Are you tired of being limited to just stocks, bonds and mutual funds in your retirement account? It’s time to discover the world of self-directed IRAs, where the investment options are endless. In this episode of The Agent of Wealth Podcast, host Marc Bautis is joined by Mat Sorensen, CEO of Directed IRA and the best-selling author of the go-to book for investors and professionals in the self-directed IRA industry, titled The Self Directed IRA Handbook: An Authoritative Guide For Self Directed Retirement Plan Investors and Their Advisors. His knowledge as an attorney is sought-after for real estate, private funds, notes, rules and regulations.
In this episode, you will learn:
- What a self-directed IRA is, and how it differs from a traditional IRA.
- What types of assets you can invest in using a self-directed IRA.
- How to use a self-directed IRA specifically to invest in real estate.
- The risks and potential benefits of investing with a self-directed IRA.
- How to set up a self-directed IRA, and how to ensure you are compliant with the IRS regulations when using a self-directed IRA.
- And more!
directedIRA.com | The Self-Directed IRA Handbook: An Authoritative Guide For Self Directed Retirement Plan Investors and Their Advisors | Mat Sorensen Social Channels: Instagram, Facebook, LinkedIn, Twitter, Tiktok | Bautis Financial: 7 N Mountain Ave Montclair, New Jersey 07042 (862) 205-5000 | Schedule an Introductory Call
Disclosure: The transcript below has been lightly edited for clarity and content. It is not a direct transcription of the full conversation, which can be listened to above.
Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. Today I’m joined by Mat Sorensen, the best-selling author of the go-to book for investors and professionals in the self-directed IRA industry, titled The Self Directed IRA Handbook: An Authoritative Guide For Self Directed Retirement Plan Investors and Their Advisors.
As CEO of Directed IRA, Mat led the trust company to One Billion in Assets Under Administration in three years. His knowledge as an attorney is sought-after for real estate, private funds, notes, rules and regulations. Mat, welcome to the show.
Thanks, Marc. I’m happy to be here to talk about self-directed IRAs.
This conversation is timely, because alternative investing is popular, especially now with everything going on in the markets and banking world. Can you start off by explaining what a self-directed IRA is, and how it differs from, say, a traditional IRA?
What Is a Self-Directed IRA?
Like you mentioned, the stock market has been a rollercoaster lately, so our business at Directed IRA has significantly grown.
A self-directed individual retirement account is a type of IRA that can hold various alternative investments normally prohibited from regular IRAs, as well as the usual range of financial investments. Using a self-directed IRA, you can invest in the following alternative assets:
- Private stock
- Investment real estate
- Limited partnerships
- Precious metals, such as gold
- Crowdfunded assets such as loans
Most people are blown away when they learn that this is even a possibility.
IRA vs SDIRA: What’s the Difference?
When you have a traditional IRA, you’re with the traditional assets that a brokerage has on the menu – stocks, bonds and mutual funds. With a self-directed IRA – which can be either a traditional IRA, Roth IRA or 401k – the account owner directs all of the investment decisions through a custodian or broker, like our company Directed IRA. As a result, the owner has a much greater degree of flexibility in choosing investment options.
Yeah, a lot of people don’t realize SDIRAs are an option, probably because self-directed IRA custodians don’t have the same marketing budgets as Fidelity or Schwab, for example.
Right, we’re outspent.
But, like you mentioned, you can invest in almost anything. As far as restrictions go, there are only three, right? Life insurance, S corporation stocks, C corporation stocks, and collectibles… Am I missing any?
That’s it. Those are the three no-nos.
- Life insurance is not permitted inside of a SDIRA, but you can buy it inside of a 401k, in some fashions.
- Because IRAs and 401ks don’t qualify as S-corporation shareholders, they cannot own s-corporation stock. But SDIRAs can own c-corporation stock, LLC units and LP interest.
- While collectibles are not permitted, precious metals like gold, silver, platinum and palladium are.
We’ve had clients buy ownership in Mexican soccer teams, livestock, water rights… All of these are assets that people don’t really think of investing in using their IRA or 401k.
So, how does someone open a self-directed IRA?
How to Open a Self-Directed IRA
If you want to open a self-directed IRA, you’ll need a custodian. Typically, this is a bank or trust company. And because not all custodians support nontraditional assets, you need to find a special SDIRA trustee or custodian that offers the alternative investments that you want to buy and sell.
Our company, Directed IRA is a trust company. We’re audited and regulated by the banking department. There’s maybe 30 companies that do what we do in total.
For example, if you have $300,000 in a traditional IRA at Fidelity, and you want to invest $100,000 in a private placement in some business – whatever it is – you just transfer over the $100,000 grand from Fidelity to your IRA at Directed IRA. Then, we’ll go invest the money and hold the asset in your IRA with us. The remaining $200,000 can remain at Fidelity, or you can transfer the whole thing, it’s up to you.
A lot of self-directed IRA investors invest $50,000 chunks, but we have as much as eight figure accounts at Directed IRA. You can transfer whatever you want, depending on your interest, knowledge and how you want to diversify.
How to Use a Self-Directed IRA to Invest in Real Estate
Can you walk through an example? Let’s say an individual opens up a self-directed IRA account at Directed IRA to purchase a piece of real estate inside the IRA. In this example, let’s say they’re buying it using cash and not leverage. So, they transfer over $200,000 to cover the purchase of the investment property… And here comes the first question: This real estate property has to be an investment, right? It can’t be a vacation home, or a home that is rented sometimes, but used by the owner other times?
Exactly. Yeah, that’s one of the first rules you have to know. The prohibited transaction rule is what restricts you from having use of an asset that your self-directed IRA owns.
When you purchase assets with your self-directed IRA, they need to be investment assets, not for personal use. And it can’t even be quasi personal use, like a vacation home that’s rented for 51 weeks in the year but used personally for one week. It has to be held 100% for investment purposes.
Also, the prohibited transaction rule requires you to buy and sell your assets with third parties. You’re restricted from buying and selling assets from yourself to your IRA, and the same goes for your spouse, children and parents – you self-directed IRA can’t buy or sell assets with them.
Back to your example… Let’s say you’re buying the $200,000 investment real estate property with cash. The self-directed IRA is the buyer in the transaction, so it will take title of the property. It’s not “Mat Sorensen” buying property. On the contract to purchase, it would read something like: “Directed Trust Company, FBO, Mat Sorensen IRA.” As the trust company, we send the money from your self-directed IRA for the earnest money deposit to acquire the property.
Let’s say this is a rental property, and that you have a property manager. That property manager is going to get the rental income, pay the expenses, then send the cash flow back to your IRA. So everything’s happening inside of your IRA, you just own it. The money remains in your account with us, which we keep for qualified retirement account purposes. It is a legitimate IRA.
The nice thing is that the income inside of the self-directed IRA doesn’t hit your 1040 tax return. It’s just like buying and selling stock in a traditional IRA account. You don’t have to pay tax as you accumulate this wealth, and get gains on the assets.
Can you talk a little bit more about income and expenses? Can I take the income and go on a vacation with it?
You can, in a way… You can receive it in your IRA, and if you’re 59½, you can take a distribution. But otherwise, no.
If you’re familiar with buying and selling inside of a traditional IRA or 401K, think about this the same way. An investor doesn’t live off of the income in their retirement accounts – it’s growing until you qualify for a distribution.
The same thing is true on the expenses side, right? Let’s say the investment property needs a new roof, which will cost $10,000. The owner of the self-directed IRA can’t take $10,000 from their personal bank account to fund the expense. That money has to come from the funds inside of the self-directed IRA, right? Either in the form of a contribution, or from the funds that have built up as a result of the rental income.
Exactly right. Those are the two options. The IRA gets the benefit of the income of the asset, which you don’t pay tax on, but it also has to bear the expense of the asset.
That said, you want to make sure there’s enough cash in the account to cover unexpected expenses, because if you’ve maxed out your contributions for the year, you can get stuck.
Now, there are some workarounds, like a revenue ruling called 80-28, where you can lend money to your IRA to avoid losing an asset or wasting an asset. It’s possible to get around sometimes, but it’s very painful.
Now, going back to our example… In it, the $200,000 to purchase the investment property was available in the self-directed IRA funds. What if that’s not the case? What if $100,000 is available, and the individual wants to take out a loan for the remaining $100,000?
You can get a loan to buy real estate with an IRA, but you’re not getting it at Wells Fargo or Bank of America. You’ll have to go to a bank that lets you do what’s called a non-recourse loan.
One of the other types of prohibited transactions is what’s called an extension of credit prohibited transaction. Again, these prohibited transactions are rules that are applied to self-directed IRAs and 401ks and, if you engage in one, you lose qualification of the retirement account. If you’re under 59½, there’s penalties… It’s ugly. You don’t want to commit one.
So there’s this extension of credit to transactions that prevents you or your IRA from guaranteeing debt. So my IRA can buy real estate, it can get a loan on real estate, but my IRA can’t guarantee it, nor can I, as the IRA owner, or my spouse or kids.
There’s a number of banks out there, we have them listed on our website, that do non-recourse loans. What they do is they lend on the property, and in the event of default, they will foreclose and take the property back. They’re not going to go after the IRA or the IRA owner for any deficiency.
Because those banks don’t have any individual or account on the hook, they typically require 30-40% down. So, in your example of a $200,000 property where the investor has $100,000 in the self-directed IRA, they’d qualify for the non-recourse loan and acquire the property that way.
Now, the property needs to be income-producing. You can’t get a non-recourse loan on raw land, although your self-directed IRA could own that type of investment, a bank won’t lend on it.
Will a bank deny the loan if the investment property is being purchased for the depreciation aspect, rather than cash flow?
That will depend on how much money you have down. There’s going to be a debt service coverage ratio that the bank looks at. Every bank’s going to have their formula. If you want to get into the details, we have webinars available on directedIRA.com about lending.
Okay. Sticking with real estate, I have a question about the benefits to it. Let’s say an individual has $200,000 in a self-directed IRA, and $200,000 available to invest outside of their IRA. Why should they purchase investment real estate using the self-directed IRA, and not the other way around?
That’s a good question. I say: Do both.
If we’re only talking about one opportunity in your life to purchase an investment property – with or without funds inside of a self-directed IRA – I see the argument to buy it personally and invest your IRA in something else. What happens, though – and this is tax lawyer Mat talking – high-income individuals don’t really get the benefit of depreciation. I own a lot of rental properties. I don’t get to take the depreciation right off. I can offset other income on other properties, but I can’t use it to offset my ordinary income.
You have to be a real estate professional to use real estate losses against your ordinary income. Well, I’m not a real estate professional. I have a day job and run businesses, but they aren’t real estate businesses.
So, for a real estate professional, that argument could make sense. But, keep in mind, when you sell rental real estate property, you have depreciation recapture. The real estate professional gets depreciation, but eventually the IRS gets paid on that. You could do a 1031 exchange and try to kick the can down the road… But, again, I have a lot of sophisticated real estate clients, and sometimes they end up putting deals and time deadlines that don’t really work. I’ve seen a lot of clients sell great properties and end up in crappy ones due to a 1031 exchange.
For our real estate clients, our message has always been to do both. That’s what I do – my SDIRA invests in real estate, and I choose to do it because I get a better, overall return then, say, a mutual fund.
Speaking of real estate, a lot of people like to lend out of their IRA. I’ve heard CPAs recommend doing that, because it’s ordinary income versus capital gains. Also looking at, all right, if you’re doing both, does it make sense to kind of look at the taxes that you would pay outside versus inside and try and maximize what types of assets they’re putting into each?
Yeah, great point. Private money lending using an SDIRA is very popular. This is just a secured note to some other investor, and the lender gets points and interest.
It’s becoming even more common right now, as banks are tightening up and cash is becoming more valuable. So there’s an opportunity for it, for sure.
What’s the actual mechanism for opening up a self-directed IRA?
Our accounts are all online, so you can do an e-sign application to open an account. We also have new account reps that can walk you through it by phone.
Basically, it’s a simple, three-step process.
Step 1: Open the Account
Again, you can do this online. It’s pretty straightforward.
Step 2: Fund the Account
I’d say 95% of our clients move money from an existing IRA or 401k to the self-directed account. Some people start at $0 and begin making contributions, but most are transferring existing funds.
Step 3: Making the Investment
Whatever your interest is, the next step is actually investing the money. Within this step, there’s going to be investment documents. It might be documents for an LLC, or a subscription agreement, or the actual real estate closing paperwork.
One thing a lot of people do when it comes to real estate is they would actually rather have their IRA own an LLC – which they manage – and then the LLC owns the investment property. This is for people who want a little more control. They get the checkbook for the LLC, but their IRA owns the LLC.
So, essentially, a self-directed IRA can own an LLC, and the individual can manage that LLC, despite it being owned by their self-directed IRA?
Yeah. They don’t own the LLC, their self-directed IRA does. But they can be the manager of the LLC, which is like being the president of the corporation, they act on behalf of the LLC. If the LLCs is called “XYZ Investments LLC,” they would sign documents as “Manager of XYZ Investments LLC.” And that’s what’s on the title.
Now, you can’t take money from the LLC, because you don’t own it. The self-directed IRA does. So it’s got to go from the IRA to the LLC, then back to the LLC’s bank account, back to the IRA. Then, you can take a distribution from the IRA.
This LLC strategy is popular for people buying properties at auction, or doing a lot of private money lending. We have lots of clients who do non-performing notes, where they’ll buy bulk defaulted notes and try to work them out. I even use the IRA LLC structure.
Makes sense. Going back to our earlier example of purchasing that $200,000 investment property… Let’s say that I have $100,000 in my self-directed IRA. We talked about getting funding in the form of a bank loan, but what about if I have $100,000 in a personal account. Can my IRA partner with myself to purchase something?
Yes, but you have to be careful how you do it. Remember, there are prohibited transaction rules, and you are restricted from personally transacting with your IRA (same goes for your spouse, children and parents), but you can co-invest into assets.
So, using your example of a $200,000 property where you have $100,000 in your self-directed IRA and $100,000 in personal funds, you could put both sets of funds into an LLC where your IRA owns 50%.
Or, what’s even more common is co-investing with a spouses’ IRA. For this example, let’s say the property is $100,000, so that I can do the math easier. If your spouse puts in $60,000 and your account puts in $40,000, you would break up the ownership in that LLC at 60%-40%. You always break up the ownership based on dollars invested. But it is possible to combine personal funds with your IRA, or your spouse’s IRA, as an example
What’s the best way to avoid prohibited transactions? Can the owner of a self-directed IRA go to the custodian and give a scenario? I’m sure the custodian does not want to provide legal advice… I know your book has a lot of really good examples, but I’m sure people come up with all kinds of scenarios.
Yeah, we get all types of questions. The book is a great resource, but we also have a lot of free, educational content on prohibited transactions at directedIRA.com.
I always tell my clients that self-directing your IRA is like playing a board game. It’s not rocket science, but you have to learn the rules before you start rolling the dice.
But, like you mentioned, the custodian does not provide legal advice. At our office, we provide some education, and will teach you the clear cut rules, but if you’re in a gray area scenario, our team will make a suggestion to talk to an attorney, CPA or financial advisor who is familiar with the rules. In those cases, you’ll require professional advice.
Makes sense. Alright, that concludes the questions I had for you today, Mat. Thank you for sharing your expertise with our listeners. For those of you who tuned into today’s episode and are interested in learning more about self-directed IRAs, Mat’s book The Self Directed IRA Handbook: An Authoritative Guide For Self Directed Retirement Plan Investors and Their Advisors is available on Amazon. Mat, can you share Directed IRA’s website, or any other place that you’d like to send our listeners to?
Great, we’ll link to those resources in the show notes. Thanks again Mat, and thank you to everyone who tuned in to today’s episode. Don’t forget to follow The Agent of Wealth on the platform you listen from and leave us a review on the show.