What Questions Should I Ask the Self Directed IRA Provider??

Question

I want to setup a Self-Directed IRA. I have a list of dozens of providers. Before I start reaching out, what questions should I consider asking to ensure they are the right fit?

To provide context: I'm an Active-Duty military officer (12 years) as my Full-Time job, I invest in Buy & Hold, Wholesale, and passive Financial investing to other peoples flips for profit splits. I DO NOT have an LLC yet either.

As always, you all rock!!

Brian Eastman · Answer

@Zach Lemaster

Your understanding that an IRA would be subject to taxation on income from mortgaged buy and hold investing, while a 401(k) would be exempt is correct.

An IRA is subject to trust tax tables, which scale up based on income.  The maximum rate is 37%, but it is unusual for most IRA investors to get to that level, and even then the tax is on such a small percentage of overall income that the effective rate based on the investment will be much, much lower.

The portion of income derived from the non IRA (borrowed) funds is taxable.

In a 60% leveraged property, that means 60% of the gross income is considered UDFI and taxable.

You then get to take a $1000 exemption as well as 60% of all the normal deductions such as interest, depreciation, etc.

The net taxable number is then run through the trust tax table and the tax owed is paid by the IRA.

A $100K property that is 60% debt-financed and producing 10% return will likely have a tax bill of between $150 - $200 at the end of the year.  That is a small price to pay for the benefits of leverage and the higher cash-on-cash return the IRA will receive via the use of mortgage financing.

Of course, for those who legitimately qualify for the Solo 401(k), an exemption from the headache of a tax return and getting to save that $150 or so is a nice benefit.  It is certainly not the kind of savings that induces once to "create" self-employment just to avoid that tax as is so often recommended here on BP.

Brian Eastman · Answer

@Adam Scheetz

As a plan provider, I cannot make a specific recommendation as to a company to work with per BP guidelines.

What I can help you do, however, is refine your question.

Self-directed IRA's come in several formats offered by different types of companies.  The type of self-directed IRA that will best suit your situation and goals will drive the process of identifying the right firm to work with.

A self-directed IRA custodian is a processing entity.  Think E*Trade or Fidelity with different paperwork.  All IRA based plans are required to have a custodian to administer and report on the account.  What makes a self-directed IRA custodian different is that they are not purely connected to the public exchanges and limited to investing in stocks, bonds and funds, but rather have the staff training and paperwork to document the IRA's investment in the more individualized transactions that occur when investing in real estate, notes and other non-traditional assets.  Such custodians will hold funds, sign documents, issue expenses and receive income on behalf of your IRA and act as your processing layer.  This works OK for relatively static and simple investments like a private placement or crowdfund, but can become rather cumbersome and expensive with a more time sensitive and transaction intensive asset such as a rental property.  You also need to be aware that custodians are passive in nature and simply process transactions at your direction.  They do not provide meaningful oversight or guidance with respect to tax code compliance.

A checkbook IRA LLC is an enhancement on the above structure that is generally more time and cost efficient for investors with a more diverse portfolio.  It starts with a self-directed IRA held by a custodian, but the IRA simply makes one investment into a specially designed LLC entity.  The IRA owns the LLC, but you can be the non-owner manager of the LLC and have signing authority.  This allows you to directly manage transactions via the LLC and eliminates the paperwork, processing delays and per-transaction fees of the custodian.  These plans typically cost a bit more to establish due to the legal work, but in most cases will save you considerably over the long term.  With a quality provider, such plans also come bundled with meaningful consulting guidance to help you get the most out of the program while staying inside the IRS guidelines.

A similar checkbook program is a Solo 401(k).  Such plans are available to those who have some form of self-employment  and no full time employees.  As an owner-only business retirement plan, the Solo 401(k) has higher contribution limits, allowing you to build your savings on the front end as well as providing investment flexibility.  The Solo 401(k) also has the advantage of being more favorable for real estate investments using debt-financing such as a mortgage - as the 401(k) is exempted from a small tax called UDFI that an IRA would pay on the percentage of income derived from the borrowed money.

So, as you continue your research and get feedback here on BP, think about what type of program will best suit you needs and be sure to ask questions along that line.  Get on the phone and speak with a few of the providers that are active here on BP.  You will pretty quickly be able to tell who is just selling something and who can become a valuable member of your team.

I would, if I were you, start by determining if there is even the possibility of a self-directed IRA.  If you are active military and have a TSP, those funds cannot be moved.  You would need an IRA or old 401(k) from prior employment to rollover into a self-directed plan.  Of the activities you mention you are personally engaged in, only buy and hold rentals are a good fit.  Equity splits on flips and wholesaling are business activities that will have the potential for taxation within the IRA known as UBIT.  Pure lending with the receipt of interest (not a split of profits) may be another avenue suited to an IRA.

Zach Lemaster · Answer

@Adam Scheetz ask if you could possibly quality for the solo 401(k) instead of SDIRA to avoid paying the UBIT tax.  I also have a great reference for a custodian if you would like.  Just pm me.

George Blower · Answer

If you are self-employed with no full-time w-2 employees, you can set up a Solo 401k which allows for investing in real estate. Unlike an IRA, there is an exception to UDFI for income derived from real estate owned by the Solo 401k and acquired with non-recourse debt.

Zach Lemaster · Answer

Also is UFDI a %?  If so do you know what that is?  Just trying to wrap my head around how much that would be.

Zach Lemaster · Answer

@Brian Eastman Thank you for clarifying.  So just to make sure I understand you completely.  For buy and hold RE, a SDIRA would be subject to UDFI tax, but a solo 401(k) would not correct?  I appreciate you breaking this down for me and everyone else interested in this.

Brian Eastman · Answer

@Zach Lemaster

A mortgaged buy and hold creates exposure to UDFI (Unrelated Debt-Financed Income).  A Solo 401(k) has an exemption in that case.

Unrelated Business Taxable Income (UBTI) is generated when a tax-exempt entity engages in a trade or business on a regular or repeated basis, such as flipping/wholesaling in the real estate space.  That tax applies to a Solo 401(k).

Zach Lemaster · Answer

@Brian Eastman I would be referring to buy and hold properties only for rental income.  Can you clarify pertaining to this please.

Brian Eastman · Answer

@Zach Lemaster

A Solo 401(K) does not provide exemption from UBIT.  A Solo 401(k) provides a narrow exemption from Unrelated Debt-FInanced Income taxation (UDFI) when the debt instrument is secured by the acquisition of real property.

Trade or business activities such as flipping will have UBIT exposure in a Solo 401(k).

Adam Scheetz · Answer

@Brian Eastman Wow! I hope that was copy and pasted because that was a ridiculous amount of great info!! Thank you so much!!

What Questions Should I Ask the Self Directed IRA Provider??

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