fit well there also. But to Theo’s point, we’re not giving you any kind of financial advice, so please seek your own lawyers, attorneys, CPAs, etc, for this kind of stuff, and financial planners. We’re just going to be sharing what this stuff is and how it functions. So with that, I guess I’ll just go ahead and dive in or do you have anything else to add, Theo?

Theo Hicks: That 20 trillion dollars is interesting. You talked about how it’s close to the national debt; there’s a solution there – just take that money and pay that debt, right Travis?

Travis Watts: Yeah, yeah. That’s what they should do. We’re going to write a letter and propose that. [laughs] So let’s just get started with what is a self-directed IRA. The important thing to distinguish here is that a self-directed IRA is independent of a brokerage firm. So a lot of folks – I’m going to use two examples, because they’re very widely known. Charles Schwab or Fidelity Investments; a lot of people hold 401Ks, IRAs, etc, through brokerage houses like that. Of course, there are way more examples to give, but you get the point. These are not self-directed custodians. I’m going to cover the differences there and how they function.

First, let’s define what a custodian is. It’s basically an entity that specializes in IRA accounts. So for this purpose, we’ll talk about self-directed. So they manage the transactions that are happening – the wire transfers, etc, they manage the paperwork that goes along with doing these types of investments, the title work that you have to do when you close on properties etc, financial reporting… I forget what the tax forms are, as an example; like a 1099, for example – they issue those and they upload those for you. They’re making sure at the end of the day, how I see this – most important element, there making sure that you are staying compliant, that you’re following the rules that have been set forth by the IRS with what you can and can’t do. Theo, you’ll dive into that just a minute here in a little more detail.

Here’s the biggest difference, and it could be a shocker for some folks… But a self-directed custodian charges fees for you to have an account with them. So why did they do that? Well, because if I open an account for free with them, and I just go buy a piece of real estate, and it’s going to be a rental property, well, then how do they make any money? They don’t. So they have to charge you for opening the account, maybe they charge a percentage per year based on how much you have in your account… They have to charge you fees in order to operate their business, and rightfully so.

Then why is it “free” to have a Fidelity or Schwab IRA? It’s because they are making fees in a different way. Most of the time, they’re trying to push their own products to their customers. So if I have my IRA with Fidelity, and I call them up and say, “What do I do with this money?” They’re probably going to persuade me to go with the ABC Fidelity Mutual Fund, which has – what? Fees built into it. That’s how they’re recapturing these costs, that’s how they can offer these free accounts for folks. It’s not that one’s free and one costs, it’s just, you’re going to pay it one way or another, whether that’s more of a slightly hidden cost, versus an out-of-pocket kind of thing. So that’s the difference in structure between your traditional brokerage houses and how they operate and a self-directed custodian.

A couple of more things to point out – when you’re investing with an IRA, this is its own entity. Kind of like if you were using a business or an LLC. If I go purchase a property, I, as in Travis Watts, I’m not on title. My IRA is on the title. So it’s going to say, ABC Trust Company for the benefit of Travis Watts’s Roth IRA, just to give an example. It’s kind of a long handle there, but that’s how that works. So your IRA actually owns the real estate, and therefore it’s not taxed as an individual; they have their own little tax system that they have to follow. It’s completely different than the individual brackets that we all see and know.

I mentioned you can invest in real estate, private real estate, not just publicly-traded REITs, gold, silver, private businesses, on and on. So these are things that if you have an account with a Schwab or Fidelity or brokerage and you say, “Hey, there’s this house in my neighborhood I want to go buy and rent it out”, you can’t do it. Stocks, bonds, and mutual funds. You’re very limited… Well, I shouldn’t say it’s very limited. But you’re limited to stocks, bonds, and mutual funds that are publicly traded. So, Theo, I’ll turn it over to you for just some general either pros and cons, or things to look out for, or things to know beforehand, I guess. Take it away.

Theo Hicks: Yeah, one of the things you said in the beginning was how you’ve got the self-directed IRA, and then it’s also the 401k. I remember I had a buddy who bought a property using his 401K, and used a loan against his 401K, like $50,000 or whatever, and he used that money to buy real estate. From my understanding, I’m pretty sure when you do that, when you get that loan, you’re not really limited on what you can use it for. Whereas for this self-directed IRA, you can’t use it to buy whatever you want. There are certain restrictions; they’re called the qualified or disqualified persons or types of things that you can buy. So I think you mentioned this in the beginning, but you can’t use your self-directed IRA to buy your own personal house, or you can’t use your self-directed IRA to buy a vacation home for yourself in Florida, California, or wherever. It has to be used for purely investment purposes for yourself, also. So the types of things you can buy are restricted, and also who they’re bought for, or who they’re benefiting are also restricted.

The IRS has a list of what they call disqualified persons. This basically means that they can’t have involvement in this investment. So I’m going to steal Travis’s analogy that he gave me before the show, but below you, above you, and next to you. So your parents or grandparents, your children, your grandchildren, your spouse, your siblings, your cousins – you can’t buy a property for them as a gift, you can’t buy a property as an investment, but your mom is living there, or your dad is living there, and they’re paying you money; those people are disqualified. Other things that are disqualified would be any service vendor to your IRA, as well as any entity that owns more than 50% of the property.

And not only can you not buy it for these individuals, but you can’t buy it from these individuals either. You can’t use your self-directed IRA to buy a house from your mom or buy a house from your brother or sister. These people are disqualified, in every sense of the word. You use a self-directed IRA to buy an investment property for yourself, from someone who’s not related to you, or married to you.

A couple of other things that I didn’t realize was a case with the blog post was that it’s not as easy to obtain financing on a property that you’re using a self-directed IRA to purchase, as opposed to you just going out and doing it yourself or having a business that buys real estate. A lot of times you have to buy the investment all cash, or you’re going to have to use it to invest in a private placement, like an apartment syndication. Now, it doesn’t mean it’s impossible to get a mortgage. I’m pretty sure I’ve talked to people out there who specialize in helping you get mortgages when using your self-directed IRA. But as a general rule of thumb, it’s more difficult to obtain financing when you’re using a self-directed IRA to purchase.

When you are using leverage when you’re using a mortgage, there’s a certain portion of the tax code that’s going to apply to [unintelligible [00:12:56].20] unrelated business, taxable income. We’re not going to get to that, talk to your CPA about that, and talk to your CPA about this, in general. We are just giving kind of general advice.

Something else that is interesting, too… When you use your stuff to IRA, you’re investing your earnings after you’ve already been taxed. So when you withdraw that money, it’s not taxed, right, Travis?

Travis Watts: It depends whether you’re doing a Roth IRA, for example, which you’re not getting any tax benefit as you put the money in. You’re earning money paying the tax, then putting it over into a Roth, then you’re kind of compounding tax-free as time goes on. And then yeah, to your point, hopefully withdrawing after 59,5 tax-free withdrawals out of the account. The traditional IRA account is a little bit different. You do get a tax deduction when you transfer money into it in that current year, but then as you pull out the money, you do pay tax on it. It’s kind of an unfavorable tax, which I’ll highlight here in a minute.

Theo Hicks: Perfect. So when you’re using an IRA that you already pay taxes on, and you pull it out tax-free at some point, then you’re not going to get the same tax benefits from your real estate investment. You’re not going to benefit from the depreciation, interest deduction, assuming you get a mortgage on it, the property tax deduction, any other operating expenses, maintenance deductions, things like that, because the self-directed IRA is not taxed like a regular individual person is. The tax code is specifically for the self-directed IRAs, so understanding that and making sure that you’re not taking that into account when you’re making the decision of whether or not to use your self-directed IRA to invest. “Oh, I want to use that because I can get double tax benefits.” That’s not necessarily exactly how it works.

Travis Watts: Yeah, exactly. Again, without being tax advisors and not giving any advice, but the fact is, to your point, Theo, many of us invest in real estate for the tax benefits. Well, if you put it inside of an IRA, you’re losing that ability, because it just doesn’t matter what’s happening inside the IRA as far as you’re investing. What matters is when you pull money out of the IRA, when you do that, how much you do that, and it’s taxed at ordinary levels. So you can pay much higher taxes, realistically, by doing this kind of thing. So it might be an unfavorable situation for you. But again, that’s why everybody is different. That’s why it’s so hard to say, this is good, this is bad, this is right, this is wrong. It’s not black and white. So it really takes some strategy planning with your CPA, etc, and that’s what you should do.

To that point, I just want to share something real quick before I move to my section. You mentioned the up, down, left, and right, and the disqualified persons. The bottom line is, you could probably tell how you can manipulate the system, and that’s why you can’t do these things. You can’t buy your grandma’s $100,000 house for 300k, you can’t move a parent in and have them pay you 50,000 a month in rent when the market rents 2k. There are things that could be manipulated that’s why you have to shy away from the disqualified persons.

The bottom line is there are so many different rules. That’s why you use a qualified self-directed custodian to help you navigate compliance. It’s, quite frankly, very difficult if you’re doing individual purchasing of property using a self-directed, like a single-family home, because you as the individual behind the scenes shouldn’t have any active involvement with that. You should be hiring third-party contractors, third party managers, third party everything; you should never be going in there and saying, “Hey, I’m going to reach in my pocket and upgrade this unit here with 100k in cash, and then sell it for a higher price.” You can’t do this stuff. It’s illegal. So that’s why you want to take the proper measures to that.

I want to share a couple of things. I used to have, as I mentioned at the beginning of our episode, a self-directed IRA, I had a Roth, I had a 401K, I had different things. And generally speaking, to your point earlier, Theo, if you have a 401K it’s usually tied to your current employer. So if you’re still actively working for that employer, it’s probably not going to be a self-directed 401K. You’re going to have to actually end your work relationship with the employer, now have like a rollover IRA, where you’re no longer actively working there, and then you can switch that into a self-directed account. Usually, you can’t; not in all cases, but usually you can’t if you’re currently employed there. What your friend did by taking a loan against it is not really investing inside the IRA; they just gave him a loan based on the balance that’s inside his 401K as collateral. So when you take a loan against something – yeah, you can do whatever you want with that money. That doesn’t fall under these rules that we’re talking about.

I want to talk a little bit about some pros and cons additionally, that I see here. The reason that I liquidated my self-directeds, my 401Ks, and my Roths, early on before I had tremendous amounts of money in there over time, is that really the way the structure is set up is you’re not wanting to pull the money out before 59,5. That’s just the age that the IRS has stated that if you’re pulling your funds out before then, that there could be a penalty. Right now, I think it’s like a 10% early withdrawal penalty. That was one thing. For many of you listening or those who know me, I live on cash flow. So I don’t want to park money into something I can’t touch till I’m 60, because I can’t touch it, and then I don’t have my cash flow. I just lost that ability to do that. And that’s my whole message to the world, is helping folks with financial independence etc. So that didn’t make sense for me.

Number two, something to think about is right now in 2021, we are at historically low income tax brackets. You can go to taxfoundation.org, on the upper left of the website you can click on tax brackets and look at the historic. Get this – this just blows my mind… Back in 1963, we had the highest marginal rate tax bracket at 91%. So you just think about that – people making over 200,000 a year in 1963 we’re paying 91% in tax. So we have just drifted down and down and down and down and down to today. Our top brackets are 37%, or something like that. They could be going up with a new administration, we don’t know. But still, hey, I’ll pay 37 over 91 and day.

So the idea here is, to your point earlier, Theo, if I have a traditional self-directed IRA, I’m getting a tax deduction today for funding it.  Say I go put $5,000 in it, I’m getting to basically deduct 5,000 against my income today and save whatever bracket I’m in, which is historically low, whether I’m in 20, 25, 30, 37 at the top. And then taking a chance that when I’m 60 and I start pulling the money out, that tax brackets are equal or lower at that point. But realistically, could they be higher again? What if they were 91% again? So I’m getting a little deduction today, and I’m going to pay maybe theoretically twice the tax in the future. We don’t know this stuff; I’m not here to predict the future. I’m just saying what if that scenario were to unfold, the likelihood. It’s kind of like saying “Interest rates are really low today. So when I’m 60, I think they’ll be the same.” Well, probably not. The odds are they’ll probably be higher at that point.

So something to think about… Those are the reasons why I decided, for me personally, it wasn’t a good fit. But that’s not to bash these IRAs, by any means. They do allow you to invest in private real estate, and these real estate private placements, which I’m huge on and I invest a lot in. That’s a great thing if you’re not a fan of the volatility of the stock market, or you’re just looking for diversification, or you’re already in retirement, and you’re looking for ways to generate passive income. Maybe apartment yields make a lot more sense than putting your money in bonds or something like that, just for example purposes. What else? Diversification… Then there’s also the QRP plan. This conversation could go way more in-depth; we’re not the professionals here. But to your point about the UBTI tax, unrelated business income tax – solo 401Ks, QRP plans… There are different versions out there that could perhaps potentially avoid that type of tax. But again, we’re not here to tell you what to do or how that works. It’s beyond my scope, I’m just letting you know; talk to the professionals and figure this stuff out for yourself.

We talked a little bit about Roth IRAs, and those perhaps can have different types of advantages with the tax-free compounding, tax-free withdrawals one day. But there are income phase-outs; if you’re a very high-income earner, you may not even be able to open a Roth or to fund it, rather. So that’s why everyone’s different and you need to consult on things like that.

With that said, that’s a whole jumbled mess of my thoughts, and a couple of stories, and a couple of examples, and what this stuff is… So as Theo pointed out, we do have a blog that was written in much more detail and clarity, so click on that blog, get some more information, reach out to the professionals on it. But I think that’s all I got on the topic.

Theo Hicks: Well, thank you for sharing your explanation as to why you liquidated. Like a lot of things that we talked about on this show, should you use your IRA to invest in real estate? Well, it depends. There’s no absolute yes you should, or no you shouldn’t. It really kind of depends on where you’re currently at. If you don’t have an IRA at all, then ask yourself, “Is it better for me to have one to start investing my money into that? Or is it better for me to maybe use that capital for something else?” Or if I’m 59 and a quarter years old and I’ve got $3 million in there, is it worth liquidating all that when you’re going to be able to start pulling capital out in a couple of months? Or should you just keep your self-directed IRA and do nothing? Or use it to invest in real estate? So it kind of depends on where you’re at and what your ultimate goals are. Understanding how it works, I think, is important to help make that decision.

As Travis mentioned, we’re not telling you that you should or shouldn’t do anything; we’re just trying to give you some information on the strategy, how people have used it in the past, and then direct you to the expert or the individual who wrote the blog post, or your own CPA. Travis, anything else want to mention before we close out?

Travis Watts: Yeah, that was a great point. I just want to add one thing to what you just said. A lot of folks that I come across in the investor relations capacity that I’m speaking with, that are using self-directeds, fit a similar bill to what you described. They have been contributing to these types of accounts for many years, sometimes many, many decades. They have perhaps a few million dollars in there. And at this point, it’s like would that make financial sense to take an early withdrawal penalty when you have that much at stake? You’re going to have to decide that for yourself. But I was fortunate enough to make my decision early on, before I had millions of dollars at stake. So my little 10% penalty really didn’t amount to that much, and it was more important for me to have that long-term flexibility over my investing. But yeah, I think I would feel a lot different if I was 50 years old with $3 million in an IRA. I doubt I would go pull $3 million out myself and take that kind of tax hit at that time. But yeah, there are strategies, there are things you can do. We’re not here to tell you what to do. But great points, Theo. That’s all I got.

Theo Hicks: Perfect. So the blog post on our website is How to Invest in Real Estate With a Self-Directed IRA, for more information on the topic we discussed today. To close out, if you want us to answer a question that you have, either on this show or on the 60-second question segment that Travis and I do and we post on social media and YouTube, you can email me –theo@joefairless.com– that question, and then we will add it to our list of questions to answer. So, Travis, as always, thank you for joining us today. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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