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April 5, 2010 Special Report

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AprApril 5, 2010 Premium Member Special Report

Self-Directed IRA's and 401k's for Tax Lien & Real Estate Investing

With April 15th fast approaching, many of us have taxes on our minds. Mostly, we are thinking, "How come I'm paying so much and where is it going?" This topic is so time critical and I've had several premium members ask me questions about how to invest in tax liens and real estate using their retirement accounts.

Just a quick reminder for those of you who would rather focus on an online tax lien or tax deed sale, California has tax deed sales going on right now. In fact, Kern County's sale is on Or, take what we learned last month and visit for the Jasper County, Indiana sale going on now and scheduled to end on April 13th. I'll be happy to address any questions you have on either sale, during our conference call. Next month, we will have Florida tax lien sales in full gear and I will profile a Florida sale.

Now, back to investing without paying taxes...

One of the best ways to maximize your investing returns is to become tax efficient by investing through an invidual retirement account (IRA).

Imagine being able to invest in real estate, tax liens or even businesses tax free or tax deferred. Well, amazingly you can.

By many estimates the retirement industry is in the mulit-trillions and yet only about 2% of that money is invested in non-traditional retirement investments like real estate or tax liens. I have to admit that I have only known about true self-directed IRAs for a few years. The problem is that many of us think we have a self-directed IRA through our brokerage company and it's far from being truly self-directed.

What you may not realize is that you can also buy any of the following with a true self-directed IRA:
  • Real  estate – raw land, single-family homes, multi-family units, apartments, mobile homes, commercial property, etc.
  • Tax liens
  • Tax deeds
  • Notes and mortgages
  • Businesses
  • Partnerships
  • LLCs
Whether you’re buying and selling foreclosures, holding on to rental properties for an extended period, purchasing tax liens or buying notes, Uncle Sam is anxiously awaiting his cut of the profits. If you’re like me, you don’t mind paying your fair share, right? The point is to minimize your tax liability. You are not trying to get by without paying taxes; rather, you just want to make sure that you only pay what is required.

Tax Rates - Beware They Are Changing
If you buy and sell property and make a profit, you incur capital gains. Long-term capital gains are generally taxed at a rate lower than your personal income tax rate. The IRS (Internal Revenue Service) considers long-term investments as being more than one year. Short-term capital gains and interest income are taxed at your normal income tax or marginal rate, which is generally 25 to 28 percent for most taxpayers, but could be as high as 35 percent for some taxpayers. The current federal tax rates (retroactive for the 2003 tax year) are 10, 15, 25, 28, 33 and 35 percent.  The long-term capital gains rate is 15 percent for most taxpayers. If you fall into the 10 or 15 percent tax brackets, for 2008 to 2010 the long-term capital gains rate is 0 percent.


The rates are changing and this makes retirement investing even more important.

Starting in 2011, the long-term capital gains and dividends revert back to pre-2003 levels or 10% for those below the 15% marginal rates and 20% for those above that rate. In essence, most taxpayers who own real estate will now pay at least 20%.

On March 21, 2010, Congress signed into law the new Health Care Reform Law. This law increases taxes on medicare for individuals making over $200,000 or couples earning over $250,000. The surcharge imposed is approximately 3.8% on all income making the long-term capital gains rate as high as 23.8%.

All of this is to say that investing inside of a retirement account is getting more and more attractive.

An Individual Retirement Account or, as the IRS now calls it, Individual Retirement Arrangement (IRA) is a savings account that allows you to set aside investment income allowing it to grow tax deferred (Traditional IRA) or tax free (Roth IRA). Depending upon your modified adjusted gross income, you may qualify for a tax deduction in addition to the tax deferred or tax free earnings growth.

Most of you have heard of IRAs and many of you probably have an IRA account. To qualify for an IRA account all you need is a social security number and earned income equal to or in excess of the amount that you contribute. In other words, if you only make $1,000 in income for the year, you can only set aside up to $1,000. Additionally, when you reach age 70 1/2, you are required to start taking distributions or dipping into your account.

For 2010 the contribution limit is $5,000. If you are over 50 years old you can increase your contributions by an extra $1,000 per year. You are not allowed to withdraw money or assets from a traditional IRA before age 59 1/2 without paying a 10% penalty.

For Roth IRA’s, you are allowed to withdraw your contribution amount penalty free, but not the earned interest amount. There are some exceptions to the withdrawal penalty amount, such as:
  • Unreimbursed medical expenses that exceed your 75% adjusted gross income
  • Disabled individuals
  • Distributions to buy, build or rebuild your owner-occupied home
  • Beneficiaries of a deceased IRA owner
  • Annuitized distributions
  • “Qualified” higher education expenses
For the latest rules (2009 and 2010) on IRAs, refer to IRS Publication 590: 

To find the publication, go to and type 2010 publication 590 in the Search Results. The latest PDF document is actually still a 2009 version.

IRS Publication 590 webpage

For 2009, the money you contribute is tax deductible if your adjusted gross income (AGI) is below $89,000 as a joint return or $55,000 as a single taxpayer or head of household. The deduction phases out for joint taxpayers between $89,000 and $109,000, and $55,000 to $65,000 for single taxpayers or heads of households.

For married individuals filing a separate return, the deduction only qualifies if you make less than $10,000.

For 2010, the AGI limits increase for single taxpayers to between $56,000 and $66,000; for single taxpayers or heads of households and joint filers the limits remain the same.

Also, if you or your spouse is not covered by a retirement plan at work, you may qualify for the full deduction. Unfortunately, this exception used to be unlimited. For 2010, the limits are $167,000 to $177,000. Even if you don’t qualify for a deduction, you can still contribute up to the maximum annual contribution and the taxes are deferred until you pull out your money during retirement. If you are over age 50, you can set aside even more using the government’s “Catch Up Limits.”

Deductibility Requirements

Year Single/Head of household Married/Joint
2009 $55,000 - $65,000 $89,000 - $109,000
2010 $56,000 - $66,000 $89,000 - $109,000

Contribution Limits for Traditional and Roth IRAs

Year Maximum Contribution Over 50 
2009 $5000 $6000
2010 $5000 $6000

Roth IRA
The Roth IRA was named after the late William Roth, a Senator from Delaware. Roth IRAs are an ingenious design, which allows you to pay taxes on the front end and receive tax free earnings on the back end. For real estate investors this is almost too good to be true. You can setup a Roth IRA and you will be required to pay taxes upfront. In other words, you don't get the tax break now on what your contribute, but your earnings are tax free later.

Example: You set up a Roth IRA and contribute the maximum. You are age 52 so you can contribute up to $6000. You use this money to purchase a tax deed for $3500. You then hold the deed for two years and sell it wholesale to another investor for $15,000. Assuming your expenses are a total of $2500 with taxes, insurance and realtor fees. You are in it for a total of $6000 so your profit or capital gain is $9000, which in year 2012 would have been taxed at 20%. You save $1800 in taxes.

YearSingle/Head of HouseholdMarried/Joint
2009$105,000 - $120,000$166,000 - $176,000
2010$105,000 - $120,000$167,000 - $177,000

Again, if you are married and filing separately, your limit is $10,000.

A Simplified Employee Pension Plan (SEP) is a retirement plan that allows you or your company to set aside retirement savings under the umbrella of an IRA. The maximum percentage of annual compensation that an employer may choose to contribute is 25% of the participant’s salary or $44,000, whichever is smaller. A SEP is considered as a Defined Contribution Plan and according to IRS guidelines you cannot contribute more than the maximum contribution ($46,000 for 2009 and $49,000 for 2010) to all Defined Contribution Plans (refer to IRS Pub 560, Chapter 4). SEPs can be set up anytime up to the date of the employer’s return, including extensions.

Eligible Employees:
  • Are 21 years of age or older
  • Have worked for the company for at least 3 years of the last 5 years, and
  • Have received at least $450 in compensation.
Your business can establish less restrictive requirements.

To set up a SEP plan, your business must put together a formal written agreement (Form 5305 – SEP) to provide benefits to all eligible employees. You are also required to provide information regarding the SEP to your employees.

Special Note: A SEP-IRA cannot be set up as a Roth IRA. If you are self-employed, special rules apply to how you calculate your deductions using a SEP-IRA.

Self-Directed 401(K) Plans
Individual (K) or Solo 401(K) Plans are designed to bridge the gap between the benefits that an individual would receive working for him or herself versus working for a large company with a 401(K) plan. The catch here is that it is only designed for sole proprietors or businesses where only the owners or spouses are covered. In other words, outside employees would not be eligible.

Okay, so how does this work? Well, if you or your spouse earn income through self-employment, as a sole proprietor, partnership, LLC, corporation or as an independent contractor without any employees, then you are eligible for this unique retirement plan. Like IRAs, you must decide whether you will tax defer your income or use the Roth alternative and delay your gratification for a potentially huge tax-free windfall.

Roth versus Traditional Solo 401(k) plans allow you to set aside up to $15,500 for year 2009 or $16,500 for 2010. If you are over 50, you may be able to include a catchup amount. With the Roth alternative, the first portion of your income goes to the Roth and the rest goes to your traditional solo 401(k).

Why Roth? Again, imagine buying an investment like a tax deed for $4,500 and selling it for $50,000 without paying any taxes on the capital gain. Imagine purchasing a short sale foreclosure for only $9,000 (it’s possible in some locations) and selling it for $76,000 without paying any taxes. Or, imagine buying a piece of paradise (beach front property) for only $50,000 and selling it for over $120,000 all tax free. Your Roth can make this happen and the benefit of a Roth 401(k) is you can set aside about three times more than you can with a Roth IRA.

Remember, you can’t take an immediate tax break with a Roth, but your benefit comes later when you pay no taxes on the interest, income or capital gains of your investment. Why Traditional? With a Traditional 401(k) your contribution is deducted from your adjusted gross income and you receive a nice deduction on your current taxes. For example, if you made $76,000 and you set aside $15,500, then your new adjusted gross income is only $60,500. Or, in simple language, you are not taxed on the $15,500. This can be a real life saver when April 15th (tax day) rolls around, plus it is a forced way to save. Now, when you withdraw this money during retirement, you will be required to pay taxes on it plus any interest earned.

Here are the requirements for a Solo 401(k)
1. You must establish an account before the end of the tax year so the April 15th date doesn't apply.
2. You can begin taking distributions at age 59 1/2. You are required to take distributions at age 70 1/2 with a Traditional solo 401(k) plan.
3. You cannot contribute more than you make.
4. Your income must be 1099 or W2 income; it cannot be distributions, such as K1 income.
5. For tax years 2009 and 2010, you can set aside up to $16,500 in income plus 25% of revenue from a business or 20% from a sole proprietorship. Your spouse can set aside the same amounts. If you are over 50 years old, you can set aside an extra $5,500 in income per spouse.
6. You must hold it in the plan for at least 5 years. If you know anything about IRAs, already you will recognize that you can set aside more money by far in a solo 401(k) plan than an IRA. Currently, the limit for IRAs in years 2009 and 2010 is $5,000 or $6000 if you are over 50 years old.

Here is what you can’t do in a Solo 401(K)
1. Invest in, sell to, lease to or exchange property with a disqualified person. The following are disqualified persons: you, your spouse, mother, father, kids, grandparents or any person you designate as a beneficiary. 2. Use your 401(k) for certain investments, but the requirements are not as stringent as IRAs.
3. Use your 401(k) as collateral for a loan.
4. You or a disqualified person cannot receive a benefit or goods or services from your 401(k).
5. Invest in a business of which you own more than 50 percent or of which a combination of you and/or disqualified persons own greater than 50 percent. The fees to set up a self-directed 401(k) account range from about $50 to $250 per year, with a setup fee of about $100. While there are Administrators who will help you set up a solo or individual 401(k) plan, most are brokerage houses that will limit your investments to stocks, bonds and mutual funds.

Here's what you can do in a Solo 401(K)
1. You can self-direct your plan and set it up with check book control.
2. You can borrow up to 50% of your plan’s value, usually up to a maximum of $50,000.
3. You can invest in S-corporations and some other investments not allowed through your IRA.
4. You can set aside more money tax free and/or tax deferred than in an IRA.
5. There are no income requirements to qualify, like IRAs.
6. You can obtain a non-recourse loan for buying real estate without triggering the unrelated business taxable income (UBTI) rules, unlike with IRAs.

The Savings Incentive Match Plan for Employees is a type of retirement plan that allows small employers (less than 100 employees) to provide the same type of retirement benefits that a large company might have. SIMPLE plans can be set up as SIMPLE 401(k) plans or SIMPLE IRA plans. According to the IRS (see Publication 560:, an eligible employee must have received at least $5,000 in compensation during any 2 years preceding the current calendar year. An eligible employee must also be likely to receive $5,000 in the current year. However, these rules are the maximum requirements, so you can setup a SIMPLE as a business owner and make the requirements less restrictive or you can completely remove the requirements. You cannot make the requirements more stringent than the $5,000 and 2 year maximums.

With a SIMPLE plan, an employer must match between 1% and 3% of each employee’s compensation or an employer can choose to contribute using a fixed contribution of 2%. SIMPLE plans must be set up between January 1st and October 1st of any calendar year. With a SIMPLE plan, you can tuck away even more than you can with a traditional or Roth IRA. Compensation for employees is the total wages required to be reported on Form W-2.

With a SIMPLE Plan, you can contribue $11,500 + $2,500 if you are over 50.

Special Note: A SIMPLE-IRA cannot be set up as a Roth IRA. If you or any other employees take advantage of another employer plan during the same year, then the salary reduction contributions under the SIMPLE IRA count toward the overall elective total. You can also deduct contributions to a SIMPLE IRA plan, if they are made for that tax year and are made by the due date (including extensions) of your federal tax return for that year.

Educational Savings Accounts
Educational Savings Accounts, also know as Coverdell Education Savings Accounts, allow individuals to contribute money for a child’s education in a tax-deferred environment. Although the contributions are not tax deductible, the earned interest is tax-deferred. As of 2010, the annual contribution limit is $2,000 per child and children are considered 18 years or under. And you are eligible for a full contribution to an Educational Savings Account if your modified adjusted gross income is below $110,000 (individual) and $190,000 to $220,000 (joint) the contribution is prorated.

What You Can’t Buy - Everything Else You Can
There are a few items that you can’t buy through an IRA and these are included in IRS publication 590 (

In short, you cannot invest your IRA money in the following:
  • collectibles,
  • antiques,
  • coins,
  • stamps,
  • life insurance contracts,
  • metals,
  • gems, and
  • alcoholic beverages.
Who Can Touch Your IRA Money
You are also not allowed to buy, sell or exchange property or investments with a disqualified person, such as you, a spouse, child, father, mother or others who are closely related to you (refer to Publication 590).

Warning: It is possible to trigger a taxable event in your nontaxable account, which could result in your entire account being taxable – oops, we don’t want that. It may be a good idea to set up a separate account and fund it gradually or only rollover a limited amount of your retirement money; in other words, don’t put all of your “eggs in one basket.”

Generated Income
All income generated by an investment that is owned by your IRA must return to your IRA, in order to retain the tax deferred or tax free status of the investment. An example would be if you buy a rental house and it earns income, the income must return to the IRA, not you. Make sure your renters write checks directly to the IRA and send it to the IRA. You can request that your renters submit a copy to you. Any expense should also be paid from the IRA, not you.

You Are Not Your IRA

Your IRA is Like a Business or Trust

You cannot have your IRA do the following:
  • Buy real estate through your IRA that you currently own or will own or that a close family member owns, such as your wife, son, daughter, etc.
  • Loan you money
  • Buy into a partnership or business that you currently own
  • Receive unreasonable compensation for property management
  • Invest in or start up a Subchapter S Corporation
  • Use it as security for a loan.
You can not receive a personal benefit from your IRA.
An example that I heard recently was a gentleman who bought a classic car as an investment. Okay, so far so good. It is not restricted according to IRS Pub. 590. However, strictly speaking he got into trouble when he occassionaly drove it around on a Sunday afternoon. The proof was in the odometer. What he could have done is rent it out at a reasonable rate to his IRA or prove that he needed to take it to a mechanic using IRA money and fix it or improve the value.

Another common mistake is to buy a vacation property with your IRA and then use it for personal benefit. 

What about borrowing money for a rental house? Welcome to a whole set of complicated rules in tax laws called UBTI.

Tax on Unrelated Business Income. Certain tax exempt entities, such as charities or universities, as well as IRA’s, are subject to taxation of the portion of their income that is not substantially related to its exempt purpose. So, how does this apply to real estate investing? In short, the amount of investment income attributed to debt financing is taxable. In other words, if you use your self-directed IRA to purchase a property and you finance (obtain a loan) any portion of the property, the amount of income received from that financed portion is taxable. Here is an example: You purchase a rental property for $100,000 and use $20,000 from your self-directed IRA. The remaining $80,000 is obtained from a hard money lender through a mortgage. The amount you borrowed from the hard money lender ($80,000) is referred to as acquisition indebtedness. You fix up the property and sell it for $125,000. You would be liable for $25,000 in capital gains minus expenses (paid by your IRA). Assume $5,000 was spent to fix up the property, you would be liable for 80% of the $20,000 = $16,000 and your tax deferred portion would be $4,000. Also, note that any rental income would be treated in a similar manner. A portion of it would be taxable. Since this gets a little complicated, you will need to speak with an accountant or IRA facilitator. (Refer to IRS publication 598 at

You may have heard of checkbook control. How does that work?

Checkbook Control with an IRA
When purchasing tax lien certificates with an IRA, it is often advantageous to have your IRA own a separate business entity, such as an LLC (limited liability company). In fact, your IRA will own the business 100% and either you can be the manager with no ownership rights or you can designate a manager, such as your accountant or attorney.

The point is to be able to use an employer identification number and bank account to quickly and efficiently transact business. Otherwise for tax lien certificates, you will be requesting money from your Trustee and that can take 3 business days and create unnecessary fees.

This brings up a good point about valuing a business. You may be required to submit a valuation on an annual basis.

IRAs in Summary
You will need to contact another company that is set up to handle a true self-directed IRA. You can find information from these companies on rolling over an existing IRA or qualified retirement plan or setting up a new IRA account. Any purchases or sales will need to be made in the name of the IRA trust account, unless you have the IRA invest in an LLC that you control. Then, you can truly realize flexibility. A list of trust companies is presented below.

Remember, you can set up a traditional IRA and earnings are deferred until retirement. You can also set up a Roth IRA by paying the taxes upfront. Any earnings in a Roth IRA are tax free. That’s right. You do not pay taxes on the earnings. The sky is the limit. If you have children, like I do, consider setting up or rolling over an educational savings account. If you’ve left an employer and have a 401(k) plan, you can roll it over into an IRA. For small businesses, you should consider setting up either a SEP or SIMPLE plan in addition to your standard or Roth IRA, then you can truly recognize the power of savings and compounded interest.

Your IRA was designed to give you flexibility in saving for retirement; however, it seems that only brokerage companies caught on. They control much of the process and they limit what you can purchase. After all, they don’t make any money off of your purchase of a foreclosure or a tax lien certificate. Take control of your savings now by contacting a qualified trust company. Be sure to do your research, ask questions and make sure you are comfortable with the company that you select.

Getting Started with Self-Directed IRAs/401ks

Step 1: Decide How You Will Fund Your IRA

There are two ways to fund a retirement account. First, you can make original contributions within the guidelines, depending on whether it is an IRA, solo 401k, SIMPLE or SEP. Another option is to rollover existing retirement accounts from previous employers or an IRA account you have now.

If you have worked for an employer and contributed to a 401k plan, you rollover the account into a self-directed IRA account. You may have already rolled over your account into an IRA account and selected a brokerage company, like TD Ameritrade, Schwab or Fidelity.  These accounts can be rolled over in whole or in part into a self-directed account.

For example, I worked at an engineering company (Black & Veatch). I contributed to a 401k plan while working and later left the company. After I left, I rolled over my 401k plan into a Fidelity IRA Rollover. Later, I took out a portion of the IRA (about 20%) and set up an account with Equity Trust Company. I then self-directed the money into a real estate investment in France, which my IRA still owns.

Note: You can rollover a portion of your existing IRA and not necessarily the whole account.

Step 2: Select a Trustee or Facilitator

Self-Directed IRA Trust Companies
Special Note: Some Trust companies are active in the process of your investment selection and some are passive. An active company, like Pensco, will probably require that the investment is approved by them. This will mean that they will contact the company and ask for additional documentation. A passive company, like Equity Trust, assumes that you are making the correct decisions and they are just providing the means to help you. I have found passive companies easier to work with.

You may find it beneficial and easier to have someone take care of helping set up an IRA account, create a company, provide bylaws or operating agreements reviewed by attorneys, prepare an opinion letter and basically do everything for you. These companies are not typically Trust companies. I refer to them as facilitators.

They earn a fee for providing these services and it is typically in the range of $2500 to $3000. One of the largest facilitators is Guidant Financial. My contact at this organization is David Nillsen, the founder. Recently, I spoke with another company called Passport IRA and they seem to be knowledgeable, but I have not had anyone complete a transaction with them.

You may wish to be the next facilitator. As far as I know, there are no licensing requirements, but you will need to have access to an attorney.

Step 3: Set up Your Account

If you are doing it yourself, visit the company's website and either download the paperwork you need, fill it out and send back or call and get some personal help. Most of the better companies will help walk you through the process and answer most all of your questions.

Example: Visit

My personal contact at Equity Trust Company is Tim Debronsky.

Equity Trust
Notice that Equity Trust has a phone number, contact us information, forms online and tons of information.

Step 4: Select an Investment

Once your account has been set up and you have either rolled over funds or sent money to start a new account, you will instruct the trust company to purchase your investment. Funds will come directly from the IRA or the company that is connected to your IRA. The trust company will be purchasing on behalf of your IRA or acting as its custodian, so all title work will be done as though your IRA owns the investment, not you personally.

If you buy real estate, it will be titled like this:

Equity Trust Company, FBO Susan Smith IRA

FBO means "for the benefit of." You are the beneficiary of the IRA. It will not be titled "Susan Smith." Also, be careful with putting down security deposits. Most trustees do not like for you to put down a deposit in your name even temporarily.

When you select an investment, you will fill out the paperwork that the trust company requires and provide the necessary information for the property, such as location or legal description, purchase amount, address to submit the check, and funds needed from your account. You will also be required to pay any transaction fees.

Remember, your IRA can buy into an LLC. So, it is possible to have your IRA invest into an LLC. The LLC can then more easily buy and sell real estate taking some of the hassles out of the paper work. Be sure to check with the trust company, your attorney and accountant to make sure you have everything set up correctly and you understand the rules.

One crucial document is an attorney opinion letter that basically states that the LLC and IRA were set up correctly together and legal precedence exists for this.

Step 5: Fund the Investment

Trust companies are not free. In fact, one of the frustrating parts of self-directed investing is paying the hefty annual fees and transaction fees. These fees are necessary because these companies are not trading public securities on high volume. They are much smaller and there is a lack of competition. I believe this will change as more and more investors become fed up with traditional investing methods and look to unique opportunities like tax liens.

Furthermore, I have seen an increase in the number of individuals who have been downsized and now have decided to fund a startup business using IRA money.

Step 6: Manage Your IRA/401k Account

Most IRA Trustees will require annual appraisals or some sort of valuation of your real estate investments. For tax liens, it is simply the value of the lien until it is redeemed and you earn interest or until you foreclose and convert a lien to a deed.

Step 7: Withdrawal

At age 59 1/2 you can start withdrawing traditional IRA/401(K) retirement funds. At age 70 1/2 you are required to withdraw your funds according to prescribed levels. Failure to withdraw can result in strict penalties. However, you are not required to withdraw money from your Roth IRA/401(K). Your beneficiaries, upon death, may be required to take distributions. Also, any contributions (not capital gains or interest) you made to a Roth can be withdrawn at any time because you really already paid taxes on that amount. 

All the best,


P.S. Feel free to send me emails with questions on self-directed IRAs and I will have the answers ready. I think you will agree, it is an exciting way to tap into money for investing and by self-directing there are many other alternatives besides stocks, mutual funds and bonds.

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