Can't seem to figure this out...

Tax, SDIRAs & Cost Segregation
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Can't seem to figure this out...

Ryan Sanders
Realtor · Colorado Springs, CO · Member since 2016 · 124 posts · 34 votes

I have begun my investing journey and was lucky enough to stumble across my neighbor, who has access to close to $250k in a 401k from a previous employer which he has not moved yet. As such, he is eligible to move it into a self-directed IRA and I have suggested he do that so we can invest in real estate together with this. Reading more about self-directed IRAs, I now have some questions that I can't seem to find answers to.

1) I am the 'primary' investor and I own the LLCs used to purchase the real estate and his IRA would merely provide funding to the LLC through a partnership agreement between us. Can his IRA do this without the IRA being listed as the owner of the property, and can he keep any profits or do they have to roll back into his IRA? Also, are my share of the profits affected in any way? This then leads to another question:

2) Can I invest some of my free-and-clear (non retirement account) income in these deals and use his IRA for the rest?

3) As many on here will attest, leverage is very powerful, and just because I've gotten lucky access to a large fund of cash, I would still like to leverage properties to maximize my growth and return. Can we still leverage deals using the IRA for down payment?

4) Lastly, If my LLC purchases a rental property using solely my neighbor's IRA funds and I rent the property, is my LLC allowed to contribute to maintenance of the property at all, or does all money for the property have to come from the IRA?

Thank you for any assistance,

Ryan

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Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
10y

@Ryan Sanders

Your neighbor can either partner with your LLC or lend to your LLC using a SDIRA. How you wish to structure your relationship will affect entity structuring, vesting of title to property, and how the income to your neighbor's IRA may be treated.

If he is using IRA funds, he needs to avoid mixing in his own non-IRA funds. All proceeds that flow to his side of a deal must go to the IRA. He cannot take income from the IRA investments, though if he is over age 59 1/2, he can take taxable distributions from the IRA at any time.

Because you are not a disqualified party to your neighbor's IRA, his IRA and you (or your LLC entity) can structure deals in many different ways. He can provide all the capital or some of the capital. Capital can be lent or can represent equity in the property. His IRA and your LLC can joint venture, or his IRA can take an equity stake in your LLC. You will want to work with a good real estate attorney to see what will work best both at protecting your mutual and individual interests, but also from a tax reporting perspective.

There does not necessarily need to be a direct relationship between the percentage of capital provided and the percentage of equity in a deal. He could provide 80% of the capital and you could provide 20% of the capital plus all of the operational services, and you could then take a larger than 20% cut of the profits. The IRS is OK with any of that, so long as he does not transact with a disqualified party to his IRA.

If he has equity in a deal, and the deal uses debt financing, then the IRA will be subject to UDFI taxation. Any debt instrument will need to be non-recourse, at least with respect to his IRA. He cannot pledge a personal guarantee. Something you will want to study up on. Not a deal killer, but something to understand.

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  • Brian EastmanPro Member
    Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
    10y

    @Ryan Sanders

    Your neighbor can either partner with your LLC or lend to your LLC using a SDIRA. How you wish to structure your relationship will affect entity structuring, vesting of title to property, and how the income to your neighbor's IRA may be treated.

    If he is using IRA funds, he needs to avoid mixing in his own non-IRA funds. All proceeds that flow to his side of a deal must go to the IRA. He cannot take income from the IRA investments, though if he is over age 59 1/2, he can take taxable distributions from the IRA at any time.

    Because you are not a disqualified party to your neighbor's IRA, his IRA and you (or your LLC entity) can structure deals in many different ways. He can provide all the capital or some of the capital. Capital can be lent or can represent equity in the property. His IRA and your LLC can joint venture, or his IRA can take an equity stake in your LLC. You will want to work with a good real estate attorney to see what will work best both at protecting your mutual and individual interests, but also from a tax reporting perspective.

    There does not necessarily need to be a direct relationship between the percentage of capital provided and the percentage of equity in a deal. He could provide 80% of the capital and you could provide 20% of the capital plus all of the operational services, and you could then take a larger than 20% cut of the profits. The IRS is OK with any of that, so long as he does not transact with a disqualified party to his IRA.

    If he has equity in a deal, and the deal uses debt financing, then the IRA will be subject to UDFI taxation. Any debt instrument will need to be non-recourse, at least with respect to his IRA. He cannot pledge a personal guarantee. Something you will want to study up on. Not a deal killer, but something to understand.

    2Reply
  • Ryan Sanders
    OP
    Realtor · Colorado Springs, CO · Member since 2016 · 124 posts · 34 votes
    10y

    @Brian Eastman Thanks so much for the quick and informative response! One situation I have thought about is using my LLC funding to gain financing then use his IRA funds to fill out the remainder of the deal if necessary. Would this provide him the best tax benefit while still allowing us to leverage our deals?

    As for the entity structure, so far we have a partnership agreement specifying how much our capital contributions are and how much our profit shares are. These partnership agreements are done for each property we intend to put under contract, and each of those properties would be owned by a single LLC which is, in turn, owned by my primary LLC. This seemed like the best way to have our partnership flexible. Does this seem like a method that should work? Unfortunately, while we've had two properties under contract (one fell through and the other is still UC), we haven't closed on anything yet and I want to be sure my ducks are lined up before one of us gets ourselves in trouble.

    Thanks again

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  • Brian EastmanPro Member
    Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
    10y

    @Ryan Sanders

    You will likely want to get an attorney or CPA familiar with self-directed IRA's on board as part of your team.

    If you have a formal partnership, then that partnership needs to file a partnership return.  A joint venture with tenancy in common may not need to, as an example of different approaches.

    If his IRA is involved and there is debt financing such as a mortgage, you would need to ensure the debt is non recourse and consider the potential implications of UDFI taxation to his IRA.

    If a LLC is purchasing a property with a mortgage, and his IRA is a member of the LLC, or a JV partner with the LLC, the implications of debt could potentially be different for his IRA dependent upon how income is allocated.

    It is more complicated than an internet forum can address... but you are heading in the right direction and asking good questions.

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  • Mindy JensenPro Member
    BiggerPockets Money Podcast Host · Longmont, CO · Member since 2014 · 7k+ posts · 10k+ votes
    10y

    @Ryan Sanders, read the first sentence from Brian's second post again. "You will likely want to get an attorney or CPA familiar with self-directed IRS'a on board..."

    Don't bother with someone who doesn't specialize in this. I'm currently trying to set up a self-directed solo 401k, and Vanguard (the investment company, who should at the very least be familiar with the concept) is really throwing a wrench into the works with their lack of knowledge.

    [email protected]Podcast Guest on Show #261
    BiggerPockets
    1Reply
  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    10y

    @Ryan Sanders

    Does your neighbor already have self-directed IRA setup and does the partnership agreement list his custodian on behalf of his IRA as the partner?

    Perhaps the easier way for all parties will be when your neighbor just acts as a private lender to your deals. He provides the financing, you pay him hard money rate and then you end up keeping all the profit. Keep things simple... but I agree with what Brian and Mindy suggested to use guidance of the someone who specializes in this.

    @Mindy Jensen

    your and Carl's experience with Vanguard when you simply trying to move the funds out of their custodial account and every time you talk to someone get different and conflicting instructions shows the ignorance of the people who work there. Unfortunately this happens with major brokerage firms and banks such as Vanguard, Fidelity, Wells Fargo, etc. but once that rollover is completed you will be in the "driver's seat" of your 401k (as one of my clients said) and can fully appreciate the power of "self-directing".

    1Reply
  • Justin WindhamPro Member
    Banker · Nationwide · Member since 2015 · 4k+ posts · 1k+ votes
    10y

    @Mindy Jensen

    Are you trying to open an account in the name of your Solo 401k at Vanguard or are you trying to get Vanguard to transfer assets to the Solo 401k? I've seen people run into issues with both, but there are solutions, of course.

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  • Ryan Sanders
    OP
    Realtor · Colorado Springs, CO · Member since 2016 · 124 posts · 34 votes
    10y

    Thanks very much everyone! My neighbor has decided to sit on his 401k for right now and see how our first deal or two together go before he risks his entire retirement (can't say i blame him but it is disappointing lol). This will allow me more time to do the necessary research and determine our best course of action going forward.

    @Dmitriy Fomichenko Can he act as a private money lender while getting a profit-share return per deal? His contribution to my investing is insistent upon a profit-share instead of a hard rate of return.

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  • Justin WindhamPro Member
    Banker · Nationwide · Member since 2015 · 4k+ posts · 1k+ votes
    10y

    @Ryan Sanders

    You may want to look into a revenue participation agreement to satisfy both your desire for funds and your neighbor's desire for profits beyond a set interest rate.

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  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    10y

    @Ryan Sanders

    again, you (or actually your neighbor) need help of an experienced tax professional to guide you through this. When you participate in revenue share this would probably indicate ownership and in the active business event could result in UBIT taxes to be assessed on the IRA profits. Simply being a private lender without any ownership would not have this issue and all incomes would not be subject to taxation.

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  • Minna Nah
    Solo 401k Provider · Anaheim, CA · Member since 2014 · 18 posts · 7 votes
    10y

    Ryan, we have seen people violate the rules because they didn't have competent guidance. Please follow advice above.

    1Reply
  • Ryan Sanders
    OP
    Realtor · Colorado Springs, CO · Member since 2016 · 124 posts · 34 votes
    10y

    I definitely will be talking to my CPA soon. Now that my neighbor and I have a couple deals going, he will see that this works and will want to invest that 401k somehow so I want to be sure I'm educated first.

    1Reply
  • Justin WindhamPro Member
    Banker · Nationwide · Member since 2015 · 4k+ posts · 1k+ votes
    10y

    @Ryan Sanders

    Sounds like a good plan. Keep us updated.

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