[Originally Published at JeffNabers.com]

You may be wondering why I haven’t blogged about real estate investing in a while. There’s a very good explanation video at Nabers.TV for you to check out.

In the last post, you learned about how doing an active “entrepreneurship-ish” deal inside your Solo 401(k) is an open invitation for the IRS to tax the hell out of you.

In this post, you’ll learn the solution.

• The solution is not to avoid doing active deals.
• The solution is not to stop pursuing massive profits or to lock away your talents and skill to be unused.

The solution is to structure both your active entrepreneurship and your passive investment activity in a way that that puts you in the most control. Put another way, avoid giving the IRS an open invitation to tax attack you.

I bet you can guess where this is going (one commenter had a pretty good idea on Part 1 of the post)…

Active Deal Structure

Run your active entrepreneurship activity (a.k.a. “business activity”) in your… (wait for it)… business! Your business can be a Sole Proprietorship or it can be more formally structured as an LLC or Corporation.

If your entrepreneurship needs a financial kickstart, borrow up to $50,000 (or $100,000 between you and your spouse) in the form of a “participant loan” from your pre-existing retirement funds. Do your business activity, generate massive profits, and contribute up to $54,500 (or $109,000 between you and your spouse) tax-deductibly each and every year. That adds up quickly.

Passive Deal Structure

Run your passive investments through your Self-Directed Solo 401k (a.k.a. your investment account).

My God, that sounds too simple to be effective, you may think. Hey now, don’t fall into the “scheming pit.”

Over 95% of the Self-Directed Solo 401(k) conversations I see online are all about some sneaky structure to reign triumphant over the IRS, like a clever fox. Sounds like a good bubble to burst, so I don’t mind if I do…

The IRS doesn’t like being tricked. They can even be mean from time to time. I can’t help but to wonder how much profit would have been made if the millions of hours of sneaky scheming were to be replaced with taking action on making good investments with a non-risky tax approach.

Side Benefits

There are side benefits to this sound approach too.

Many Self-Directed Solo 401(k) investors are doing active real estate deals inside their retirement plan. That introduces further limitations, especially with debt financing, such as:

• Lower LTV (loan-to-value ratio) loan limits
• Less lenders and loans available in the marketplace
• Higher down payment (more cash investment required, which lowers cash-on-cash return)

Don’t get me wrong. Many healthy, profitable real estate deals are done inside retirement plans and with debt financing.

But, not all real estate deals should be done either inside or outside of a retirement plan. It depends on the circumstances.

If it’s truly a passive investment, go for it inside your plan. If it’s truly an active deal, go for it outside of your plan. If you want to pay cash or make a large down payment, that sounds fitting for inside your plan. If you want to invest as little cash as possible, that sounds fitting for outside your plan.

So, I hope this helps you get your mental strategery in order.

Like many lessons in life, the real progress is made in unlearning myths, deceptions, and bad information. I mean, it isn’t exactly earth shattering to stand up and say “Business activity goes in a business, and investment activity goes in an investment plan,” is it? Yet, after thousands of hours in the Self-Directed Solo 401(k) industry, it may make a big impact.

——

Odds & Ends:

Don’t miss out on my year-end Solo 401k special promotion. Get on my email list to be notified when it kicks off.

]]> http://www.solo401k.com/2010/11/18/the-most-elusive-dangerous-self-directed-solo-401k-practice-part-2/feed/ 8 http://www.solo401k.com/2010/11/16/the-most-elusive-dangerous-self-directed-solo-401k-practice/ http://www.solo401k.com/2010/11/16/the-most-elusive-dangerous-self-directed-solo-401k-practice/#comments Tue, 16 Nov 2010 21:09:10 +0000 Jeff Nabers http://www.solo401k.com/?p=323 [Originally published at JeffNabers.com.]

There’s something that most “successful” Self-Directed Solo 401(k) investors do that can spin them out of control and get them into trouble.

I say “successful” in quotation marks because I’m talking about the particular kind of Self-Directed Solo 401(k) success that is sexy enough to be frequently written about.

What is this dirty deed that leads to massive profits and the potential implosion the very same Self-Directed Solo 401(k) that got those profits?

Entrepreneurship.

Bad Entrepreneur!

Yep. Entrepreneurship is so powerful that it seems to be the source of all aggressive wealth creation. So where’s the danger?

Let me explain. Some of the most [initially] profitable Self-Directed Solo 401(k) stories sounds something like this…

Joe, a Self-Directed Solo 401(k) investor, knows how to work real estate deals into profits. So he buys and sells real estate in his Self-Directed Solo 401(k). Sometimes he involves bank financing. Sometimes he involves private financing and partnering.

But one thing is for sure: Once Joe purchases a property, the work has just begun. He has a system. He only buys properties that meet a certain criteria. After the closing, he usually has repairs and/or remodeling work done.

And his system works. He’ll put $30k or $40k of his Self-Directed Solo 401(k) money into a deal and get $80k to $100k out, often less than a year or two later.

First, applaud Joe for being a successful entrepreneur.

Did you catch that? Joe is being an entrepreneur rather than an investor. This is because his deals have his active involvement rather than the passive placement of his money.

The Pinless Grenade

Unbeknownst to Joe, he’s no longer in control of his financial outcome. His choice to try to sneak business activity inside his Solo 401(k) gives the IRS an open invitation to tax the hell out of him.

How much?

Well, the IRS can declare Joe’s Solo 401(k) deals to be a “trade or business” in which they’ll apply the UBTI tax. Also known as the most aggressive tax schedule in the United States. It ramps up to 35% federal tax after only $10,000 of profit.

Will the IRS make this move? When?

That’s unknown, and Joe is no longer in control of his financial outcome.

Terrible Success

All kinds of strategies fit into this same category. I have a friend who has done over 100 deals inside his Self-Directed Solo 401(k), producing a return-on-investment of over 9,000%.

And he’s hiding under a rock. He won’t returns the calls of the newspaper and magazine reporters who want him to share his strategies with the world. He rarely teaches investing seminars, and when he does he only invites people who he has personally met and known for at least 6 months. He essentially lives a life of fear because he knows the day his Self-Directed Solo 401(k) gets audited may be the day he gives up at least $1,200,000 plus late penalties and interest to the IRS.

Enjoyable, Controlled Success

Do you know how to do deals that turn pennies into thousands? Thousands into millions?

Fantastic.

Don’t ever consider not pursuing massive profits, and don’t ever lock away your talents and skills to be unused.

Just take a few minutes to educate yourself about the best way to structure your deals to keep you in control.

More info coming in Part Two of this post soon  :-)

Suggested reading: World Wealth Report

This annual report examines the behavior of high net worth individuals (HNWIs) – those with over $1 million in investable assets. I believe this report is skewed a bit because it is based on survey data of Merrill Lynch clients around the world. Even so, it offers interesting information.

Among the most substantial findings is that business ownership is estimated to be the leading source of wealth among HNWIs globally. This is contained in the 2006 WWR.

Click here to view WWR archives.

For the self employed, a fantastic development has occurred over the past few years – the Solo 401(k). One distinct advantage of the Solo 401(k) over an IRA is that it is not subject to paying UBIT on profits from financed real estate. Eliminating UBIT by using a Solo 401(k) eliminates the need to file a return (Form 990-T) as well as the accompanying tax. Sound pretty good so far?

The difficulty in recent times has been obtaining nonrecourse financing. The leader of NR financing in the Self Directed IRA industry for the past few years has been North American Savings Bank. Last year, they took the familiarity of IRA lending and applied it to Solo 401(k). Unfortunately for many Solo(k) investors, this has only been available to plans who choose to name a custodian as trustee of the plan. Qualified plans (which is what all 401k plans are) are different than IRAs in that they are not required by law to name a custodian (bank or trust company) as trustee of the plan assets. Investors who establish Self Directed Solo 401(k) plans that name themselves as trustee for simplicity have not been able to readily obtain mortgage loans for their Solo (k) plan from NASB.

Well, as of this month, NASB has expanded their loan products to include a nonrecourse loan program for self trusteed Solo 401(k) plans. I caught up with Matt Allen to discuss the great news on UNLIMITED RETIREMENT ACCOUNT® Radio. The skinny is that the program is almost identical to the IRA lending program. If you aren’t familiar with their guidelines, check out the URA Radio show podcast as it become available soon.

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What is a participant loan?

A Solo 401(k) participant can borrow up to either $50,000 or 50% of their account value with the following terms:

• To be repaid over an amortization schedule of 5 years or less
• Regular payments no less frequently than quarterly
• At a reasonable rate of interest… generally interpreted as prime rate + 1%

Such a loan may only be made in accordance with the Solo 401(k) plan documents. While most plan documents disallow this type of loan, the Unlimited® 401k offered by my company does allow it.

Under what conditions is this allowed?

Any. As long as the plan documents allow for it & the proper loan documents are prepared and executed, a participant loan can be made for any reason.

When is this useful?

This can be useful when someone is thinking about distributing money out of their Solo 401k plan for some reason. I recently talked to a man who was going to distribute his 100k IRA to pay for finishing the repairs of 2 fixer upper houses. After we spoke, his strategy was amended to instead:

• Setup a Solo 401k plan (adopted by his business) and transfer IRA funds into it
• Take a participant loan of $50k
• Use the loan proceeds to finish rehabbing Property #1 (which was owned personally free & clear)
• Do a cash out refinance on Property #1 once rehab is complete
• Use refi proceeds to finish rehabbing Property #2 & pay back the Solo 401(k) participant loan

In his situation, it made sense to pull some equity out of Property #1 to pay for the completion of Property #2 (and the early repayment of the participant loan) because the rental income (upon completion) of Property #1 covered about 350% of its new loan payments.

The result of the new strategy

• Avoided IRA distribution
• Avoided $35,000 in distribution taxes
• Paid participant loan back within a few months
• The rental income of Property #1 will payoff its mortgage within 6 years (with maximum principal reduction payments)
• Left $100k in his retirement account for maximum tax deferred growth

There are many other common uses for a Solo 401(k) participant loan. If a person wants to make a <$50k investment that would otherwise be a prohibited transaction, they can just borrow the money and do the investment as an individual.

What other uses can you think of?

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Conventional Tax Strategies for Real Estate

Many real estate investors boast of their tax strategy as involving one or more of the following:

Depreciation – This is a tax concept where the property owner pretends that his property is decreasing in value. For residential real estate, it assumes that the property’s improvements will become worthless over 27.5 years. In commercial real estate, the calculation is for 39 years. During each year of property ownership, the owner can take that year’s pro rata depreciation as if it is a loss against the income of the property… which reduces the taxable income of the property, thus reducing the amount of taxes due. Upon future sale of the property, depreciation normally must be “recaptured” which means that there is no more pretending, and the taxes on the truly realized gains must be paid anyways.

Cash out Refi – This is where the owner of the property will refinance the mortgage. The new loan will have a higher balance than the old one, resulting in “cash out”. Because this is just borrowing, it is not a taxable event. Upon future sale of the property, however, taxes will normally be due on the actual gains anyways.

1031 Exchange – Upon the sale of real property, the gains can be deferred if they are used to purchase property of “like kind” within a certain time period. It goes something like this:

• Sell Property A
• Have a “qualified intermediary” receive the proceeds of the sale
• Replacement property (“Property B“) must be identified in writing within 45 days of the sale of Property A
• Property B must be purchased (closed) within 180 days of the sale of Property A

• Property B must be of equal or greater value to Property A
• Both properties must be “like kind”. For instance if Property A was U.S. real estate, Property B must also be U.S. real estate.

So, savvy real estate investors often pride themselves in combining these tax strategies to drastically reduce or even eliminate taxes. This can be a very powerful strategy.

Don’t let the tail wag the dog

Perhaps an even more powerful strategy is to use a Self Directed 401(k). I think where using retirement accounts can add an advantage is by not requiring you to 1031, refi, or follow any restrictive plan in order to defer or eliminate taxes.

Let’s imagine I buy an investment property in my Self Directed 401(k), and you buy a similar property outside of your 401(k). We both want to eliminate or defer taxes. I have more options on how I can proceed with my investment than you do.

1. When I sell my property, I don’t have to buy another one within a few months.
2. I don’t have to continue buying more expensive properties; i.e. “trading up“.
3. I don’t have to use a certain amount of leverage to ensure I have enough interest expenses to sufficiently reduce my taxable income.
4. I don’t have to borrow my gain through a refinance and bear the interest expense. I can just sell.
5. I can focus on maximizing cash flow instead of trying to hit a sweet spot of only getting enough cash flow that can be hidden by depreciation deductions.
6. I can invest in real estate options, mortgage notes, revenue participation contracts, and virtually anything else with my proceeds… including assets in a foreign country.

Repeat this situation over and over, and I believe my additional options will sometimes result in better bottom line investment performance. I want maximization of investment performance as my unconditional primary focus, and that is only possible when I can buy what I want when I want.

Simple Advice: Buy & Sell at Different Times

When I had my mortgage company, I asked one of my wealthiest clients why he didn’t use 1031 exchanges. He explained to me, “Jeff, I’m not a genius. I don’t know everything about the real estate market and what it’s going to do. So I have to keep things simple: I buy when property is cheap, and I sell when property is expensive. Normally these two events are further apart than 180 days, so I don’t use the 1031.” He was basically playing on market cycles. Things go up and come down. He buys when they are down, and sells when they are up. I like to take his philosophy a step further: to fully make use of market cycles you must be prepared to invest in real estate in different locations, and in different ways… (i.e. real estate options, debt instruments secured by real estate, different purchase prices, etc.)

In another item of notability, the inflationary situation is creating an encouraging opportunity for investment into any asset not exposed to US Dollars. You can’t use 1031 to defer the gains of a US property into a foreign property.

Imagine how your next real estate investment will go if you knew you could buy and sell when and where you want and still defer the taxes on income and gains.

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If you talk to the average CPA, he’ll tell you that UBIT is the boogeyman and is to be avoided… always. Discussing this topic with an above average CPA (such as Eric Wikstrom of Integrated Wealth Strategies) yields different advice.

The Two Types of UBIT

1. Triggered from a trade or business – if a tax exempt entity (such as an IRA or 401k) owns a trade or business, the income of that business is taxed at trust rates (i.e. very high tax rates). Both IRA & Solo 401k accounts are subject to this type of UBIT.
2. Triggered from ownership of leveraged real estate – if a tax exempt entity (including IRA) owns real estate leveraged with a mortgage loan, the portion of that income attributable to the mortgage loan is taxed at trust rates. This type of UBIT is specifically referred to as UDFI – Unrelated Debt Financed Income. Solo 401k accounts & other qualified plans are exempt from UDFI.

Trust tax rates are very high, so it might make sense to avoid Type 1 UBIT at all costs. On the other hand, a close examination of UDFI tends to revoke its “boogeyman” status.

The reason UDFI isn’t a detrimental cost is that non-recourse mortgage loans (the only type an IRA/401k can legally obtain) are typically only offered at a 65% loan-to-value maximum. So this means that the UDFI tax is only payable on up to 65% of the property’s net income. (That’s right – net income. You do get to deduct depreciation and other expenses before paying UDFI tax).

Let’s examine a simple comparison of the taxes payable on net real estate income with 50% leverage:

Example A

Example B

The gap between the dollar amount of taxes paid widens as the income increases:

Let’s go back and look at Example B. Take the difference in taxes and examine the long term effects of 25 years of investing and compounding returns. These charts assume a 15% annualized ROI:

Example B1

This uses an effective tax rate of 16.23% for UDFI

Example B2

This uses an individual tax rate of 28%

The result? The IRA has a balance of $631,385.87 more than the individual does.

Conclusion

It might make sense to avoid Type 1 UBIT, while Type 2 UBIT (UDFI tax) results in less taxation than the alternative of investing with individual funds. For those eligible for the Solo 401k, Type 2 UBIT (UDFI tax) generally does not apply.

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1. Be eligible for a Solo 401k in the first place. This means that you have to have self employment activity (such as Schedule C income on your 1040 or own a business), and you have to have no employees at any businesses in which you or your spouse have significant ownership. (An “employee” is somebody who works over 1000 hours per year for your business and receives a W-2).
2. Add me on Facebook. Go to my Facebook profile to add me to your friends. If you don’t have a Facebook account, just create one. It’s very simple and easy, and it will help you stay connected for updates, news, events, etc.
3. Write a brief explanation of the most powerful business or investment opportunities in our current recession. Explain the “how” and the “why” as much as you can, but be direct and to the point at the same time. Submit it in a comment on this blog post (the one you’re currently reading) OR post it to the “wall” at the bottom of the Facebook Solo 401k Contest page. I’ll review all entries, and the person with the best idea will get a Solo 401k setup for them by Nabers Group with the entire establishment fee waived.

Submission Deadline: March 15, 2009

Value: $210,585

The math: Over the past 10 years, most stock indexes have produced a return of approximately 0%. With a Self-Directed Solo 401(k) plan, the accountholder can buy real estate, gold, stock in private companies, and loan money to individuals or corporations. Surveys have shown us that over 80% of our Solo 401(k) clients have a target return of investment of 12% per year or more. An investor with $100,000 of existing funds who earns 12% per year for 10 years will generate a profit of $210,585.

We’ve never done this before, and I don’t know if we will ever do this again. Now’s your chance – start working on your entry today!

* The value is based on the potential profit you could earn and will vary based on your investment decisions. With a Self-Directed Solo 401(k), it’s up to you to find and choose investments, and only you will decide how profitable and valuable this investment vehicle will be.

We’ve never done this before, and I don’t know if we will ever do this again. Now’s your chance – start working on your entry today!

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This is quite a simple concept so this post will be very brief.

• Our weak economy has brought very high inflation: as high as 13% over the past year.
• Future dollars are worth much less than dollars today.
• With a Solo 401k you can make tax-deductible contributions to your retirement plan in today’s dollars and pay taxes later in less valuable dollars.
• Successful entrepreneurs and self employed individuals can contribute $49,000 per year or more to their Solo 401k in 2009.

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