| In life there are a lot of things we learn by accident, | | | | - No 1031 requirement! |
| which can be very beneficial to us. Sometimes | | | | - No annual tax reporting |
| understanding these processes can take a while. | | | | Taxable investments non SDI |
| Sometimes after proper explanation ...BLAM, you get it. | | | | - Tax deferred cap gains (if 1031) |
| That is exactly what happened to me. When I first | | | | - Tax on net earnings |
| heard about the topic, I will discuss in this E-book, it | | | | - Annual reporting required |
| was perplexing, however, I knew that it could reap | | | | How it works |
| huge rewards in the future. It took a while for me to | | | | You have an account with Pensco (you can roll over |
| understand the process. I remember trying to tell a | | | | your current IRA account to them) you tell them what |
| buddy who owned an apartment building about | | | | you want to invest in, they do all of the paper work, |
| _________ and what it could do for him. I | | | | make out the check and now it is in your trust account. |
| remember getting it all confused (like telling someone a | | | | All money that is needed for expenses and all profits |
| good joke, but while you are trying to say the good | | | | go into/taken out from the trust account. The title of |
| joke, in mid sentence you realize that you don't | | | | the property in your IRA will be held with Pensco Trust |
| remember it all and it is not coming out right, so you | | | | as follows: "Pensco Trust Custodian, FBO (client name) |
| just say forget it because you are screwing the joke | | | | IRA, (Acct #). All documents will be reviewed and |
| up). Fortunately, by mistake I came across the | | | | initiated by the you (the IRA owner) and signed by |
| company Pensco Trust who has educated me on this | | | | Pensco Trust. |
| great opportunity of____________. I am | | | | Introducing SDI on steroids in the neck...Solo 401(k) |
| considered one of their "Preferred Professionals." My | | | | A solo (k) is a combined salary deferral and profit |
| learning curve is your benefit. Enough with my teasing | | | | sharing retirement plan for sole proprietors, small |
| games, the purpose of this E-book, is to educate you | | | | business owners with no employees (other than part |
| on Self Directed IRAs. So buckle up! | | | | timers working less than 1,000 hours per year or their |
| This publication is made to provide basic information in | | | | spouses). |
| regard to Self Directed IRA's. It is presented with the | | | | Roth contributions can increase tax free $15,000 to |
| understanding that I am not engaged in rendering | | | | %20,500 per year or 30k to 41k per married couple |
| accounting or legal advice. If you need legal advice | | | | (for 2007). Unlike a Roth IRA, there are no income |
| services of a proficient professional should be | | | | limitations placed on the contributor. You could be a |
| contacted. I can not in any way guarantee that this | | | | zillionaire and it would not matter! Currently a single |
| material will be properly used for the purposes | | | | person making over 110k can't contribute to their Roth |
| intended and I assume no responsibility for its correct | | | | married couple is 160k. |
| and proper use. | | | | Who can benefit from Solo (401)k |
| We all know that Social Security (SS) is struggling and | | | | - Real estate brokers |
| the money there will eventually disappear. Prior to 1935 | | | | - Consultants |
| there was no personal SS. All that existed were | | | | - Contractors |
| people saving their money in their bank/under the | | | | - Lawyers |
| mattress. In 1935 SS was created. Remember that this | | | | - Electricians |
| was the same time period of the Great Depression. | | | | - Any sole practitioner |
| Keep in mind the life expectancy back then was like | | | | - Even if you work full time for an employer and have |
| 62 years old. Now it is 76. Baby Boomers make up a | | | | a business on the side where you are a sole proprietor |
| huge portion of the population. Baby Boomers are | | | | you can establish a solo K |
| retiring everyday. You want some hard facts? Well | | | | The difference is... |
| according to Research Corporation Study: The New | | | | - You can borrow up to 50k (or up to 50% of balance, |
| Landscape of IRA Rollover © 2005 BISYS | | | | if less) from your Solo 401 k |
| Retirement Services. | | | | - You can invest in life insurance |
| - The first of the baby boomers reached age 59.5 in | | | | - You can invest in "S" corporations |
| July 2005 | | | | - You can avoid UDFI and capital gains UBIT (UDFI and |
| - 4 million more will reach age 59.5 each year | | | | UBIT will be discussed later) when using leverage to |
| - 24 million people will reach age 65 by 2010 | | | | buy real estate |
| - 55% plan on to work after "retirement" | | | | - A portion of your savings can grow tax free for life |
| Now on the flip let's say there was no problem with | | | | - You can put away more money faster with larger |
| SS. Have you ever talked to someone who gets SS | | | | contributions |
| checks? They don't get a lot of money. It is sad | | | | - No income cap on contributing to the Roth |
| sometimes. I am not trying to offend anyone, but the | | | | component |
| majority of the older people you see at Wal-Mart | | | | - Above 50 year old employee has the option to put |
| greeting you and marking your receipt didn't have a | | | | up to $20,500 per year away, to grow tax free |
| "nest egg" to rely on when they "retired". The topic I | | | | Why appealing |
| will discuss will prevent that from ever happening to | | | | - Allows the sole proprietor funds to grow tax free |
| you and I. | | | | - While Roth IRAs allow similar contributions they are |
| 1974 congress created IRA (Individual Retirement | | | | limited to $4,000 in 2007 ($5,000 if over 50), and to |
| Account) to supplement Social Security. We know | | | | those earning annual gross income of less that |
| these are programs to help shelter money away for | | | | $110,000 for that year |
| tax benefits. Typically people go after the traditional | | | | - You can increase tax free growth opportunities by |
| investments. We always hear about stocks, bonds | | | | also contributing to a Roth IRA ($4,000/$5,000) in |
| and CD's. Yes all investments have risks, but the thing | | | | addition to the Solo (k) (15,500/$25,000), if you are |
| about these investments is that you can not affect the | | | | eligible (check with Pensco for details) |
| outcome of the business/your return. You are a | | | | - A married couple in business together can put up to |
| spectator, watching the game. Also, you can't use | | | | $51,000 ($25,500 each ) per year of after tax money |
| leverage (an example of using leveraged will be | | | | into retirement accounts that will grow tax free for |
| discussed later). Also, with stocks if any little blip in | | | | their lifetimes and those of their heirs (including $5,000 |
| market occurs, like oil, war, scandal, etc. your value | | | | Roth IRA contributions) and another $59,000 ($29,500) |
| could go down. Real estate does go up and down but | | | | each that will grow tax deferred. That is a total of |
| generally you don't lose all of your money in worst | | | | $110,000 as a couple of which $51,000 will grow tax |
| case scenarios. Real estate appreciation has kept | | | | free (assumes each is over 50 and earns less than |
| pace or exceeded inflation. It is a cycle. When it goes | | | | $100,000 |
| down, the value does not go down instantly (like | | | | - And there is no income limit on contributions |
| Enron). | | | | - May roll pre existing plans and IRAs into it |
| Self Directed IRA (SDI) an overview. Now I am not | | | | Types of purchases of SDI |
| bashing stocks, I have them, if you talk to any financial | | | | All cash |
| planner, they will tell you to always be diversified in | | | | Your SDI buys one property all cash. No debt, LLC, |
| your investments. This is what SDI does for you. Ideally | | | | and partners. When you do this your SDI needs to |
| you should have SDI, stocks, bonds etc. | | | | have enough funds to cover purchase price, all closing |
| SDI has been a well kept secret. Why? I think it is | | | | costs, custodial fees and ongoing property expenses. If |
| because of ignorance, and I also the folks on Wall | | | | you run out, you can loan your personal money to your |
| Street don't benefit. A broker at an investment | | | | SDI (with interest and principal). |
| company will not tell a person about it, because they | | | | Multiple SDI - All cash T.I.C. |
| can't make money off of the transaction (let alone | | | | SDI may belong to anyone - even prohibited people. All |
| having them understand how it works). The last | | | | SDI go on contract, and on title, as "tenants in |
| reason is because there are "professionals" who don't | | | | common." Ownership percentage must be identified |
| have a clear understanding on its use. | | | | and all costs and proceeds prorated correctly |
| To get a SDI, you would either have to go through an | | | | according to these percentages. |
| Administrator, or a Custodian. What is an | | | | Multiple Parties - IRAs & People all cash T.I.C. |
| Administrator? Banks, brokerage firms (like Charles | | | | Same as multiple IRAs, as long as there is no loan (as |
| Schwab) and insured credit unions. | | | | an all cash deal) it does not matter who the SDI |
| What Is A Custodian? There are very few | | | | belongs to, or who the people are. All names must be |
| self-directed IRA/401k custodians in the United States. | | | | on contract and title for unique percentages. |
| In order to be a custodian for self-directed products, | | | | All cash |
| the custodian is known as a "passive custodian." This | | | | Buy/sell, with/without, friends/family is by far the |
| simply means that they are obligated by law to | | | | easiest and most common transaction. When this |
| provide only custodial and administrative services for | | | | happens all income comes back to SDI, so having |
| the qualified plan. They can provide NO investment | | | | a1031 exchange is not required to defer taxes. The |
| advice. This tremendously reduces the fees | | | | money in your trust account is also used to pay any |
| associated with traditional investments because you, | | | | expenses incurred. Real estate investment related |
| the investor, make all of the investment decisions. | | | | expenses are paid out of the SDI. |
| They are also FDIC insured. | | | | Getting a loan to buy |
| What is the role of the custodian | | | | In the past there were NO banks lending to SDI. Only |
| - Holds your IRA assets | | | | until recently a few banks in the nation offer this |
| - Performs all IRA transactions | | | | service. The loan that is offered is a non-recourse loan. |
| - Keeps all IRA records | | | | This is great news, because now investors could use |
| - Provides all IRS required reports | | | | leverage. |
| - Keeps IRA plan in compliance | | | | When you get a loan for your SDI you: |
| - Provides access online access | | | | - Can't guarantee the loan personally. |
| There are only three things your SDI can't invest in and | | | | - Can't co-invest with your IRA. |
| they are | | | | - Pay the tax on any income or capital gains derived |
| - Collectibles/antiques | | | | from leverage. |
| - Life insurance | | | | - Increase the returns and growth of your SDI two to |
| - Stock of a sub-chapter "S" corporation (these are | | | | three times. |
| companies that are traded publicly on the stock | | | | What is a "non recourse loan?" |
| market) | | | | - You are not personally liable for repayment of the |
| As long as the transaction is for investment purposes | | | | loan. In the event of a default/foreclosure the lender |
| and you have not created a "prohibited transaction" | | | | can only recover the property and your equity. |
| (will discuss later) the list of investments are endless. | | | | - Typically requires 30-35% down payment. If there is |
| The beginning of a long list of real estate you can buy | | | | low cash flow or the condition of the property is bad |
| with your SDI | | | | then they may require a larger down payment. |
| - Foreclosures, Options, Pre-construction, raw land, | | | | Non recourse loan process |
| apartments, offices, strip malls, mobile homes, public | | | | - After setting up the SDI, it will typically close in 30 |
| storage, any type of investment property | | | | days. |
| - Trust deeds/mortgage notes | | | | - Cash out refinance: funds are distributed back into |
| - Privately held C-Corp stock, LLC membership . The | | | | the SDI. |
| rules on prohibited transactions | | | | THERE IS NO PRE PAYMENT FOR A |
| - Cant buy from or sell to a disqualified/prohibited | | | | NON-RECOURSE LOAN! |
| person | | | | Property Eligibility |
| - Cant make personal use of property | | | | - Single family residential |
| - Cant use SDI as collateral for personal loan | | | | - Condo's (100% complete, 33% or more sold, and |
| Personal use prohibitions | | | | HOA turned over by developer) |
| You can't personally use a vacation home. Even if you | | | | - Duplexes |
| rent it out for 354 days and spend one day in it, this is | | | | - 4-plexes |
| illegal. You can't perform maintenance on the property. | | | | - Multi-family (5 or more) |
| You can hire a maintenance crew using the money | | | | - Commercial property: including retail, warehouses, and |
| coming out of your SDI, but you can't physically work | | | | office buildings |
| on the property. You also can't hunt on raw land, dock | | | | Ineligible properties include: |
| boat at a SDI owned boat slip. There was a person, | | | | - Residential with large acreage |
| who worked with Pensco, that bought a specific area | | | | - Raw land |
| of a water fishing spot in Alaska. The person, couldn't | | | | - Farms |
| fish there, so she leased out the area to other | | | | - Manufactured homes |
| fishermen and received profit. | | | | - Hotels, condo-hotels |
| More on disqualified persons | | | | - Co-ops, timeshares |
| You can't buy from a person providing services to the | | | | - Senior or assisted living facilities |
| investment. It has to be a clean slate. It can't be | | | | - Non-franchise restaurants |
| business between employer and employee. If you | | | | - Entertainment properties |
| have your SDI in an LLC and you want to buy | | | | - Mini-storeage |
| property, you will not be able to if you own more than | | | | Requirements for debt financing must be verified for |
| 50% of the company. You can't buy/sell to a member | | | | purchase along with reserves (10-20% loan amount). |
| of your family including spouse, ancestor, lineal | | | | Documentation required for loan approval: 1. Completed |
| descendant and any spouse of a lineal descendant. | | | | loan application |
| Meaning, not you parents, children, your son in law etc. | | | | 2. Most recent asset statement verifying IRA assets |
| But, you can buy/sell to a sibling. There can't be a sale | | | | for purchase and reserves. |
| exchange/leasing of any property or providing a loan | | | | 3. Purchase sales contract |
| between a plan and a disqualified person. Lastly, you | | | | 4. Acceptable real estate appraisal for the property to |
| can't buy something you already own (SDI can't be | | | | be financed. The appraisal must come from lender. |
| used for funds to pay off your mortgage. There | | | | 5. Copy of drivers license |
| should be no perceived direct or indirect personal | | | | 6. Property insurance should read the IRA/LLC as the |
| benefit to the account owner). | | | | insured |
| Basic rules | | | | Income requirements for homes |
| - Can't involve the account holder, his/her spouse a | | | | - The financed property must generate sufficient net |
| lineal ascendant/descendant of family nor the spouses | | | | operating income to exceed debt service payments |
| of your children and you can't use SDI funds to pay | | | | by:10%single family (less then 10% or negative cash |
| off a personal mortgage | | | | flow is acceptable with sufficient reserves on SFR). |
| - Can't make personal use of property (must be for | | | | For 2-4 unit properties it is 10-15% |
| investment purposes only) | | | | - IRA assets must be verified for purchase along with |
| - Can't personally guarantee the loan for your SDI nor | | | | reserves |
| use the SDI as collateral for a personal loan | | | | How the closing process works: |
| - Can't work for or take income from an SDI | | | | 1. Title company prepares closing documents. |
| investment | | | | 2. SDI owner initials for approval. |
| - Can't have your spouse, nor your family members | | | | 3. Originals sent to Pensco for execution by the tile |
| (your siblings are ok) own the property prior to its | | | | company or broker. |
| purchase by your plan | | | | 4. Pensco signs, notarizes and returns package. They |
| - Can't have your business lease or be located in or on | | | | overnight and wire balance of funds for closing. |
| any part of the property while it's in your plan. You | | | | 5. Title company forwards recorded grant deed to |
| may receive any property as a distribution from your | | | | Pensco. |
| plan as a retirement benefit | | | | 6. Through your trust, you now own the property. |
| What transactions are prohibited? | | | | Another way to invest using IRA |
| The following are defined as prohibited transactions | | | | This is a true story from a Pensco client. One investor |
| when they involve the account holder: | | | | wanted to buy a property in San Francisco. They |
| - Borrowing money from the SDI | | | | buyer didn't have all of the money for a down |
| - Selling property to the SDI | | | | payment. So, he approached his friend and asked |
| - Receiving unreasonable compensation for managing | | | | about him if he was interested in earning a certain |
| assets for the SDI | | | | percentage return on his IRA. He agreed. So, the buyer |
| - Using the SDI as security for a loan | | | | took his portion and combined it along with his friends |
| - Buying property for personal use with the SDI | | | | SDI, to purchase the property. His friends SDI issued |
| - Collectibles/antiques | | | | him a second on the property. This created a "win" |
| - Life insurance | | | | situation for everyone. The buyer gets the property. |
| - Stock of a sub-chapter "S" corporation | | | | His friend gets a great return on his IRA (that is |
| 50% rule | | | | secured by real estate) the sales agent wins because |
| If a disqualified person(s) owns 50% or more | | | | the deal closed. The owner of the property is happy, |
| collectively of an entity, then the SDI can't engage in a | | | | because they sold the property. The bank, is happy |
| transaction with the entity because the company is | | | | because they are making a return by giving a loan. All |
| considered a disqualified person. | | | | of this is possible because the SDI was used. |
| Using IRA as collateral | | | | There was another person, who used his SDI to buy |
| You can't use your SDI as collateral for a loan. If you | | | | pre construction property. In Las Vegas, there was a |
| will get a loan it must be an unsecured loan. If you | | | | developer who was forming a community. The |
| default in paying the loan, the lender can't go get the | | | | investor approached the developer and solved a |
| money out of your IRA, nor can they go after personal | | | | problem for them. Apparently there were some fall |
| assets. | | | | outs with buyers. The investor, said (paraphrasing) "I will |
| Any type of prohibitions have penalties, if you violate | | | | buy any homes that fall out of escrow for a discount." |
| them. SDI is no different. Here are the consequences if | | | | If you would like to read upon an investor who used |
| you do not comply: | | | | their SDI, look up: Time June 14th 2005. Investor used |
| - Loss of IRA status resulting from prohibited | | | | $195,000 to invest in property on Marco Island FL. Sold |
| transaction | | | | resulted in a $500,000 profit going directly to IRA |
| - Loss of tax exempt status | | | | Rental property purchases |
| - Income tax on account value | | | | Question: |
| - Penalties and interest | | | | I want to purchase a rental property for $100,000 can I |
| - Possible audit to determine extent of prohibited | | | | use: |
| transactions | | | | - A. $30,000 of my IRA funds |
| If you really want more information on the rules check | | | | - B. $65,000 of my personal funds |
| out: | | | | - C. $5,000 loan from my brother to do this? |
| - IRS code 4975 | | | | - D. All of the above |
| - UDFI/UBTI: IRS code 598 | | | | - Answer: D |
| - Department of Labor (DOL) 2004-8 | | | | In the begging of this E-book, I expressed that using |
| Tax court cases | | | | SDI has been kept a secret. One of the reasons is |
| - Swanson 1997 | | | | because of misinformation from "professionals" is from |
| - Rollins 2004 | | | | CPA's. Some CPA's say not to use an IRA to invest in |
| - Rousey v. Jacoway 2005 | | | | real estate because: |
| Ways to invest by using your SDI | | | | - You will lose tax benefits e.g. depreciation (not quite) |
| - Property purchase all cash | | | | - Using SDI "destroys" tax deferred compound growth |
| - Property purchase using a loan (NOTE this has not | | | | in IRA (wrong) |
| always been the case where you can get a loan from | | | | - You have to pay ordinary income tax versus capital |
| a bank for your SDI. These past couple of years a | | | | gains tax at the end of the line (true just like any other |
| few establishments are offering loans to SDI. I have | | | | IRA investment) |
| those contacts, contact me and I will explore options | | | | Some CPA view points do not take into consideration |
| for you) | | | | the following: |
| - As a member of an LLC or "C" Corp. | | | | - They do not address need for diversification in the |
| - As a lender on a trust deed (mortgage note) | | | | retirement portfolio to hedge against other assets |
| - As a partner in a joint venture | | | | - Broadly implies that even if you know that you can |
| - As a Tenants in Common T.I.C. member (if any of | | | | get better results investing in real estate through your |
| the terms I use are unfamiliar to you, look them up | | | | SDI you shouldn't do it |
| online) | | | | - It is IRRELEVANT if real estate out performs other |
| - Make a private loan to an entity or person (hard | | | | IRA investments |
| money loans) | | | | - IGNORES the facts that 44% of net worth in US is in |
| To give you ideas of what investors have bought | | | | real estate |
| through Pensco: | | | | - Does not recognize that after tax yield is the primary |
| - Largest US massage school | | | | goal of the investor |
| - Cypress tree farm in Costa Rica | | | | Unrelated Business Taxable Income (UBTI) |
| - Fish farm in Salinas, CA | | | | If your SDI produces income from activity not |
| - Interests in movies, plays | | | | "substantially related" to the exempt status UBTI |
| - Condo in Lithuania | | | | comes into play. The purpose of UBTI was to alleviate |
| - House on a private lake in Colorado | | | | unfair competition by exempt organizations with |
| - Thoroughbred race horse | | | | taxable enterprises. Basically when you conduct |
| - Nudist resort in Virgin Islands | | | | business and it is not passive income, you come |
| - Over 35 U.S. banks | | | | across UBTI. Further explanation; if your SDI is going to |
| - Napa Valley B & B | | | | open up a restaurant, you are going to have ordinary |
| - Biotech company | | | | income. The IRS feels that is fair that you pay tax on |
| Pensco's top investor success story is going to amaze | | | | the money you make everyday. Because it is not fair |
| you on the potential your SDI can have. In March of | | | | for you to open up a restaurant and for someone else |
| 1999, four men opened up SDI accounts. They each | | | | to open up a restaurant down the street, but you don't |
| invested individually and through their IRA's in a | | | | pay tax. If it is "ordinary income" UBTI applies. If it is |
| company they were starting. They brought in other | | | | passive income UBTI does not apply, such as rent, |
| unrelated investors. That company is bought out a | | | | interest and capital gain. |
| couple of times. The company goes public and sells | | | | Unrelated Debt Financed Income (UDFI) |
| out in June 2002. Well how much did they make? CEO | | | | Income generated by activity that had debt financing. |
| made $34 million (12,000% return). Chief scientist made | | | | Tax is applied to that portion of gain/income that is |
| $22 million. CFO make $17 million. Marketing VP makes | | | | debt financed. Most "passive" investments income |
| $8 million (4,000 return) What is better than that? They | | | | such as rents from a property are normally excluded |
| all invested $2,000 through their IRA's except the CEO | | | | from taxes, but such investment income is going to get |
| who invested $1,800. Pensco explained the features of | | | | taxed if derived from debt financed property (UDFI). |
| the 1 year Roth IRA and they all chose to invest with a | | | | Basically, if you buy a property for 5 million. You have |
| Roth IRA. If the CEO gets an average return of 12% | | | | your SDI, put up 2.5 million and you get a loan for the |
| until he is eligible to withdraw tax-free at 59.5 he will | | | | other 2.5 million. Well the gains you get from the |
| have $1 billion, $100 million tax free! Yeah that is | | | | borrowed 2.5 million from the bank will get taxed |
| right...show me the money! | | | | (UDFI). You will not get taxed on the portion that |
| Let's compare Real Estate Investing - with SDI | | | | comes out of your SDI. |
| - Tax deferred growth on income and cap gains | | | | |