The Most Elusive & Dangerous Self-Directed IRA Practice – Part 2

In the last post, you learned about how doing an active “entrepreneurship-ish” deal inside your IRA 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 IRA or 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 IRA 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 IRA & 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
  • UDFI tax (if done inside an IRA) calculation, form preparation, and payment
  • 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 IRA industry, it may make a big impact.

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Reader Interactions

Comments

  1. Rod E.
    Jeff, I currently have passive rental income for many years, then I retired from my day job and would like to invest in alternative investments such as real estate with my lump sum and possibly old 401k money. Would I be able to give myself some earned income from my passive income to qualify for a solok as a sole proprietor and become a property manager of my existing rental properties? I would only pay myself a small amount to minimize any tax consequences, just to be able to qualify for a solok.
    Thank you

  2. I am starting over from nearly scratch at 57. I intend to create cash flow and capital gains through real estate investment strategies. I want to create a checkbook control Roth solo 401(k) plan that establishes and owns a New Mexico LLC (for privacy, limited liability, and asset protection) that establishes and owns a Wyoming LLC (for asset protection and limited liability, with no state income tax) that generates cash flow and capital gains through real estate investment strategies and services.

    Can I personally earn reasonable compensation for services rendered through the Wyoming LLC? Your article warns about active investing through an IRA, but what about active investing in an LLC owned by the 401(k)? What about active investing in an LLC that has another LLC between it and the 401(k)?

    Can the Wyoming LLC establish a self-directed SEP IRA for my benefit as LLC employee?

  3. Rod, talk to your CPA about that.

    Stan, no matter how many layers of entities you involve, you cannot earn compensation from your retirement plan. I don’t know what you mean about an LLC establishing an IRA… as IRAs are established for natural persons (living, breathing people) and not fictitious persons (like an LLC or Corp). I suggest you simplify your approach. If you’re trying to buy passive investments, do it directly in a Solo 401k. If you’re trying to earn a buck, do it as a business (sole proprietorship or LLC) 🙂

    Jeff

  4. Hey Jeff!

    Do you have any suggestions for simple viable businesses that would qualify one for a solo 401K. Would a simple online links page with a “pay for clicks” set up qualify?

    – greg

  5. Hi Jeff, 2 questions. Can a solo 401k be set up for the tax year 2010 even though it is now 2011? I have income in 2010 in a small business and if possible, I would like to defer the taxes in that business by setting up and contributing to the solo 401k (2010 contribution made in April 2011).

    Second question, can my existing Roth IRA be rolled into the new solo 401k? If so, does it retain it’s tax exempt qualities with respect to the earnings? Thanks, Larry Veldre

  6. Jeff,
    I’ve owned 15 rental properties for many years and the income is taxed as passive. I recently retired from my day job and would like to invest my 401 money from my previous job into additional income producing property. I would prefer a solo 401k, but I do not currently have a business. Would it be legit for me to establish a property management business and give myself some earned income from my passive income in order to qualify for a solo k ? I would only pay myself a small amount to minimize any tax consequences, just to be able to qualify for a solok.
    Anything wrong with this plan?
    Thank you

  7. Greg,
    Great article and I may be asking a repeat question. I am currently in law enforcement and want to leave the department to open a micro brewery. I dont have the capital personally to open and I dont want to take a loan. I have enough money between my 401k and 457 accounts to fund my brewery. I wanted to use the money as a self directed IRA LLC, or single member 401k to fund my business, I want to operate the business, grow it and when I am ready to retire sell the business and use the money made selling the business to support me during retirement, I also intend to put the maximum amounts allowed by the plan back into either the IRA or the 401k. Would doing this be allowed by the IRS? I am not trying to “trick” or “outsmart” the IRS, simply find away to use my own money to fund my business, I believe this would be a passive investment.
    Thank you for any advice you can offer.

    Keith

  8. Jeff,
    Im so sorry, I refered to you as “greg”, which is my accountants name he was unable to advise me on this question and I was talking to him right before I posted. Please accept my apology.

    Keith

  9. So if I form an LLC with my self directed IRA as the sole member and the LLC engages in business activity, that would be illegal?

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