All Forum Posts by: Nick B.

I have recently heard of an interesting tax-saving strategy of how to convert traditional IRA to Roth while paying very little in taxes. I would like to share it and get some feedback.

In this example I'll use a traditional IRA with $100K in cash held at a bank or a broker.
I assume no transaction or maintenance fees charged by the SD-IRA custodians to make the math simple.

The general idea:

- Set up two self-directed IRAs, traditional and Roth, and fund them from the existing IRA:
  $95K goes to traditional (direct rollover) and $5K goes to Roth via conversion. Taxes on the Roth conversion are paid from cash outside of the IRA.

- Create an "Investment LLC" with two classes of shares: 5% of shares is Preferred equity (P) and 95% are Common shares (C).

- P-shares get 95% of all profits generated by the LLC while C-shares get 5%.

- Traditional IRA buys all C-shares and Roth IRA buys all P-shares of the LLC.

- The LLC invests the proceeds in something that doesn't create UBIT situation. The simplest example would be an index fund such as SPY or QQQ.

- During its lifetime the investment produces some dividends and realized capital gains totaling 100% of the original investment (this is an assumption for the easy math, actual results may vary).

- The Investment LLC distributes the proceeds as follows:
- Roth IRA gets $5K of the principal and $95K of the dividends/gains, totaling $100K;
  - Traditional IRA gets $95K of the principal and $5K of the dividends/gains, also totalling $100K

- If account owner decides to cash out and close all accounts at that point, they would get $170K in cash (assuming 30% tax rate and no penalty because of age over 59 1/2)

Tax savings:

- Traditional IRA that doubled from $100K to $200K: cash out value is $140K (30% tax on the entire balance).
- Converting the whole initial amount of $100K to Roth would cost the investor $30K in taxes.
  The resulting balance of Roth ($70K) would double to $140K - same result as in keeping everything in the traditional IRA
- As we can see, the "two IRAs and LLC" strategy saved $30K ($170K - $140K) in taxes.

The tax savings would become more pronounced if the Investment LLC invests in a high cash flow/high depreciation business instead of an index fund.
In that scenario all equity would eventually be converted to dividends 95% of which would end up in the Roth IRA.
E.g., if $100K investment produces $200K of income and no principal is returned, the final balances would be $190K for Roth and $10K for regular IRA.
Only that $10K would be taxed upon withdrawal saving $57K in taxes comparing to traditional IRA.

Questions:

- Are there any legal hurdles with this strategy? I heard it from a tax planner who sells it. Obviously he was biased and said it was totally legit. I'd like to get unbiased opinions though.

- Assuming "two IRAs and LLC" is a legit structure, what kind of business would produce reasonably high profits while depreciating original equity to 0?
  From what I understand, something like oil drilling, oil equipment lease, car wash, convenience store, or laundromat should qualify.
  If so, would they be subject to UBIT?

No reasons to do that. LLC taxes (I assume partnership) are pass-through to the LLC holder(s). Asset protection is also irrelevant because LP shares are illiquid and cannot be easily separated from their owners.

Disclaimer: I am not a lawyer or accountant. Seek legal or tax advice from appropriate professionals.

 It is one of possible schemes that some sponsors use. 

There are others that are more investor-friendly. E.g., when a pref is based on the original capital and never goes down, or straight split with no pref at all.

Look at the sponsors and their track record first. Stick with those who have been in this business for at least 10 years. If there are multiple sponsors for the same deal tread lightly. There are plenty of newbies these days who team up (7 or 8 people is not uncommon) to raise money for a more experienced sponsor (relatively speaking - 3 years vs 0-1 year for the rest of the team). Stay away from those. 

As for the property/location, do that research upfront. State/Metro/Sub-market/demographics/rents - these are you base data points. Choose what suits your personal preferences.

Cap rate is a measure of supply and demand. There is more demand for larger properties hence lower cap rates.  

 Buy $3.33B worth of 30yr Treasures. They pay 3% which is $100M

Quote from @Casey Decker:

Hello and thank you for putting up with my rookie question. I'm trying to get a rough idea of if I can even get basic numbers to work before I start looking more seriously into some deals. As I look around the Austin area, it seems there are a few places where I can get a property for the mid $300,000s and charge a little over $2k for rent. With these basic numbers, I'd be losing hundreds a month. Am I looking at this the wrong way? How do so many other people seem to be able to do this? Was it because they purchased before interest and home prices shot up?

Thanks again for helping a newbie out.

 Rent is less than 1% of the all-in cost. It won't cash flow. Also, your insurance is way too low but your repairs are too high provided that you spent $10K to fix everything. 

100% of 10 units is more than 5% of 80 (only 4). So, all other things being equal, I'd own 10 units

Offer whatever you're comfortable with and add a note that you may increase that offer once they give you financials.