SDIRA/401k questions

Tax, SDIRAs & Cost Segregation
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SDIRA/401k questions

Scott Sauri
Silver Spring, MD · Member since 2012 · 8 posts · 0 votes

First of all, thanks to everyone who takes the time to post on this site. I've been reading for a few months now and have learned a lot. This is my first post and I hope this thread isn't too old to be commenting on now, but after some searching, this seems to be the closest to what I am looking for.

I have already converted an old 401k to a SDIRA and used that to fund a checkbook/IRA LLC. I am currently looking at properties and there a few that I can buy outright, but I have more options available if I decide to finance (obviously).

My questions are regarding the financing. From what I can tell there are only a few lenders that make non-recourse loans and I am currently working with someone from NASB as they seem to be the most referenced national lender in this area.

However, after reading this thread, I am now wondering if I should be borrowing against my current 401k rather than obtaining financing from NASB.

1. Can I borrow money from my current 401k and then lend that money to my SDIRA LLC? Can I or my 401k even make a non-recourse loan to my SDIRA LLC at all?

2. I'm reluctant to borrow the money to partner personally with my SDIRA LLC on a deal, because I am worried about that creating a prohibited transaction since I can't really afford anything on my own without investment account money. Although I'm not really clear on
the rules there.

For example, if I have $100k in my SDIRA LLC and $200k in my current 401k, could I borrow $100k from my current 401k to buy a $150k property? Would this not be considered a prohibited transaction because I, technically, could have afforded the property on my own by borrowing $150k from current 401k?

3. This is really a separate, but related, question. Given the above account balance examples, even if I decided to buy a cheaper property outright with my $100k SDIRA LLC, would it make sense to borrow against my current 401k to buy a second property outright? The cheaper properties that I am looking at are between $60k and $90k and would likely get a rent between $900 and $1100. Those numbers seem in line with what Mark H. was calling a good deal earlier in this thread.

What is the downside to doing this? Just the risk that the real estate investment will not perform as well as the mutual funds that those funds are currently invested in?

Sorry for the long post!

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Jon Holdman
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
13y

$54,000 / $60,000 = 9%. A $60K loan at 9% interest for one year would return you $5,400. Not sure how you got to 16%.

If you were to make hard money loans to a rehabber, getting 12% interest would be on the low end for such loans. If you could keep the money at work all year, you would get $7,200 back per year. Trouble is, when one loan pays off it may take a month or two before you can get the money loaned out again. And a borrower may need $45K or $50K, leaving you with money in the bank earning very little. I used to do exactly this. The broker I work with has moved to a pooled model instead. Me and other investors put our money into the pool and he uses that to make the loans. We get back 8% as a base, then additional payments based on the actual earnings. There's still times when some of the money isn't earning the full return (15%, by the way), but that gets spread across everyone in the pool. So returns really are pretty close to 12%.

It doesn't matter if you create an entity or not. When two parties (i.e, you and your IRA) do something together you have created a partnership as far as the IRS is concerned. You need to keep track of what the partnership does and how the money comes and goes. Each of you will need to account for it.

UBIT is the killer for owning real estate inside an IRA. If you simply work through the math for owning a property free and clear vs. owning one with leverage, using leverage almost always produces higher return. There is, of course, more risk. If values fall, all that loss is coming out of your down payments. A fall of 10% on a free and clear property loses 10% of your money. OTOH, if you buy four similar properties with 25% down each, and they lose 10%, you're losing a total of 40% of your money. Yes, you can reduce the taxable income by the depreciation amount. But if you have taxable income (and good rentals produce taxable income, not losses), UBIT kicks in. If you get to $11,000 of income, you're looking at a marginal rate of 35% for UBIT. You have to be in a pretty high income for that to happen with rentals you own directly. So, you're taking an investment which already gets advantages for tax treatment and putting it into a tax sheltered account. My math says this just doesn't produce as good a return as owning property directly.

Keep in mind that if you down own property in your IRA, and you later distribute the property or the income from the property, you will still pay tax on that. So, its entirely possible to be paying UBIT on some of the income AND paying regular tax when you take the earnings for yourself. This is, of course, exactly what's happening when you own stocks. The company pays tax on their earnings, and then you pay taxes on your earnings, too.

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    13y

    I split this from a different post, since these area really separate questions from the original thread:

    http://www.biggerpockets.com/forums/49/topics/74608-cashing-out-401k-to-invest-in-re

    1. No, this would be a prohibited transaction. You can borrow from your 401k. Your 401k cannot make a loan to any other entity. So, while you could borrow the money from the 401k, it would then be a prohibited transaction for you to loan that money to your IRA. You (and all other disqualified persons and entities) cannot loan money to your IRA, period.

    2. You can't borrow $100K from your 401k at all. The upper limit is $50K or 50% of the account balance, whichever's less.

    Having borrowed $50K from the 401k, you could then create a partnership. Your SDIRA could then invest into that partnership. So, you could put in $50K and the IRA could put in $100K and have the partnership buy the property. That's not a disqualified transaction. But then all the normal rules come into play. You can't work on the property because its partially owned by the IRA and doing so would be a contribution. If more money is needed, you should add $1 and the IRA should add $2 to keep the ratio the same. I don't think that's essential (I'm neither a lawyer nor CPA), but the accounting will get VERY complex if you're kicking in money on an ongoing basis. Similar, money should come out of the partnership and go into the IRA and you in the same proportions.

    3. Work through the math. Simple as that. What's your expected return? Taking the bottom end ($60K for $900 in rent) and applying the 50% rule gives you $5,400 a year in return. If that's going into the IRA, the full $5,400 goes back in for a cash on cash return of 9%. Now, the lawyer I worked with said managing a rental owned by the IRA was OK because even the IRS considers management a low-effort task. But doing repairs or maintenance would not be. So, your return might actually be a bit better. (For full disclosure, others have different opinons of managing IRA rentals yourself.) OTOH, if you could borrow $60K from your IRA (you can't), you're looking at a five year repayment at, say, 5% interest. Your monthly payment is $1132. Subtract the $450 in net operating income and you have to kick in another $682 a month. Now, if you do that, after five years you own it free and clear.

    Also consider that 401k loans often must be repaid if your leave your job. Quit, get laid off, or get fired and your stuck either paying back the outstanding loan fairly quickly or else the outstanding balance is treated as a distribution. That means taxes and penalties would be due that year. And, possibly, underpayment penalties if you wait until you file your return to make that tax payment.

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  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    13y

    It appears that your post was separated from another thread a created a brand new one so I have no reference to follow previously.

    With that said, question 1. You are a disqualified party and thus may not borrow from or lend to your IRA with two exceptions: if you get permission first from the IRS or in the example of borrowing from, there is a rule that allows you to pull IRA funds as long as they are replaced within (it has been a while so not sure) 30 or 60 days. This is not technically a loan, but a once per calendar year allowed event.

    Question 2. You could not borrow the $100k from your 401km in your example simply because 401k borrowing provisions are limited to a max of $50k. However, you could borrow up to $50k and then use those funds to personally partner with your IRA. It would be no different than partnering with your IRA with your own cash outside of your 401k. In fact, it ends up being the same thing because once you borrow from your 401k, those funds are now cash outside your retirement plan. One of the many advantages of a 401k over an IRA.

    Question 3. You can certainly borrow from your 401k and then use the funds to make a RE purchase, keep in mind the loan limits I mentioned above.
    In my humble opinion, except for specific circumstances, I would not recommend owning RE inside an IRA. You lose some of the advantages that RE offers by doing so.

    Will Barnard

    Podcast Guest on Show #130
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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    13y

    Sorry, Will Barnard, I was typing that long reply with the reference to the other thread. It was about the possible advantages of cashing in a 401k to buy real estate.

    I agree with Will, though. I'm unable to come up with a scenario where owning real estate in an IRA makes sense. Buying or originating notes makes more sense.

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  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    13y

    No problem Jon, we are both on the same page, the note investing or lending from the IRA is much more advantageous in my opinion.

    Podcast Guest on Show #130
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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    I think Jon Holdman and Will Barnard covered it perfectly.

    -Steven

    [email protected]224-381-2660
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  • Scott Sauri
    OP
    Silver Spring, MD · Member since 2012 · 8 posts · 0 votes
    13y

    Thanks for the quick responses. Sorry that it's taken me so long to get back to you, but I wanted to do some more research before chiming in again.

    I guess I hadn't learned as much as I thought I did.

    I actually did know that you money can't be exchanged between the SDIRA and a disqualified party. I just managed to confuse myself when I started to factor in my current 401k.

    I did not realize that there is $50k limit on 401k loans, because I had never really considered doing so and hadn't researched it. I've now read several articles/FAQs about that and feel that I have a handle on it.

    Jon Holdman Will Barnard

    You both mentioned an example where I could borrow $50k from my 401k and then form a partnership with my SDIRA to buy a property. Do I need to establish a formal/legal entity or can I just write two checks, one from personal account and one from my LLC account, and then make sure that both myself and the LLC appear on the deed?

    Also, both of you indicated that you would advise against owning RE in a SDIRA (except in specific circumstances) because you lose some of the advantages. I've read similar comments in several other threads and depreciation is usually mentioned.

    Two questions on these benefits:

    1. Are there other benefits lost besides depreciation deductions?

    2. If I do end up financing part of the purchase price through my SDIRA via a non-recourse loan, the I would have to pay UBIT. In that scenario, wouldn't I then be able to take advantage of the depreciation deductions to offset the UBIT?

    Finally, I know nothing at all about note buying or originating. I've read a little bit about peer-to-peer lending, but I'm not sure that's the same thing. I've done some searching on the forum for a beginner's introduction on this, but haven't found anything yet.

    Actually, I did find this one (https://www.biggerpockets.com/forums/70/topics/48164-do-i-have-enought-capital-to-enter-the-area-of-notebuying-), but I think I need a little bit more elementary intro to start.

    Could you direct me to any could posts/sites/articles that would help me begin to understand why this may be a better option for SDIRA investing than RE is?

    Thanks again!

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  • Scott Sauri
    OP
    Silver Spring, MD · Member since 2012 · 8 posts · 0 votes
    13y

    One more question. It's funny that you mentioned personal loans being a better option than RE for a SDIRA, because I'm actually attempting to compare two opportunities and was wondering how to accurately compare a real estate opportunity to a personal loan opportunity.

    Jon Holdman - in your math example you came up with a cash on cash return of 9% ($5.4k/$60K). I understand that and it makes sense to me.

    However, when I try to figure out what a comparable personal loan situation would be, I get a little bit confused.

    Using a loan cost estimation calculator (based on monthly compounding), if I were to lend a person $60k, I would need to charge 16% interest in order to get $5400 back after a 1 year.

    Does that comparison make sense?

    Either way, at the end of 1 year, I will have my original $60k (either in the form of cash paid back via loan payments or in the form of the property) plus an additional $5400 (received as interest payments or rental profit).

    It seems to me that the difference is that in the personal loan scenario you are getting about $5400 monthly payments (assuming 1 year/16% terms) that can be reinvested throughout the year while in the rental property scenario you are only getting $450 in rental profit that is liquid. The rental property, on the other hand, has the potential to appreciate in value.

    Sorry if this off point again and should be a separate thread.

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  • David Beard
    Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes
    13y

    I don't follow at all where you're getting the 16% rate on the $60K note to produce $5,400 of interest income, as you must be using your calculator erroneously, but...

    I'll point out that borrowing from a 401K for reasons such as you describe can typically be for a max 5-year fully-amortizing term, so if you borrow $50K, your monthly payments back to your 401K will be more than $900 P&I. If you don't make these payments on schedule, the amount borrowed will be deemed withdrawn and incur income taxes and a 10% early withdrawal penalty, so tread very carefully and keep adequate cash in reserve.

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    13y

    $54,000 / $60,000 = 9%. A $60K loan at 9% interest for one year would return you $5,400. Not sure how you got to 16%.

    If you were to make hard money loans to a rehabber, getting 12% interest would be on the low end for such loans. If you could keep the money at work all year, you would get $7,200 back per year. Trouble is, when one loan pays off it may take a month or two before you can get the money loaned out again. And a borrower may need $45K or $50K, leaving you with money in the bank earning very little. I used to do exactly this. The broker I work with has moved to a pooled model instead. Me and other investors put our money into the pool and he uses that to make the loans. We get back 8% as a base, then additional payments based on the actual earnings. There's still times when some of the money isn't earning the full return (15%, by the way), but that gets spread across everyone in the pool. So returns really are pretty close to 12%.

    It doesn't matter if you create an entity or not. When two parties (i.e, you and your IRA) do something together you have created a partnership as far as the IRS is concerned. You need to keep track of what the partnership does and how the money comes and goes. Each of you will need to account for it.

    UBIT is the killer for owning real estate inside an IRA. If you simply work through the math for owning a property free and clear vs. owning one with leverage, using leverage almost always produces higher return. There is, of course, more risk. If values fall, all that loss is coming out of your down payments. A fall of 10% on a free and clear property loses 10% of your money. OTOH, if you buy four similar properties with 25% down each, and they lose 10%, you're losing a total of 40% of your money. Yes, you can reduce the taxable income by the depreciation amount. But if you have taxable income (and good rentals produce taxable income, not losses), UBIT kicks in. If you get to $11,000 of income, you're looking at a marginal rate of 35% for UBIT. You have to be in a pretty high income for that to happen with rentals you own directly. So, you're taking an investment which already gets advantages for tax treatment and putting it into a tax sheltered account. My math says this just doesn't produce as good a return as owning property directly.

    Keep in mind that if you down own property in your IRA, and you later distribute the property or the income from the property, you will still pay tax on that. So, its entirely possible to be paying UBIT on some of the income AND paying regular tax when you take the earnings for yourself. This is, of course, exactly what's happening when you own stocks. The company pays tax on their earnings, and then you pay taxes on your earnings, too.

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  • Dennis Tierney
    Investor · Omaha, NE · Member since 2011 · 475 posts · 211 votes
    13y

    Scott SauriAs an invetor who owns apartments in a SDIRA I disagree with several of the opinions expressed here that it is a bad move. I personally do it to get the money out of the stock market for income to the IRA and asset diversification. There have been several times stated that you can partner with your IRA personally as long as you keep the funds clearly separate, however, I have recently talked with the lawyer who was referred to me by Guidant and with whom I've consulted for 5 years and he stated that while it is not a direct benefit to you it is an indirect benefit and the IRS has taken a position against that in several cases so I would not partner with your SDIRA in any venture or risk a fight you are likely to lose with the IRS.

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  • Scott Sauri
    OP
    Silver Spring, MD · Member since 2012 · 8 posts · 0 votes
    13y

    David Beard Jon Holdman

    So I knew that I was probably misusing the calculator I was using, but I still can't figure out what I'm doing wrong.

    This is the calculator that I'm using:
    http://members.cunamutual.com/calcs/calc.asp?nav_dest=calc:LoanCost&site=01901629

    It's a pretty standard loan calculator that I've used many times for estimating mortgage payments and it is accurate for that use.

    It takes Loan Amount, APR and Term of Loan (in months) as inputs and then outputs the Monthly Payment, Interest Cost and Cost of Loan (just the sum of the Loan Amount and Interest Cost).

    I tried to use this calculator to reproduce the scenario in our example where I lend buy a property outright for $60k and end up with $5400 in profit after one year.

    So I entered in $60k for the Loan Amount and 12 months for the Term of Loan. I then adjusted the APR until the results came out close to $5400 for the Interest Cost.

    With an APR of 16%, the Interest Cost after 12 months is $5,326.22.

    I've had a feeling that whole time that I'm missing some basic concept that completely invalidates this as a way to compare opportunities, but the only major differences that I can see between the property purchase scenario and the personal loan scenario are:

    1. Liquidity and Opportunity Cost Associated with the Principal:

    In the personal loan scenario, I would be getting a monthly payment of $5,443.85 that could be reinvested throughout the year and at the end of the 12 months I would have $65,326.22 in cash (assuming I hadn't reinvested those funds throughout the year).

    In the property purchase scenario, I would only be getting $450 per month in rental profit (assuming the 50% rule) that could be reinvested throughout the year and at the end of the 12 months I would have only $5,400 in cash and property that I would then have to sell if I wanted to do anything else with those funds.

    There is an opportunity cost to having the principal tied up in the property.

    2. Possible Appreciation:

    In the personal loan scenario, there are no other benefits besides the interest received.

    In the property purchase scenario, there is the possibility of appreciation, especially if you know your market and are able to get a good deal on property.

    I think these two differences somewhat offset each other, although to what extent depends on the specifics of the property and the opportunities for reinvestment.

    Both have risks, but I don't really know a way to evaluation the risk of someone defaulting on a loan vs. the risk of getting a bad tenant and/or have a property lose value.

    Anyway, please tell me where I'm going wrong on this line of thinking.

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  • Scott Sauri
    OP
    Silver Spring, MD · Member since 2012 · 8 posts · 0 votes
    13y

    Dennis Tierney

    Thanks for the alternative perspective. Concerning the concept of an individual partnering with his SDIRA; it is my understanding that the IRS only views it as an indirect benefit if you could not have afforded to purchase the property without involving the SDIRA. If you have purchased the property via other means (e.g. a HELOC, 401k loan, savings, etc...) then you are simply making a choice to partner with your SDIRA and aren't really gaining a benefit. However, if you didn't have a 401k loan or HELOC as an option and didn't have enough money to purchase he property without the involvement of the SDIRA, then you are gaining an indirect benefit because you are gaining access to something you would not otherwise have had access to.

    Am I wrong on this?

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    13y

    That's a fully amortized, 12 month loan. Loans made to rehabbers are more commonly interest only. You get a monthly interest payment and then the principle is repaid when the property is sold or refinanced.

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  • Scott Sauri
    OP
    Silver Spring, MD · Member since 2012 · 8 posts · 0 votes
    13y

    Jon Holdman
    Ah. That makes sense. Although, that seems to me to mitigate most of the benefit of the personal load vs. the property purchase because you lose much of the liquidity I mentioned.

    So I guess the main benefit to loan/note scenario is that you are more likely to get a higher return (you indicate 12% is on the low side) while most of the property purchases I'm looking at are lower than that in cash on cash return. There are some very cheap properties that have better returns, but I don't really want to buy in a bad area where I think you are more likely to get a bad tenant.

    Thanks for you help.

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    13y

    Making loans is, usually, a LOT less work than rentals. I did have one loan default. We took back the house, finished the fixup, and got it sold. In hindsight, we should have done the same thing as a bank and sold it as-is.

    When you own property in an IRA, cash reserves in the IRA are essential. If you have a big expense and don't have the cash in the IRA you can be in real trouble.

    Both loans and property are illiquid investments. If you want a liquid investment, these aren't for you.

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  • Joel OwensBusiness Member
    Moderator
    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    13y

    This is an awesome thread. Knew a little but not a lot about this topic.

    With the fiscal cliff they are talking about taxing dividends at the ordinary income rate instead of the current capital gains rate. If that happens how would that affect Scott's situation as far as returns or would it ??

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  • Dennis Tierney
    Investor · Omaha, NE · Member since 2011 · 475 posts · 211 votes
    13y

    Scott SauriWhile you may be able to afford buying it without partnering with your IRA you still get the indirect benefit by being able to use those funds freed up by involvement of your IRA for another purpose. Do you really want to go to court with the IRS to prove it? That's the worst case scenario I realize and I don't want to discourage you from using a SDIRA for real estate as it helped save me a ton of money I would have lost 2008-09 had I left it in the market. I just want you to avoid a real potential headache.

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    Joel Owens, It will not affect his tax situation as he will not receive either in the form of a dividend. Interest is taxable at your ordinary rate. Even at the point where it becomes a business he is operating that will still be taxed at his ordinary rate. It may just include Self Employment tax.

    -Steven

    [email protected]224-381-2660
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  • Chris Martin
    Investor · Willow Spring, NC · Member since 2009 · 5k+ posts · 3k+ votes
    13y

    A couple comments. First, UBIT is only applicable to leveraged deals. Second, if the return is good, consider buying instead of lending. It depends on the deal. You can lend after the buy.

    Example: A 37,000 investmnt, $0 deferred maintenance and initial $0 reserves (new roof, A/C, appliances, etc. covered in the $37K, done after closing) where long term tenant placed at @700/month provides (actual) trailing 12 months income at almost $6500... or 17.5% actual annual return. Keep receipts and copies of rent checks. Exit options: sell to investor for $44K and offer seller financing via a note for $37K @7.0% over 15 year amortization... when the tenant leaves and/or you want to carry paper, take $7K and the note. Verification of expenses and income is helpful. Target other active SDIRA owners or CH investors. Don't guarantee the return, but show yours. Hang on to the rent income as long as you want. You are in the driver seat when you (your SDIRA) is th eowner.

    Another option not yet mentioned that I am working on doing (I've done multiple buying and lending via SDIRA) is to do debt financing with an equity participation. In my world, slightly lower rate but better upside, in general.

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  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    13y
    Originally posted by Chris Martin:
    A couple comments. First, UBIT is only applicable to leveraged deals.

    Another option not yet mentioned that I am working on doing (I've done multiple buying and lending via SDIRA) is to do debt financing with an equity participation. In my world, slightly lower rate but better upside, in general.

    Not true, UBIT will take place if the IRA is a competing business. Example, if you flip from your IRA, you will get hit with UBIT. You can avoid UBIT from leverage if you pay the loan off 365 days prior to selling.

    As far as the option mentioned, that is a great use of IRA/401k funds. Taking equity positions from loans can yield you high returns if you know what you are doing. Gap funding is one of several options in that arena.

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