BiggerPockets Money Podcast - The Tax-Free Retirement Strategy 95% of Americans Don’t Know About

Episode Date: March 4, 2025

The wealthy are using one unique retirement account to build their fortunes tax-free. You may have never heard of it, but knowing about it can change the course of your retirement planning, allowing you to invest in much more than stocks, index funds, and bonds in your retirement accounts.  We’re talking about making passive real estate income tax-deferred, flipping houses and sheltering the profits for when you retire, or having a rental property portfolio producing massive passive income, all with the tax benefits of your 401(k), IRA, or Roth IRA.  We’re, of course, talking about the self-directed IRA (SDIRA) and the sizable benefits that come with it.  To help, John Bowens (Certified IRA Services Professional) from Equity Trust is on the show to share the tax advantages most Americans have zero clue about. Scott starts the interview by coming in hot, throwing out his most significant objections to an SDIRA. We were even surprised by just how many benefits this single account has and how you can use it in ways most people would never assume of a retirement account. We’re talking about how to buy rental properties IN your retirement accounts (and profit from them tax-free/deferred), whether a self-directed IRA or 401(k) makes the most sense for you, the “material participation” rule that you CANNOT afford to break, and how much this account costs to set up. This is a game-changing account for retirees who want to live a rich life, so do not skip out on it! In This Episode We Cover Scott’s biggest objections to the self-directed IRA (is he wrong?) How to get tax-free/deferred passive income from real estate in your retirement accounts  The one tax that you MUST know about before investing in an SDIRA  Can you get a mortgage for a rental property in an SDIRA? How much an SDIRA costs to set up and keep going (less than you’d think) And So Much More! Links from the Show Mindy on BiggerPockets Scott on BiggerPockets Listen to All Your Favorite BiggerPockets Podcasts in One Place Join BiggerPockets for FREE Email Mindy: [e-mail] Email Scott: [e-mail] BiggerPockets Money Facebook Group Follow BiggerPockets Money on Instagram “Like” BiggerPockets Money on Facebook BiggerPockets Money YouTube Channel How to Access Retirement Funds Early Maximize Your Real Estate Investing with a Self-Directed IRA from Equity Trust Want More Smart Tax Strategies? Grab “The Book on Tax Strategies for the Savvy Real Estate Investor” Sign Up for the BiggerPockets Money Newsletter Find Investor-Friendly Lenders The Self-Directed IRA: What You Should Know About This Wealth-Building Tool Connect with John   (00:00) Intro (08:26) Tax-Free Real Estate Gains (16:45) One Tax to Watch Out For (19:59) Self-Directed 401(k)s vs. IRAs (27:36) Making $34,000 Tax-Free! (30:42) The "Material Participation" Risk (35:41) Financing Rentals in an SDIRA (39:40) SDIRA Fees and Costs (50:05) Completely Passive Income (51:56) Active Investing in an SDIRA Check out more resources from this show on BiggerPockets.com and https://www.biggerpockets.com/blog/money-612 Interested in learning more about today’s sponsors or becoming a BiggerPockets partner yourself? Email [e-mail] Learn more about your ad choices. Visit megaphone.fm/adchoices

What if the wealthy have been using a retirement strategy that 95% of Americans don't even know exists? While most people struggle with market volatility in their 401ks, a small group of savvy investors are building tax-free empires through self-directed IRAs. Please note, this episode is not for the everyday investor. Even though this is an introductory episode, it's still an advanced discussion. So keep that in mind if you want to listen up. All right. Hello, hello, hello, and welcome to the Bigger Pockets Money podcast. My name is Mindy Jensen, and with me as always is my fabulous co-host, Scott Trench. Thanks, Mindy, great to be here. I don't have a pun for Fabulous today. I have instead of a quick short story, every morning, we wake up our two and a half

year old and we comb her hair and put her in the bathroom and get her ready for school and all that kind of stuff. And we tell her she's at the salon. And at the end, we ask her how she looks and she says, I look fabulous. Thank you for calling me fabulous today. Bigger Pockets is a goal of creating one million millionaires. And specifically, we're really working on this kind of two and a half million dollar net worth that enables real true personal financial freedom and escape from middle class trap. So you're in the right place if you want to get your financial house in order and

potentially use that 401k or self-directed IRA or the new tool of a self-directed IRA to escape from that middle class trap because we truly believe financial freedom is a for everyone no matter when or where you're starting. And we hope that the advanced discussion on this episode is a helpful reference for you in years to come, as you just are aware of this option with your 401k or self-directed IRA funds. We are so excited to be joined by John Bowens today. John is the director and head of education and investor success at Equity Trust Company. Equity Trust Company is a partner of bigger pockets. We have partnered with Equity Trust Company to provide exclusive of benefits to real estate investors who want to set up self-directed IRAs or facilitate 1031

exchanges. We couldn't be more excited about this partnership. And I think you're going to find that John is a absolute friggin master at all things, self-directed IRAs. And I'm not going to pull punches. I'm coming right at him from the beginning of this saying, I see major problems with using a self-directed IRA to invest in a traditional rental property. I see five of them.

I see the problems with it losing tax benefits. I see problems with potential income tax requirements like Ubit or UDFI, complicated topic we're going to get into. I see problems like not being able to get a 30-year fixed rate, Fannie Mae insured mortgage, which I think is a superpower of real estate investors outside of the self-directed IRA. I see problems with not being able to self-manage the property or materially participate in rental activities or partner with prohibited persons like family members. I see problems with major fees and headaches that can pile up when you're, when you attempt to open up one of these self-directed accounts, renew it on an annual basis,

file certain types of paperwork with the IRS on an annual basis, and facilitate transactions like forming an LLC or buying properties. Those are real, and John is not going to shy away from them, but we're going to have a great discussion about it and talk about the nuances and when and where it still might be a useful tool for certain of our members who want to invest in real estate using a self-wrote an IRA. We're going to sprinkle in some more advanced topics, but we're going to really get into the advanced topics over the course of the year later on as we begin exploring things like pairing real estate investment syndications, private lending, and those types of things with 72T, Roth conversion ladders, and more of these advanced strategies.

With that, caveat, John, welcome to the Bigger Pockets Money podcast. We are super excited to have you on today. I appreciate that, Scott. Thank you. And Mindy, thanks for the introduction here. So this is the great, I'll call it self-debted. directed IRA debate that's been going on for now over 50 years. So the IRA itself just recently celebrated its 50th year anniversary. And back in 1974, when the Employee Retirement Income Securities Act was passed. And out of that act, it laid the legislative foundation for the IRA and that eventually the SEP IRA, fast forward to the late 90s, the Roth IRA, which came about 1998, then the early 2000s, the solo 401k. And we can talk a lot about the solo 401k and

some of the advantages there. And certainly focusing on Roth and Roth Solo 401k from a tax advantage perspective. But when the law was written back in 1974, and I thank our legislative leaders at that time, because they made the law exclusive in terms of what you can invest in, not inclusive. So they only tell us what we can't invest in, not what we can invest in. And that's why. we can own a single family rental property in a self-directed IRA, why we can invest in a real estate syndication, a partnership, a private credit fund. And in terms of real estate, and Scott, I'm glad that you brought up some of those points because I find that in the real estate industry and in the real estate education space, there's a lot of generalization in terms of what one should do

and what one shouldn't do. And I think that you have to look at one's individual situation and you need to look at where is their capital now? You brought up a great point, Scott, which is what if someone has a majority of their IRA or 401k or other retirement account capital? What if they have a majority of that in an IRA or an old 401K? So that's going to be much different than someone that maybe has less money in their retirement account and more wealth outside of their retirement account. In terms of investing in single family rental properties,

just sort of right out of the gate, I can give you examples of, you know, whether it's myself or other investors out there that are utilizing their self-directed IRA funds and some of the use cases and where it can make sense. A good example is I have a local, you know, I'm from Cleveland, Ohio, Scott, and I work with a local investor here, and he bought a house in 2020 for $63,000. Now, I know you can't find a house for $63,000 all across the country. Okay, this is the Cleveland, Ohio market, but he bought this house for $63,000 with his self-directed retirement account. And then two years later, he sold the property for $115,000. He had a teneted cash flowing and he actually sold it to an out-of-state investor and he ended up making

a 32% annualized return on investment and he saved $5,000 in taxes. So that's a perfect example of where it made sense for that individual to use their self-directed IRA. I will agree with the fact that there are some opportunities that make sense inside of the self-directed IRA or or self-directed solo 401k. And then there are other opportunities that just make sense outside of the self-directed IRA. And so it's not really the self-directed IRA is competing with non-IRA funds. I don't look at it as a competition, but rather I look at it as a rising tide. Opportunities inside and opportunities outside of the self-directed IRA.

And the last thing I'll say, Scott, and then I'll back to you for any questions that you have for me on that, is in my experience doing this for close to 20 years, studying taxes, studying tax strategy, working with some of the top CPAs and tax attorneys in the country, and reviewing thousands of on thousands of self-directed IRA transactions, being a self-directed IRA investor myself, what I have found is the areas of complexity in terms of the tax code and the tax law, the areas of complexity, those particular areas are where opportunity things. thrives. So where complexity lies, opportunity thrives is what I always like to say.

And so when we talk about self-directed IRAs, there are areas that are complex. There's unrelated to business income tax. There's understanding depreciation and how that works. There's understanding the tax-free payoff of a transaction within a Roth IRA versus a traditional IRA. There are the prohibited transaction rules such as what you said, Scott, can you manage the property? Can you not manage the property? So there are these complexities, but once you learn and you understand, you'll find that oftentimes there can be a lot of opportunity within the self-directed IRA, Roth IRA, Solo 401k, or even at HSA. A lot of people don't know that you could self-direct an HSA account. Let's go through the rental property example first here

in fairly good detail, because I think it's important to kind of just describe it as it is. What is it in a realistic sense? Because I agree, I think there's some use cases for the self-directed IRA to invest in real estate. It's just as a generalization, I like to, I like to prioritize investing in traditional rental property outside of my 401K. If I was an airline pilot with a million dollars in my 401k and that was my main source of wealth and I wanted some exposure, I would absolutely be interested in this tool, but I want to go in eyes wide open with what those risks are. So the first thing I see is the tax advantages, right? Debrate like the depreciation benefits, the ability to have passive losses, for example, on some of that income outside of

my retirement account, those are lost in the sense that they can still exist inside the retirement account, but the retirement account is already tax advantaged. So that has no near-term benefit to me. Is that right? And can you describe what maybe some offsets that are from a tax benefit perspective? Yeah. So in terms of the depreciation question, oftentimes I hear, well, I lose depreciation or I sacrifice depreciation. if I buy this rental property with the self-directed IRA. First, it's important to understand what does depreciation actually do for a real estate investor? So if we're investing non-IRA, we have depreciation, which of course is a paper loss.

Now, maybe you do a cost segregation study or you're just taking it as 27 and a half year straight line. Either way, the depreciation loss every year that offsets your taxable income, that's a paper loss. And that depreciation is going to add up over time. And then eventually when you sell the property, unless you do like a 1031 exchange or you pass away and take advantage of step up and basis for your heirs, ultimately that depreciation is going to be recaptured. Now, of course, there's, you know, the cost basis, capital improvements being added to increase your cost basis. So there's some other strategies that can be discussed there for maybe a different seminar or a different podcast. But what's important to understand is that depreciation eventually recaptures. In a IRA environment, you are in a tax-exempt environment.

So think of the IRA just like investing in stocks, bonds, and mutual funds. So when you're investing in stocks, bonds, and mutual funds compared to real estate, from a tax perspective, it's the same. If you have a capital gain from a stock sale, that goes back into your IRA, and it's exempt from taxes in that year. If it's a traditional IRA, eventually you're going to pay taxes when you take the money out. If it's a Roth IRA, no taxes when you eventually distribute from the account. And we can talk more about the Roth IRA.

So now looking at rental property specifically, if I own a rental property in my self-directed IRA, I have rental income flowing back into the self-directed IRA, which is not subject to taxes. Because there's no taxes, I don't have depreciation to try and offset. any taxable income. And then in a Roth IRA, as I have rental income flowing back in, no taxes. When I eventually distribute money from that Roth IRA later on in my retirement years, I pay 0% tax. When I own a rental property in my self-directed IRA and I sell that property, there's no capital gains tax. Because remember, along the way, there was no depreciation because there was no taxable income to be offset by depreciation. I didn't need to worry about it. I didn't need to

file a schedulee. There was no complex tax reporting of it. It was all in my tax-exempt IRA. My dear listeners, are you ready to take action today? Maybe by your first or next rental property, our Bigger Pockets concierge team is standing by to help connect you with the exact resources you need. Whether you're looking for an experienced agent, reliable lender, trustworthy property manager, or specialized tax professional, simply call or text 720, 902-8552 during business hours. Don't waste time searching blindly. Let our team help you build your perfect investing network.

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property in a self-directed IRA? Yeah. So first, a traditional IRA, that means money went into the traditional IRA. You got a tax deduction for it. It grows tax deferred. And then when you take the money out, you have to pay taxes based on the amount you pull out and based on your effective tax rate at that time. So if you distributed, let's say a million dollars at 60 years old, which most people aren't going to do, but let's say they did. And they're at a 20% tax rate. They're going to pay $200,000, right, on that $1 million distribution. That's how a traditional IRA works. And a lot of Americans, their money is in 401ks, 403Bs, TSPs, traditional IRA, so it's pre-tax. But there are some folks that have Roth IRAs.

So then the Roth IRA, that is money goes in after tax, whether that's through a conversion, or through just direct contributions, it grows tax-free, and then when you take the money out, you pay 0% tax. So if you think about it, owning rental property in a traditional IRA, you sell no capital gains tax, tax exempt in the traditional IRA, but yes, you eventually pay taxes when you distribute money from the traditional IRA. But what about a Roth IRA? What if you own rental property in a Roth IRA? All of your growth is tax-free, your appreciation is tax-free. You don't have to worry about depreciation. You don't have to worry about recapture depreciation. And then when you distribute money from the Roth IRA after the age of 59 and a half,

zero percent tax. As a quick example, and then I'll get to your question about Ubit. Kevin and Cynthia are two investors I started working with in 2011 and 12, and they had 401ks from their old jobs, and they referred to themselves at that time as stock market refugees. They rolled over their 401ks into traditional IRAs, and then they did a Roth conversion. to their Roth IRAs. They started with about $150,000. So they paid taxes over two years. And then they started buying rental properties. Now, they're very good at finding opportunities. So they find motivated sellers. They find opportunities that have significant opportunity for appreciation. They buy these houses. They fix them up. These are all in their Roth IRAs. The Roth IRAs are

paying for these expenses, of course. And then they sell these properties on owner financing, lease option to purchase, and some rent to own. And they still have 14 cash flowing properties across their two Roth IRAs, seven in Kevin's Roth IRA and seven in Cynthia's Roth IRA. And through these activities, they've actually grown their Roth IRAs to over $2 million in property value in cash that they've been able to accumulate. Now, they're over the age of 59 and a half, the qualified retirement age of 59 and a half, so they can distribute money from those Roth IRAs 100% tax-free. But they actually don't plan on using the money in their Roth IRAs. They plan on leaving it to their children or their grandchildren because you'll learn a Roth IRA can be a great

legacy or estate planning tool. So those children or grandchildren will inherit those Roth IRAs, be able to continue to grow the Roth IRAs for 10 years, and distribute all of the cash and all of the assets 100% tax-free. Along the way, Scott and Mindy, I should mention that they're also private money lenders. So when they have uninvested cash, they actually lend money to house flippers. So other investors within their community, they're lending money out of their self-directed Roth IRAs, secured by property. So they have a first lien mortgage on these properties. And then all of their interest income flows back into their Roth IRAs tax free. Now, with respect to unrelated business income tax, that's a great question. If your IRA buys real estate with debt, if your IRA buys real estate with a loan,

or takes on a loan for improvements, there's a special tax called unrelated business income tax. Some people call it unrelated debt financed income tax. This will occur with your IRA, your Roth IRA, your SEP IRA, your simple IRA, even your HSA. There is one account, and this is interesting, and we can talk about this in more detail if you want, Scott. There is one type of retirement account where you can be exempt from unrelated business income tax. as it relates to debt finance real estate, and that is a 401k, specifically a solo 401k for the real estate solopreneur. It's a super powerful account that we can dive into more detail of. If you go to Section 514C9A, there's actually an exemption for qualified plans,

including solo 401Ks, when doing debt finance real estate transactions. You do have to meet certain criteria. In my experience, in most cases, individuals meet that criteria. For those of you that are thinking, what in the world is you? But let me just give a quick explanation. If you buy a property for $200,000 with your IRA and you borrow $100,000, you're 50% leveraged, right? And so what happens is that means that 50% of your net profit is going to be subject to unrelated business income tax. Now, here's the deal. And this is interesting. We talked about how you can't get depreciation in your IRA. When your IRA owns properties free and clear, remember, you have no taxable income because you're in an exempt account. So there's no taxable income to offset with depreciation.

But when you have debt and therefore a taxable event, you can actually take advantage of depreciation. So using my example of buying a property for $200,000, borrowing $100,000, let's assume it's a buy and hold rental property. We take 50% of our gross rents, minus 50% of our operating. expenses minus 50% of our depreciation. So we can actually depreciate in this case. And oftentimes I see where with the depreciation and the operating expense writeoffs, the unrelated business income tax exposure is minimal or the investor is actually showing a loss. That loss can carry forward, can stack up and offset future gains up to 80%. And guess what? The Ubit tax rate long term gains is only 20%, not the oftentimes generalized, advertised, 37% ordinary Ubit income tax that a lot of

people talk about. So there's some interesting nuances that you need to know about with respect to Ubit. I oftentimes tell folks, just like I said before, where complexity lies, opportunity thrives. Don't be afraid of Ubit. You should run towards Ubit because in some cases, the opportunity can still make a lot of sense. Just pencil out the opportunity net of the Ubit tax are your returns still substantial. Okay. I have a question for you. If you had the option, you were going to invest in real estate and you were going to open up either the self-directed IRA or the self-directed 401k, which one would you choose? So the way I would determine self-directed IRA versus self-directed solo 401k is first understand the individual's specific circumstances.

with respect to, are they self-employed? Are they not? Are they a business owner? Are they not? Did they have W-2 employees across their various businesses? There's a few things that we need to know about first. Here's the short answer of it. Solo 401k. If the investor is interested in self-directing into real estate transactions where there's debt financing involved, and they want to take advantage of the UBIT exemption, there's two primary criteria for a solo 401k. A, they have to have earned income as a solopreneur. That could be they're a self-employed person, just filing as a self-employed person. That could be an LLC. That could be an LLC taxes in S corporation. They just have to have earned income, meaning income that they're paying Medicare and Social Security tax on.

Meaning if I have an LLC and I just have a bunch of rental properties and it's all passed through passive income, that's not going to going to qualify. I need to find a way to get earned income. It might only be a little bit, but I need to work on that with my CPA. Let's assume that the person does have some earned income. The second criteria would be they have no W2 employees with the exception of their spouse and themselves. So if someone has a business and they have their spouse as a W2 employee, great. They can open a solo 401k and then their spouse can also take advantage of those benefits. The great thing about a solo 401k, if the person qualifies, if they have pre-tax money from an old 401k, traditional IRA, sub-iray or simple IRA, they can simply roll that over into what we call the

pre-tax bucket of the solo 401K. Solo 401ks have two buckets, pre-tax and Roth bucket. So they roll it over to the pre-tax bucket, and then they can convert it to the Roth bucket, paying the taxes now, so that way all of their profits going forward are 100% tax. free. Then they use that Roth component of the solo 401k to do, for example, a debt finance real estate deal, directly rental property or fix and flip transaction maybe. Maybe they invest in a real estate syndication, which could also have you bit. But you do that with the solo 401k and they're likely going to be exempt from that. Now, let's say the solo 401k is just too complex for someone. They don't qualify. They don't want to go through the efforts of setting it up. Well, in that case, just use the self-directed

IRA, roll over your money, transfer your money, and invest through that type of account. Might you have you bit? You might, but in many cases, folks find when they pencil it out that it still makes sense. Mindy is trying to get you to agree with her strong stance that the self-directed 401k is just better than the self-directed IRA for real estate investors. If you have the self-employment income that allows you to qualify and no employees over a thousand hours a year or something. Yes. So here's what I would say. The solo 401K is, yes, superior to the self-directed IRA, providing that those various circumstances were met. It's superior, especially for a real estate investor. And in addition to what I just mentioned about

the unrelated business income tax exemption, you can make much larger contributions to a solo 401k. Here's a quick example. I'm working with a real estate agent, in fact, and their business is actually set up as an S-Corp, which is interesting. They're trying to pay themselves, right, lower amount of self-employment income so they can lower their Medicare Social Security tax. So they have about $100,000 and W-2 from their escort. Well, you can contribute in 2025, up to $70,000 to the solo 401k when you're under the age of 50. And there's actually three different buckets to get you there. There's a Roth bucket. So they can put 23,500 directly into the Roth bucket as an employee. Then they can make an employer contribution, which is

25% of their 100,000, which is 25,000. Then there's a post-tax bucket that we like to call the mega backdoor bucket. And they make that contribution. At the end of the day, they're going to have $70,000 in the Roth bucket of the solo 401k from their $100,000 W2 S-Corp salary. And then that's $70,000. They're going to be able to plow into real estate syndications and be exempt from unrelated business income tax because see that's their strategy they're a real estate agent they're really good at selling real estate they have some rental properties and then they're going to use their self-directed solo 401k specifically to invest as an LP as a passive investor into real estate syndication opportunities we have to take one final ad break but more from john bowens when

we're back tax season is one of the only times all year when most people actually look at their full financial picture including income spending savings investments the whole thing and if If you're like most folks, it can be a little eye-opening. That's why I like Monarch. It helps you see exactly where your money is going, and more importantly, where your tax refund can make the biggest impact. Because the goal isn't just to look backward, it's to actually make progress. Simplify your finances with Monarch.

Monarch is the all-in-one personal finance tool designed to make your life easier. It brings your entire financial life, including budgeting, accounts and investments, net worth, and future planning together in one dashboard on your phone or your laptop. Feel aware and in control of your finances this tax season and get 50% off your Monarch subscription with the code, pockets. What I personally like is that Monarch keeps you focused on achieving, not just tracking. You can see your budgets, debt payoff, savings goals, and net worth all in one place. So every decision actually moves the needle. Achieve your financial goals for good with Monarch, the all in one tool

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operating agreements, meeting minutes, and thousands of how-to guides that explain the complicated ins and outs of running a business. And with Northwest, privacy is automatic. They never sell your data and all services are handled in-house because privacy by default is their pledge to all customers. Visit Northwest Registeredagent.com slash money-free and start building something amazing. Get more with Northwest Registered Agent at Northwest Registeredagent.com slash money-free. Thanks for sticking with us. I love it. So I'm a high-ing. income earning W2 with a million and a half of my 401k in my 40s. And I'm thinking about retiring early.

I go get my rental property by agent license. And I stink at it for the first year. I get no income. I begin rolling over my 401k dollars into my Roth 401k. And by year three, I'm starting to earn a big income. But now I'm a real estate professional. I am able to create the self-direct. Yeah, we can get going on this to the fist fund stuff.

But that's what the power of this tool is, is. There's a large number of people out there, specifically that overlap with the bigger pockets, you know, real estate investor, you know, persona out there. The people, the people that have a couple of properties is a 401k, a good job out there. And we have this concept, the middle class trap, where folks are worth two, two and a half million bucks. And it's all of their home equity, their 401k and a couple of rental properties that are, you know, 50-50 debt to equity ratios. And they just don't generate cash flow. They feel stuck. despite the fact that they've done everything right and built up a multi-million dollar net worth.

And I believe that the tools, you know, forgetting even before we get to self-directed IRAs, just the tools of 72T, substantially equal periodic payments and distribution tools to access the funds early to spend in your personal life, the tools for the Roth conversion ladder, for example, and strategies like that that allow folks to roll over money from the 401K to a Roth without paying penalties and then begin with drawing principle from the Roth several years down the road. Those tools are super powerful. But when you layer them in with at least a portion of those 401K or those are IRA dollars with the just knowledge that you can use one of these self-directed IRA tools to provide

access to different asset classes to debt funds, syndications, or traditional regular old-fashioned real estate, I mean, it just becomes a very powerful dynamic. Like it's advanced. Like there's a lot of jargon that we're using here. You're going to have to do your homework on this one. And it's going to be complex in there. And I, I'm a little bit more cautious of what I hear the word complex where I'm a little bit more scared than you are.

I don't run towards complexity. I like to run towards simplicity personally. But I think that the complexity here is worth it because you can, it may free you mentally or much earlier in life. It may mean your 40s are spent doing what you want. If you can just think about all the tools that are available to you and create the right strategy to access that money in the retirement accounts. And Scott, I'll add, you reminded me of something.

I was just talking to a husband and wife couple earlier today, and they're in their early 30s. One is 32. The other one's, I think, 33 or 34. And they drained all of their money out of their retirement accounts. They had high paying corporate jobs. they had large 401ks and they knew nothing about self-directed IRAs, unfortunately. And they actually drained all the money out of their accounts, paid a lot of money in taxes. And I'm talking 45 to 50 percent of their accounts wiped out just to get access to the money

to be able to go out and invest in real estate because they didn't know about this concept of self-directing into real estate with their retirement accounts. So now they're sort of in this rebuilding mode. Well, these investors, they're very good at finding motivated sellers and they're very good at finding opportunities. And they have a network of private money lenders and private investors. So I shared with them a story earlier today that was encouraging for them where I have a client that only had about $13,000 in some change in his Roth IRA. So he had two years of contributions. So for example, you could contribute $7,000 to a Roth IRA. So he was between two years where he was able to contribute for

two years. He had about $13,000 in some change. He's in Dayton, Ohio. He found an opportunity, three-bedroom, one bath, fix and flip deal. He needed about $106,000 for the deal. He didn't have $10,000. He only had about $13,000 in some change. So he only had about 10% from the Roth IRA to be able to put in the deal. He worked with a call it investor teammate. So this is someone that's not related to him. You will learn there are disqualified persons to your IRA. So, You can't do transactions like this with people like your spouse or yourself or your children or your parents known as disqualified persons under 4975 of the tax code. But this happened to be a non-discualified person.

So this individual partnered their Roth IRA with this other investor. They did the $106,000 fix and flip deal. And the investor with their Roth wasn't the one swinging the hammer to the nail. He was the one just overseeing the transaction. They sold the property and made $68,000 in profit. And they had a joint venture. agreement that spelled out that 50% of the profit goes back to the Roth IRA and 50% goes back to the other investor. So this Roth IRA investor with only $13,000 and some change in the transaction

made $34,000 tax-free. So that he grew as Roth IRA from about $13,000 and some change to over $47,000 tax-free. Now, of course, there's always caveats with this. How many of those types of transactions can you do a year in your Roth IRA? Well, you've got to be careful. If you do too many, now your IRA looks as if it's running as a business, an ongoing trader business that's regularly carried on. And you actually have a different form of you bit. So in this case, he's just doing one transaction. But hey, 34,000 tax free. Had he done that deal outside of his Roth IRA at about a 30% tax rate, he would have been paying over $10,000 in taxes. Okay. So another one of the components of my, you know, if I came in with here are the five things I don't like about self-directed IRAs.

in traditional real estate investing, again, they were, you lose the depreciation and tax benefits that are inherent to real estate investing outside of the accounts. Two, you may be subject to UB or UDFI, whichever term you prefer than there. Three, it's going to be harder to get a 30-year fixed rate, Fannie Mae insured mortgage. We haven't covered that one yet. And then fourth, where we're starting to cover here, there's a fifth one here as well, but the fourth one is you cannot materially participate in the deal, and they're clear restrictions about who or how you work with the properties, right? So can you give us a broader

overview besides these prohibited persons that can be associated with any business activity inside the self-directed IRA? What are these prohibits? Like, how do I think about what I can and can't do? Can I negotiate the deal? Can I manage the property? Can I change the locks? Can I sign the lease with the tenant? What are the rules that I, that, that, that, what are the guard rails I need to be aware of going in in terms of managing or participating a rental investment. Absolutely. I always like to use the rule of thumb. This is an easy rule of thumb to think about when you're going to start doing self-directed IRA transactions or even solo 401k transactions because all these accounts, the rules are the same under 4975 of the tax code. You can do the desk work. You need to stay away

from the physical sweat equity. Within the tax code 4975, it states that a disqualified person cannot furnish services to the IRA or to the plan. Okay, who is a disqualified person? That would be yourself. You're the account owner. That would be your spouse. That would be your children. That would be your parents, your grandchildren, your grandparents. And then businesses that you own or control 50% or greater of. So your property management company, your other LLCs and entities, your trust, your living trust, those are also disqualified persons. So what is services? Well, it's not clearly defined within the tax code. It's not clearly defined by the IRS. Could swinging the hammer to the nail be considered a service? It could be. And so that's why the rule of thumb is used in the

industry that you can do the desk work, but you need to stay away from the physical sweat equity. One of the questions I get very routinely, Scott, is, well, can I be the property manager? Well, to what extent are you the property manager? Are you physically doing work on the property? Or are you administratively overseeing the transaction? I'm using administrative oversight very specifically here. So it's an optics. It's an optics thing. There's going to be no clear this is absolutely right or this is absolutely wrong. For somebody that is very concerned with respect to the prohibited transaction rules, they hire a property manager. For people that understand the optics component of it, and they're very good at keeping good

records and maintaining the transactions and not going over to the property and doing the physical work on the property themselves, those are generally the people that are going to self-manage, if you will. They're not going to compensate themselves. That's a big part of this. So you cannot take compensation from your IRA. If you were to do that, there's a good argument under 4975, the tax, it's a prohibited transaction.

What happens if you do that? What is the penalty for getting this wrong? Well, I think Mindy's going to like this one. Okay. So IRAs, Roth IRA, HSA, the consequences can be severe. The consequences could be the entire account is distributed January 1 in the year in which the transaction occurs. There are some investors that are overly concerned by this that will have separate IRAs

for their separate transactions. So maybe they do a lot of private money lending. You had brought that up, Scott. Maybe they do a lot of private money lending. So they do that in this Roth IRA or IRA. And then they have rental properties and they do it in this IRA over here. But guess what? A solo 401K doesn't have as severe of consequences.

If you do a prohibited transaction in a solo 401k, you only have a 15% penalty on the amount that's engaged in the prohibited transaction that compounds year over year until you correct it. So you can correct the mistake and you don't entirely lose the status of the solo 401k. That is another, if you will, maybe benefit to the solo 401k. It's not something that I lead with because we don't want to be going out and doing prohibited transactions, right? We want to follow the rules. We are not going to get to by all the questions I have outside of the rental property piece.

But let's make sure we finish that one for the traditional rental here because this is really, John, you're an absolutely fantastic wealth of knowledge on this, on this, on this subject matter. This is awesome. I'm learning so much right here. Okay, so going back to my framework on rental properties. Self-directed IRA, I again came with the bias of depreciation benefits are lost. Self-directed IRA can create problems with or subject properties to forms of taxation like Ubit or UDFI. We discussed how the solo 401k self-worked to solo 401k can resolve that problem to a large degree and how in your opinion in many cases it's really not that big of a deal depending on how much income you're going to

generate. Third, I said you're not going to be able to get a 30-year fixed rate Fannie Mae insured mortgage on there. That is surely true, but I bet you that there are workarounds and loan products that are reasonably, that are reasonable for folks in this space. Could you tell us about the different types of financing available and what you see folks doing? for single-family rentals or small multifamily? Yeah, and you're right, Scott. So if you're looking at a rental property and you say, should I do this with my IRA or should I do it with non-IRA funds,

if you can't get financing for the IRA, depending on the opportunity, it might make sense to not do it with the IRA. And that's something as an investor to look at. Don't use broad generalizations like we started with here. Oh, never do rental properties in an IRA. It just never makes sense. You lose all the depreciation.

Well, again, We already talked about you're not losing depreciation. There's no taxable income to offset. And so when it comes to IRA's borrowing money, the type of loan that you have to obtain is called a non-recourse loan, meaning in the event of a default, the only recourse is against the subject property. Now, why is that? Why can't your IRA borrow with a conventional loan?

The reason why is because conventional lending requires the individual borrower to sign a personal guarantee. Under 4975 C1B of the tax code, it would be a prohibited transaction. Look at that. Just know it off top of your head. Yes. We live this all day, every day, Scott. Yeah, it'd be a prohibited transaction. So you have to get a non-recourse loan. Now, I will tell you, Scott, there are non-recourse loan products out there. We have hundreds of clients that buy real estate with their IRA with a non-recourse loan. So there are lenders out there. There are more and more lenders emerging into this market. And I think a lot of it has to do with they see the opportunity. They see that there's over $14 trillion in IRAs. And back when I started nearly 20 years ago,

there was only like $4 trillion. So because the market is grown and more and more people have an appetite to buy rental properties with their self-directed IRAs and solo 401ks, there's more availability for non-recourse loan products. The rates, of course, are going to be a little bit higher than your 30-year fixed mortgage, but not unreasonably higher. The idea is, is these folks are doing it because the cash flow is still good. If they're in a decent appreciating market, and ultimately their renter is paying for their mortgage, eventually they're going to own a free and clear asset. And you know, Scott, I should have mentioned this before when you asked me about UBIT. Here's one of the beauties of UBIT. So you might have a little bit of taxable exposure if you're doing this with your IRA,

not your solo 401k paying the UBIT tax. But let's say you pay off the debt in its entirety. you own the property now free and clear in your IRA. As long as you wait 12 months in a day from the time that you pay off the debt, no Ubit tax. No recapture depreciation, no Ubit tax. So imagine a Roth IRA. I know someone that bought 20 houses with a Roth IRA on owner financing. They had an aging landlord that was willing to sell an owner financing. They borrowed money from a private money lender to rehab the units. They were nearly 100% leveraged. Well, guess what? He's got over a million dollar portfolio now in his Roth IRA of rental properties that he owns free and clear. Eventually, when he starts distributing those or selling them to distribute the money from the Roth

IRA, he pays no tax. So there's some interesting really longer term strategies that can be discussed with respect to these Roth IRAs and even while someone might have some Ubit exposure. Awesome. Okay. And then that brings me my last question here around fees and headaches. Because, so again, I think these two things kind of go together with the questions about prohibited persons and prohibited, you know, the prohibited activities with respect to managing or providing services to properties or businesses inside of a self-directed IRA. Can you give us an overview of what the costs look like to set up a self-directed IRA or self-directed 401K? And the, you know, if I want to buy a property, what am I looking at in terms of transaction expenses, paperwork, fees, to specialists, what are those specialists called in order to facilitate a transaction or changes to the property, sale, signing a property manager, those types of things. How do I think about the costs that I'll incur above and beyond, you know, an outside of the IRA transaction if I'm doing it inside one of these accounts? Yeah. Yeah. So the first place I would start is

there's a fee to pay a custodian or trust company or an administrator for, if it's like a 401k. So you're going to pay a company. If it's going to be an IRA, it's going to be a trust company or oftentimes referred to as a custodian. And that fee is going to oftentimes be dependent on the portfolio value of the account. So for example, at this moment in time, if you had an account with equity trust company, and let's say it was around $100,000 that you started with, you'd be looking at a maintenance fee of $500. But it's a sliding tiered scale as the portfolio. value increases, your annual maintenance fee is generally going to be a little bit higher. Now, you look at it on a percentage basis. So oftentimes, it's less than a half a percent.

So when you compare that to manage money, if you had someone managing your money for you, you could be one, one and a half, maybe even two percent. Keep in mind, it's a self-directed IRA. So when you go out and you make profit, you get to keep 100 percent of that profit in your IRA. You don't have to share that with your trust company or custodian. Do you have to pay? an annual fee to your custodian, yes, and they're going to give you exactly what that fee is. Solo 401K is to touch on that. It depends comparing a solo to an IRA on the portfolio value of your account. Sometimes it's a little bit less. Sometimes it's a little bit more. Generally, a solo 401k is going to be anywhere between $1,300 to $1,700 on an annual basis is what I see.

Solo 401ks do carry a little bit more burden in terms of the administration. of the actual plan because it is a solo 401K. For example, if you have over $250,000 in the solo 401k, you have to file what's called a $5,500 on an annual basis. And for example, the way we do this is we have systems and pipes and plumbing to make it easy and accommodating for that individual to be able to accomplish all of that. So to answer your question, Scott, first piece is what are your annual maintenance fees to your custodian or trust company?

some firms do pay like or I should say charge they will charge a per transaction fee or per asset fee and then some firms just charge you one fee regardless of how many assets and how many transactions you have in the account so you just want to have a conversation with them with respect to what that's going to look like for your specific circumstances and then outside of that in terms of like you asked about specialists so we always encourage folks to work with their CPAs their tax attorneys, their other professionals as they engage in transactions. Equity trust is one member of their financial team. So we're not endorsing or recommending investment opportunities. We don't give tax legal or financial advice. And that goes for pretty much all trust companies and

custodians out there. They're not going to give you that degree of advice. A lot of it can be done by the individual account owner in terms of educating themselves and learning about the system, asking their trust company or custodian who oftentimes has a lot of education and information that they can share with them. And then when needed, especially if they're going to do something a little bit more complex, that's where they would bring their tax accountant, CPA, or other professional into the equation. In terms of closing on like rental properties or maybe doing a fix and flip property investment, oftentimes we do see folks will form an LLC where their IRA will be the owner of the LLC and then that LLC acquires the property. So you would want to

to factor in some additional fees for that. Those types of LLCs are generally going to range between $1,000 to $1,600. Keep in mind, it's not a go online to one of these online LLC formation companies and set up an LLC. When you create an LLC for your IRA, it has to be a specially crafted operating agreement. You have to have language in there specific to the prohibited transaction rules under 4975. And if you don't do it properly, you could create implications for yourself. Okay. So if I want to, if I want to take $250,000 in my $1,000, I'll say I have a million bucks in my 401k, if I want to take $250,000 out of it and move that into a self-directed IRA or a solo 401k, I'm looking at a couple hundred bucks for the self-directed IRA and maybe up to $1,700 to $1,000 for

the solo 401k. Just a form of thing. I'm going to pay that every year in a recurring fee in most cases. Then I'm going to have to a transaction fee related that the custodian or the provider will then charge to help me facilitate that transactions. And I will likely have to pay other specialists, perhaps including that custodian, some fees to set up the LLC and form the operating agreement with that to make sure that they adhere to the rules that are specific to self-directed IRAs or solo 401ks. Self-directed solo 401ks. And is that, and so that can be, those can be certain added expenses that will go into buying that rental property and should be known to Fultz. And I will be prohibited from providing many types of services to that property for the life of

that investment. So those are real, real considerations. People need to go in eyes wide open if they're going to use this tool. You absolutely hit the nail on the head, Scott. I always relate this akin to when you start getting into real estate and I can speak from experience, and you're an entrepreneur and you're starting businesses. And I know, Scott, you've done this over the years and I'm sure Mindy you as well. And what happens is eventually you get to a point where you know, you have maybe partnership LLCs and you have extra tax returns like 1065 partnership returns that have to be filed. So the best way to think about is your self-directed IRA, it's like a separate entity

and you have to maintain that entity. And there's some extra costs associated with the maintenance of that entity. And you always want to analyze. I'm glad you brought it up, Scott. because it's important to analyze the benefits and the burdens, if you will. What are the benefits with the self-directed IRA, Roth IRA, Solo 401K? Well, we talked a lot about the tax advantages. And then, of course, there's the ability to diversify. So you brought up, well, what if someone has a lot of money in a retirement account? That may be all of their wealth that they have.

Instead of paying a bunch of taxes to take the money out to invest in real estate, they can do it inside of their self-directed IRA and invest in a hard asset. A lot of people want to invest in these types of real estate transactions because they want their money to be diversified beyond the traditional public markets. And that's the self-directed IRA or solo 401k allows them to do that. So is it beneficial and then look at the burden? I'll give you a quick example. I have a client when we talk about UBIT. This is a good example. I have a client in 2021 that invested in a real estate partnership. It was an apartment building syndication, value ad deal, $100,000 with their self-directed IRA. They didn't use a solo 401k. It was an IRA. And the property sold in 2023,

and they had about 231 flow back into their self-directed IRA. So their capital gain was about 164,000. Now, the property was only 70% leveraged. So they didn't have to pay taxes on 100% of the profit. That's the beauty of UBIT is you don't pay taxes on 100% of the profit, just the percentage that's debt financed. So they were 70% leveraged. They paid 70% they paid taxes on 70% of the profit, which came out to be about $23,000 in Ubit tax. So some people look at that, they're like, wow, that is a lot of money in taxes to be paid for from the IRA, 23,000. But when you netted out, they made $140,000 in their IRA, which all will continue to grow tax exempt. Their annualized return was still a 47% annualized return.

So that's a good example of, hey, are the burdens worth the benefit? Was the extra $300 to file the 990T tax return worth it? Yes. Was the extra $500 to $600 in annual maintenance fees to equity trust worth it? I would argue that it was worth it. Love it. Yeah. And what I think is awesome about this conversation here.

And again, we didn't even get to my two through six discussion topics here, right? With like, hey, here's where the, how do we think about syndications in here? We kind of, you lightly sprinkle that in with great examples here. But I think what I hope we accomplished here for folks that are listening is this is a very dense conversation. It's very technical. There's a lot of complex topics here. You've got to know it before you go into this and understand what you're doing. is I think we just discussed the self-directed IRA for what it is, right?

It's works in all. This is a great tool for a lot of people out there to potentially access those funds in there. It's not free. There is no free lunch in investing anywhere for it, but it's way better, for your example, than just taking the funds out and paying the 10% penalty and your marginal taxes for so many people. There's a lot of really good use cases for this tool. And again, I think that it's something that we're going to be exploring a lot. over the course of this year in the context of this middle-class trap dilemma for this. And so I love it.

I think you've done a really fantastic job here of describing it for what it is and where it can be used and highlighting really good examples here. You obviously do this all day long every day and are ready for everything I can throw at you in terms of questions. Yeah. And Scott, you know, you brought up some really good points around, hey, for somebody that wants path of least resistance, for somebody that they don't want to bother with some of the burdens of UBIT, tax and trying to understand it and some of the complexities. We find some people, they just want to simply use their self-directed IRAs to make a loan secured by real estate. For example, I have a client that recently made a $193,000 loan on a fix and flip deal. He's just a passive lender.

And he actually partnered his Roth, his traditional, and his HSA because you'll learn you can partner multiple accounts together. So he made a $193,000 loan and all the interest income is flowing back into those accounts tax-free. So interest income, that's passive income. That's going back into your accounts tax-free. Or I think you brought up a private credit fund. So sometimes people don't want to invest in real estate syndications where there's actual real estate with debt because they have Ubit. So they look to invest in different types of funds. For example, like a private credit fund where they have interest income and that interest income passes through on the K-1 as interest income into the IRA, and they don't have to worry about Ubit tax. So that goes into every investor is

different. They can self-direct their account and make all of their own decisions. They determine how they want to invest, where they want to invest, and ultimately they're the manager of their self-directed IRA. They're their own wealth manager. Can you use an example of that person who went into an apartment value ad deal with 70% leverage and how that generated taxable income on 70% of the gain, but it was still a huge win overall. And so that tax, the tax consequences, the tax concern is real, but it's also like, you'll only get the tax consequence if you win on there and on a percentage of that gain is, as I think John's argument. Is that, is that right, John? That's correct. Yep. One last question I had. You said you have a certain number of transactions

that you can do before your IRA becomes running a business. Is there a specific number? Yeah, so in terms of if your IRA was, and let's say you on behalf of your IRA, you're using your IRA to flip houses. If you flip too many houses and that number is not clearly defined within the tax code or within any IRS guidance. The IRS says that if there is a trader business that's regularly carried on, that's in your IRA, if you will, and you're not paying corporate tax, then you have unrelated business income. tax, which isn't necessarily a bad thing. Maybe you do four flips and you pay 37% tax, but the rest is all tax free in your Ralph IRA. The rule of thumb that people use in the industry is they don't do more than two short-term flips in their IRA. In a year. A year, correct, a year. And if they're an active real estate investor, generally they're going to limit that to one.

So there's no clearly defined guidelines on this. We always encourage folks to talk to their own CPA about what do they feel most comfortable with. But again, that's the rule of thumb that's used. Rental properties are different. That's passive income. So I mentioned a client of mine that has 14 rental properties between their Roth and their spouse's Roth or private money lending, lending money secured by real estate. So that's passive income. It's just the short term flipping that someone needs to be wise of. And then, of course, there's some really advanced strategies such as a blocker corporation where you set up an LLC, taxes as a corporation, so you pay a more favorable 21% corporate tax instead of the higher 37% Ubit tax. But that's a whole other podcast

in of itself. We're definitely going to have to come back and discuss a lot of advanced strategies. I want to think through how can I use the HSA to subsidize health care costs in early retirement or traditional retirement using a self-directed IRA and some of these strategies, right? I've been on a kick about debt funds here, which I think are a very niche product, small use case, small portion of one's net worth, but particularly attractive with these tools in order to provide certain, you know, can you match, mix and match that with the Roth conversion ladder or a 702T rule inside of a self-directed IRA. I think there's a lot of advanced and complex topics here that begin to solve this problem of all my wealth is in my 401k. And I'm going to have $7 million. at traditional retirement age in real inflation adjusted 2025, if I just leave it in there and let it compound, I want my 40s. How do I access it? And I think the answer is in this with more discussions like this one here that get into these more advanced concepts and the world of alternatives. And a quick one, Scott, if you contribute directly to a Roth IRA, 7,000, and then you make 10,000,

you can take out that original 7,000 at any time you want tax and penalty free, You reference 72T withdrawals. That's a strategy. Higher education being able to distribute and be exempt from the 10% premature withdrawal penalty. So yeah, there are ways to look at it. And of course, like I tell everybody, worst case scenario, if you take money out of your IRA, which you can do anytime you want, you just have a 10% premature withdrawal penalty and ordinary income taxes. But hey, if you did really, really well in that IRA, it might be worth it to do that in order to be able to enjoy some of the benefits now. Well, thank you so much for the partnership and thank you for bringing this incredible depth of knowledge here. I can tell I'm not the first person to ask any of these questions to you, to the point where you've literally memorized which pages, almost all of the pages that the source material from the IRS tax code is on there. We found one that you weren't sure which page it was on. Right back at you guys, I've been dialed into your podcasts and it's so interesting. Almost all of my friends growing up are now in real estate, including myself now. And a good, probably 75% of them are part of the bigger pockets community.

And that wasn't because I turned them onto the community. They found it on their own. So when they found out, I was working with bigger pockets and passive pockets. They were like, really? I've been doing that for years. That's actually how I got involved in real estate. One of my best friends, he read the Robert Kiyosaki, Rich Dad, Poor Dad book. And then he got dialed into bigger pockets.

and he's got 10 to 11 properties now. He's invested in some real estate syndications. And, you know, he's got two kids. He's over 40 or about 40. And, you know, he's on his way to, you know, creating a lot of wealth. And, you know, that's a big thank you to you guys. Awesome. Well, thank you so much, John, for coming on.

We can't wait to get another one on here talking about some of these more advanced strategies now that we've covered the basics. Woof, that was the basics. of investing in a rental property with a self-directed IRA. Happy to do it. All right, Scott, that was John Bowens. And that was a lot. And while I think this is a really great episode,

John was throwing so much information at us. I know I'm going to have to go back and listen to it again so I can pause and take notes because I can't pause him when he's talking. And then by the time I take a note, I'm like, oh, crud. He just said 15 more things that I want to research. So I'm super excited for all of these rabbit holes. Thanks a lot, John. I've got so many rabbit holes to dive down.

But what did you think of the show, Scott? I love it, right? This is not like an entry-level topic. So there's no way to discuss the material without using the language that is appropriate to self-directed IRAs and the specific language that is listed in the IRS tax code. So he didn't shy away from it. We didn't shy away from it. It's going to take you probably three or four listens to this one to really digest all

the material and you're still going to understand about 80% of it. But you really got to know what you're doing if you're going to use these tools. This is not a tool you should use. don't understand it, right? It's just an option. You should know at the highest level, there's an option for you to take money inside of a 401k, a Roth, or even an HSA, and set up a self-directed account and invest in real estate. There's some problems with that. They can be overcomable, and they can even be worthwhile for the investor, but you really got to know what you're doing, and you've got to dive into the complexity of it. And if the complexity scares you, stay away.

But if it doesn't, there's an opportunity here to potentially be getting solving some of the problems with the middle class draft. What did John say when there's complexity? That's where opportunity lies. I'm a big fan of some personally. But if I was sitting there in the middle class trap with a million and a half in a 401k, I'd be really seriously interested in exploring the complexity here and seeing how that can actually free up some of that capital earlier in life. I like a little bit of complexity and a little bit of risk or, you know, depending on what account I'm in, more than a little bit of risk. there's so much opportunity for growth. But yeah, you know what makes money so fantastic, Scott? Is it's personal. You can do your own thing.

I can do my own thing. And the only people that your money has to work for and your plans for your plans for your money has to work for is you and your partner and your family. And for me and my family, it's a little bit different. But that's okay. Absolutely. Well, should we get out of here, Mindy? We should.

Scott, that wraps up this episode of the Bigger Pockets Money podcast. You are Scott Trench. I am Mindy Jensen saying see you soon, Silver Moon.