TRANSCRIPT 🔗
Bernard Reisz: There is only one section of tax code that talks about qualified retirement. Nowhere does it act ever specify what you can invest in, People will sometimes say, show me where I heard that this can't be true. I don't believe it. I need you to show me where in the tax code it says that I can invest in IRA in real estate. It doesn't say anywhere what you can invest in. What it has is a short list of things that you can't invest in. Everything else is okay.
Ami Morgenstern: Welcome to another episode of Conversations with Ami where we have real conversations for early stage entrepreneurs on how things actually work, what to avoid, and what to start getting good at now. Today we sat down with Bernard Reisz from ReSure Financial again to discuss self-directed retirement accounts and regular retirement accounts. If you enjoy this episode, please like, subscribe, and follow the show. So Bernard, welcome back again. We discussed cost segregation, we discussed ten thirty one exchanges. Now let's get into retirement accounts. So number one, let's start off with what is a retirement account. Let's start off there and then we're gonna go you know, we'll go into what you how you help people.
Bernard Reisz: Great question. And of course, Ami, great being here again. Another conversation with Ami. Somebody that both professionally and personally I hold in such high regard. Now to get into this topic retirement accounts, let's build it from the ground up. So, and what are we talking about and what are we not talking about when we say retirement account in this conversation? We're talking specifically about Tax advantaged retirement accounts. So you can do retirement planning in a lot of different ways. What we're focusing on are those type of accounts that Congress, Uncle Sam, the IRS incentivize you to put money into and invest long term. Most well-known examples of those are IRAs and what are referred to as 401ks. So an IRA stands for individual retirement arrangement. Those come in a lot of flavors. Primarily we'll talk about ROTH IRA and traditional IRA. And a 401k plan is a type of qualified retirement plan associated with a business. And most Americans are familiar with IRAs and 401ks. 401ks likewise have a traditional and ROTH flavors, and we'll I'm sure we'll talk more about what those are as the conversation progresses.
Ami Morgenstern: Yeah, so let's go right into it. What is the difference? Just I think it's relatively simple, but what is the difference you know, how would you describe the difference between a ROTH and traditional accounts?
Bernard Reisz: So a I'm actually gonna describe it in a way that probably is not what you'd expect. so the difference between the two accounts is that ROTH money, the growth on ROTH accounts is tax-free. The growth in traditional IRA is tax deferred. now what I did not say is that deductions to a traditional IRA are tax deductible and contributions to a ROTH IRA are not tax deductible. That is only somewhat true. So there's there are two things that we have to think about when we talk about a retirement account. One is What are the effects, the tax implic effects of putting money into that account? Do you get a tax deduction for putting money for contributing to that account? And then the second question is: what is the tax impact of growth of funds once they're in that account? Two separate set of questions and they don't really go hand in hand. There is a bit of a misconception that those go in lockstep. And in many instances, they do go together, but not always. So the general conception is traditional IRA, you get a deduction for putting money in. Growth of funds in the account is tax deferred. I'll define that a little later in a moment. Vis-a-vis ROTH accounts, no deduction for putting money in, but the growth within the account is tax-free. so it's not 100% accurate because not always is a contribution to a traditional IRA tax deductible. But growth in a traditional IRA is always tax deferred. Let's break this down a little further. So money, let's first talk about the money that's in the account. So we have $10,000 that landed in a traditional IRA. Now that ten thousand dollars is invested, there are there's capital appreciation, dividends. Now thirty years later, this ten thousand dollars is worth a hundred thousand dollars. When money is distributed from that account, if there was no tax deduction for putting the money in. then all that growth will be taxable. So whatever that growth, the delta between $10,000 and $100,000, will be taxable. In contrast, in a ROTH IRA, that growth would be tax-free. So when money comes out of a ROTH IRA, again assuming it's a qualified distribution, I don't know if we should get it all that minutiae. But money that's, you know, that comes out of ROTH IRA comes out tax free. Money that comes out of a traditional IRA, to the extent it's coming out of there's no basis, the money is coming out of gain, and when it comes out of the account, it is taxable. The other question is what are the effects of putting money in? So traditional IRA deductions in many cases, contribution, contributions to a traditional IRA in many instances are deductible. But not always, if somebody is covered by a retirement plan at work and they have certain income levels, their contributions to a traditional IRA are not deductible. So there's something called a non-deductible. traditional IRA contribution. So that money goes in, there's no tax deduction for it, and it grows tax deferred. Now this is where there's something called them, something called a ROTH conversion. Something called a backdoor ROTH IRA contribution. And again, I don't know if we should get too much into the weeds of this, we'll just touch on that. So a ROTH IRA, though, in contrast, contributions to a ROTH IRA are never deductible. So traditional IRA contributions may or may not be deductible. Within the traditional IRA, growth is always tax-deferred. ROTH
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IRA contributions are never deductible. And growth is always tax-free. But there are income limits. So, as we just mentioned, on the traditional IRA side, there are no income limits on contributions, meaning you don't you don't phase out of being able to contribute, but you can phase out of being able to get a deduction for the contribution. On the ROTH IRA, you can phase out of being able to make a contribution to a ROTH IRA.
Ami Morgenstern: question over When when you're doing a backdoor, which is basically converting from traditional to a ROTH, right? when you do that, and let's say you outgrew the your income levels are too high at a retirement account from work, or whatever the reason is that you cannot take the you cannot use it as a as a like to lower your income essentially, right? To defer the can you then when you do that conversion, when you do the backdoor ROTH, Do you have to pay another thing of taxes or because you already paid the tax on that income, you're you can just do a back door?
Bernard Reisz: So it really depends on the extent to which is true whether or not you've actually paid income paid taxes on that. So suppose somebody makes a the idea when you do a ROTH conversion, right, there may or may not be a tax bill. what it depends on is the extent to which funds that are being converted are pre- or post-taxed. So if all your contributions to a traditional IRA were the tax deductible. Then you have zero basis in your traditional IRA, and every dollar that's converted is being taxed. Now, if there were non-deductible contributions made, so you have basis, so not every dollar of conversion will be taxed because you already have some basis. Where it gets tricky is what happens if your traditional IRA has a mix of pre- and post-tax money. or what happens if you made only non-deductible contributions, but the money grew, right? It grew on a tax-deferred basis. So then there will be the most important thing for people to be aware of is something called the Pro Rada rule, which means you cannot choose to say, hey, I have $100,000 in my traditional IRA. $60,000 post-tax, $40,000 pre-tax. Okay, I'm converting the post-tax amount. Doesn't work that way. It's pro rata. Every dollar of conversion is going to be a mix of pre and post-tax. Again, there are strategies to work around this and avoid that. The main thing is to avoid the pitfall. People that do a conversion say, it's gonna be tax-free, and then they get a massive tax bill or maybe worse or worsely because I've had this somebody came to me, an accountant calls me and says, Bernard, can you help me? My client just realized that he's been doing 12 years of this and He has no idea, just realized that he's doing it all wrong, and then he had tax liability. Can we just go up unravel the guy's tax basis, what his tax liability should have been, can we clean this up? So I think there the probably the better place to be is to know about the pitfall, than to find out about it after the
fact. so that's the to answer your question, to the extent that the money being converted is post-tax. There's no tax bill. To the extent that it's pre-taxed or is a tax bill, the pitfall is that it's not always obvious to people when they're converting post tax, when they're converting pre-tax.
Ami Morgenstern: Got it. So now and now well like how would you describe the difference between a 401K and an IRA?
Bernard Reisz: Okay, there are a lot of differences if we're gonna Boil it down, and again to my perspective on this, and I think we're I see a lot of mistakes being making made. Being maken. A lot of mistakes being made. and in particular, maybe you know, this is a good segue into you know where a little more of my focus is. Yeah, I do a lot of tax advisory and all sorts of advisory related to You know, the kind of stuff we've spoken about now, the general tax compliance and strategy for related to all retirement accounts. but I have a more particular focus on self-directing. we'll get more into that, but what I will say at this point is I've seen a lot of mistakes made in the self-directed space. And we say self-directed here, what we mean is using these accounts to invest in private assets: real estate, cryptocurrency, precious metals, merchant gas advance, litigation fund really you name it, private investments. and some of the mistakes that have even been promoted by you know the people that you know promote things you know that the are based on a not highlighting the most fundamental distinction between IRA 401k the most fundamental distinction is as follows the I and IRA stands for individual retirement arrangement if we go to the section of the tax code that The introductory sentence, the introductory paragraph that describes these accounts, an individual retirement arrangement, is an account, a trust set up with a trust company or a bank that is set up for the benefit of an individual. go check it out, section 408, if anybody cares to go have a look. now 401k plans are called that because if you want to find out where they are in the tax code, it's section 401 paragraph K. That's why they're called for right. So an IRA I guess could have been called a 408 plate, a 408 account. You know, to and a ROTH IRA could have been a 408A account. but we don't do those names. Maybe it would have been useful. So a 401k is in section 401. And if we go to that's 401K, if we go to 401A, go all the way back up to the top of the section. We're defining qualified retirement plans, and that is a trust that is set up for the benefit of employees. So if we want to get to the crux, the really the root of it. Now a lot of other details flow from this, but at the root of it, one is a trust set up for an individual, the other is a trust set up by an employer for the benefit of employees.
Ami Morgenstern: Got it. Okay. So now and and when it comes to self-directing with the IRA on the individual, I'm guessing again this is an assumption over here, but I'm guessing it's the individual that's self-directing his retirement account into you know wherever he wants to invest it into the private assets. But when it comes to 401K who is that individual who is the self directing? Who is that the company or is that the employee?
Bernard Reisz: amazing question. I'm gonna have to take a shortcut to the answer. because some of it is just gets way too nerdy and it in the practical world stuff that nobody most people never have to know about. but it's a great question. So you know, at the individual side, typically the one that is ultimately responsible. Is the individual. they make the investment decisions, they run the show. There is a requirement that there be a financial institution custodian there. That's a requirement in the tax code for something to be qualified as an IRA. Now a qualified plan is gonna have a trustee typically. so there's always gonna be a trustee, an IRA. you will be can be set up again it's it's getting to nitty-gritty of how it's set up custodial with a bank with a trust company what type of licensing they have but suffice it to say in an IRA the individual that the account is set up for is what we call a fiduciary for his account they make the decisions. a 401k plan, the way to think about it is imagine a company that has three thousand employees Now they can there's the there's a plan trustee. And the trustee, again, you can delegate, you can have different types of trustees, it can get very complex, but ultimately there's a trustee that makes the decisions for the plan. now people that have a 401k plan will know if they've had one at work. Yes, you go in, you can log on, and you may have a menu of investments to select from. I don't wanna go there to all the what you know what that all is about, but they can set it up. There's basically something if you want to get rid of some of your fiduciary liability. Cause you imagine here, you work at this company and I decide that we should invest all the company's all the money in the plan in a gold mine in Cambodia. Right? I think I you know, I heard great things about this. I even saw somebody post something graced about it on on X. They said we can 100X our money. I'm like, I'm all in, I control this account. Let's do it. Right? That's a lot of fiduciary liability there. so basically Congress gave people gave plan fiduciaries it's called you know a way out of there which is like hey give people a menu of investments that they can select from include something risky something not risky something and they can choose and if you give them that menu then you're kind of off the hook. so that's the that's the so but the answer to the question again is does a trustee. Now in the self-directed space, any plan Can theoretically be what we call self-directed. which it can be every 401k plan, even a 401k plan of a company that has 10,000 employees, can be invested in private assets. practically, you're not gonna see it too much in those kind of
plans because the compliance risk is just too high. Secondly, in those kind of plans, there's nobody that it matters to enough. to actually undertake it. Where because where it typically this is gonna be more relevant is where it's a small company where there's a business owner that is primarily benefiting from the retirement account, and he has more direct control to decision making, doesn't need a board of directors to approve everything he does. So we're gonna see it either with small businesses or what we call solo plans. a solo plan is where there's only one eligible plant participant, or go beyond, but you know, actually better way to say it, the eligible plant participants are include only the business owners and their spouses. So those kind of plans are subject to much less, much lighter compliance burden. and that's where it becomes very, very, very attractive. To self-direct in a qualified retirement plan. And again, yes, technically, you know, the business owner there is the trustee, but it starts looking a lot more like an IRA because it's just his money, right? Or his spouse's money. It's just the business partner's money. And so it starts looking a lot more like an IRA. So even though technically it's still a plan set up by an employer for the benefit of employees. It starts looking a lot more right, the employer is the same individual as the employee who is the same individual as the trustee. It starts looking and feeling a little like like an IRA. again, it still has a whole set of compliance rules that differ from IRAs, but it starts resembling an IRA and it can be very, very, very attractive to self-direct when it's a solo plan.
Ami Morgenstern: Yeah, so now we now that we understand the basic differences between these accounts, how like and what can you invest in as a with the IRA? Is there ever an investment that you cannot do with a self directed IRA or 401K? Is there anything that you shouldn't be able to do? And is there ever a time when doing a self directed retirement account just doesn't even make sense. You shouldn't be touching that.
Bernard Reisz: yeah, all great questions. So to answer the question as it was phrased, is there any investments that you're not allowed to do? the answer is yes, it's a very small list. and it also highlights the the the right and great perspective on this. The tax code does not give us a list. of retirement of investments that are allowed. There's a misconception out there that somehow like these accounts are like some sort of different type of retirement account. As if there's like section 408 of the tax code for IRAs that are not self-directed, and then we're gonna have like 408B for self-directed accounts. No. There is only one section tax code that talks about IRAs. There is only one section of tax code that talks about qualified retirement. I mean, they each have multiple sections that are that apply, particularly qualified plans have a whole basically 401 through almost most things
through 416 are all retirement account stuff. but Nowhere does it act ever specify what you can invest in, and this is not some sort of different, fundamentally different type of account. People will sometimes say, show me where I heard that this can't be true. I don't believe it. You know, my financial advisor says that if I invest my IRA in real estate, I'm going to jail. Show me, Bernard, I need you to show me where in the tax code it says that I can invest in IRA in real estate. And and the response is: can you show me where the tax code says that you can invest your IRA in stocks? Right? It doesn't say anywhere what you can invest in. What it has is a short list of things that you can't invest in. Everything else is okay. So on that list, what we have are we're talking life insurance, collectibles. you know that's really what we're looking at. It's a very short list, artwork, there's a very short list of things that you can't invest in. So life insurance, collectibles, You know, which is gonna have certain coins, certain precious metals. There are precious metals and coins that are allowed. so there are exceptions to the exceptions, to the exceptions, but it's really a very short list that you can't invest in. Everything else is totally okay. but the question is, what the what it does limit is not what you can't invest in. It is who can be a party to the transaction. So there's something called prohibited transactions. and I I'll share resources for all these things. I'll give you some links because education is really the most important thing. What this goes back to is what Congress is trying to avoid here. Congress created all these really attractive incentives to put money in these accounts, right? You can put $10,000 in this account, and in 30 years you might have $8 million here tax-free. We're giving you a lot of incentives here. Or maybe you're put ten thousand, you know, you put, depending on the account type, right? Or over years, you may put in hundreds of thousands of dollars or even millions of dollars to these accounts and get a tax deduction, right? Uncle Sam so to speak losing or deferring, right? There's a lot of money that Uncle Sam would love to get from you that they're not getting because you're putting money into these accounts. So there's a loss to the treasury, there's a big win to you, alright, but We wanna make sure you're actually using these incentives the way we want, right? So we want to incentivize you to put away money to grow long term. That's why Congress created these incentives. Congress is concerned that if there's some way for you to get some current benefit from these accounts, that you're not gonna use them the way it was intended. And you're getting these incentives that you don't deserve. Right? That they're getting shortchanged, Uncle Sam is not getting their money, and you're really using this account somehow to benefit you today at the expense of your future self. So, what they said is you cannot engage in self-dealing. Basically, any transaction that is not for the benefit and not for the purpose of growing the account. Is not allowed. And then they went ahead further. The IRS came to Congress and said, this is too vague. And IRS said we need to make some real clear guidelines around this. And what they got from Congress was that if you certain personal, familial, business. affiliates of yours are a party to a transaction with your IRA that is prohibited. Let's use a example that sounds egregious. Okay, so I'm gonna put money into my IRA. Alright, I put $200,000 into my IRA. By now I have I'm gonna now I go buy a building there, a million dollar building. Took out a loan, my IRA got a loan, I buy a bit a million dollar building, can I go live there? And the answer is no. Can I go live there if I pay rent? It's a good deal for my IRA. I'm the best tenant possible. I have a whole cleaning staff. I don't have any pets, no little kids running around. I'm the best tenant possible, and I'm gonna pay top dollar. Not allowed. Any transaction that involves you and your IRA. is automatically prohibited. And why is the go ahead.
Ami Morgenstern: Okay, and what about yeah, the d this just reminds me of the Peter Thiel situation which obviously had like most of his stock within his company in his retirement account. So like is that not considered like him being a party to that transaction?
Bernard Reisz: So that's a great question. the short answer, and I'll link, I did a whole thing a couple years ago about the Peter Thiel stuff. So Peter Thiel is a great lesson in a lot of different areas of taxation. And a lot of stuff we already spoke about. so if the IRS would have had full visibility into what Peter Thiel did at the time that he did it. and they were knowledgeable, you know, basically the IRS had perfect knowledge of what he did and of the tax code. There would have been room to challenge a lot of things that he did. Right? But by the time it made it onto anybody's radar, it was water under the bridge. It was too late for so did he do things that were gray, in my opinion? Absolutely. Did he do things that are potentially questionable? Absolutely. now this comes back to what I spoke about in terms of tax turkeys. Remember tax turkey? This is exact
Ami Morgenstern: That's what I was just thinking about.
Bernard Reisz: Right? Now, if somebody comes out there and says, Peter Thiel did it, sign up with me and let's do the same thing Peter Thiel did. No, Peter Thiel did it before most before any did it in the 90s, right? Where he was really innovating. He had smart tax people. He took a bit of a risk, but again, it wasn't all it was quiet, it was sharp, it was smart, it was calculated. Thirty years later, with the playbook being public knowledge, you have to be much more cautious. so yes, he definitely did stuff that we I would call aggressive. But he had smart people that were decades ahead of everybody else. so great question.
Ami Morgenstern: So
with with Peter Thiel's playbook right now, you would say he did some stuff that were very aggressive. Is there a way to actually yes do this and like do somewhat of what he did? Let's say maybe invest partly into your own company or put part of the stock of your own company into your self-directed IRA? Or if you're not a controlling partner, but you you know, you have a job there, let's say you have a position within the company, is that allowed? Is there any way for it to actually, you know, work?
Bernard Reisz: So the answer is yes. The answer is yes, but these kinds of scenarios need very careful analysis. We do have there are two things to be mindful of. One is that these rules are basically any time something is not for the exclusive benefit of the retirement account, it could potentially be characterized as a prohibited transaction. And the Department of Labor, who which basically there are these sets of rules under both tax law and ERISA law. ERISA law is labor law. and they're very similar rules under each. ERISA labor law is what will apply to a company plan. and typically the IRS and Department of Labor will not issue or any ruling that they issue on these types of questions, they'll always throw in like a qualifier that this depends on the facts and circumstances and no conclusion should be drawn because you could still have this other kind of prohibited transaction. But these kind of questions do get presented to the Department of Labor and we have rulings on scenarios where they Department of Labor said, Yeah, this is okay. and typically so long somebody's fact pattern fits that pattern that the labor that the Department of Labor ruled on, they are safe. The reality is these scenarios will very, very, very seldom will one scenario be identical to the other. So then it gets to be a question of okay, a very tricky legal question. you know, can somebody get comfortable with this? Can somebody you know, do they want to take the risk? Do they want to get an ERISA attorney that specializes in this you know, to get a legal opinion. But it is somewhat an exercise of dancing between the raindrops. What I will say is for the overwhelming majority of our clients, It's you know, most of them are doing things that don't get involved in this space at all. There's so much that you can do, right? Investing in other companies, investing in all sorts right investing in all sorts of real estate that there's no need to do this. Now, in scenarios where there is a need or a specific desire to dance between the raindrops, They have to make a choice. Are they ready to take a risk? Do they want to get a legal opinion? And getting the legal opinion for this kind of thing is very, very, very costly. and so usually you're gonna have very, very sophisticated taxpayers that are investing or substantial sums that are gonna go pursue, get that. legal opinion. but the factors that you mention are all at play, which is ownership, control, those are all factors that
play into this. And again, yes, if you really if I don't even know if I should share this with you, but I do have a whole repository of Department of Labor opinions on these kind of questions. But I don't think any of the audience is actually ever gonna want to read that stuff.
Ami Morgenstern: Yeah, no. So the next thing, is there ever in a ROTH or even in a regular I retirement account, is there ever a time when there is tax liability from those accounts?
Bernard Reisz: Yeah, amazing question. and just so I guess really for the audience, let's clarify what we're talking about with this question and what we're not talking about. When you distribute money from a traditional IRA, as mentioned at the beginning, when you take a distribution from a traditional IRA, there's typically going to be some amount of tax liability because the money is coming out pre-tax. When you distribute money from a ROTH IRA, that distribution will not generate tax liability. What Ami is asking about is within the account. Can the activities that go on within the account generate tax liability? And the short answer is to the surprise of many. Yes. Absolutely. And this is also a very, very misunderstood area of taxation. And again, it's because they're unfortunately there I've seen I've been in the space long enough to know that there are mistakes come in two flavors and they can be traced to two sources. One mistake is people not being aware of the tax at the potential for tax at all. The other one is thinking that this tax is way worse than it is. the truth is somewhere in the middle, as is usually the case. but we'll find people at the two ends of the spectrum. One is like, there's this tax thing with IRAs, I never want to do an IRA. IRAs are the w worst. and there are those that have no inkling of the fact that you can have that. so let's talk about what what can generate this. The concept here again is all of these things arose just like the prohibited transaction rules we spoke about. This also arose in response to abuse or the misuse of taxable incentives by tax-exempt entities. Incidentally, the prohibitive transaction rules actually have their root in charitable organizations. Right, which we know, right, f you know, charitable entities don't pay tax, you can get tax deductions for contributing. Again a whole other set of rules, right? But and basically those rules were kind of adopted for retirement accounts. Retirement accounts came later. And so likewise, prohibitive transaction rules, self-dealing rules started with charities. These rules, which we call you know, UBTI, unrelated business taxable income, also have their roots with charitable entities. There were two things that the main thing where it started with, I have a tax-free entity entity. Doesn't pay taxes. I have a great idea. I will have my tax-free entity. Now we have prohibited transaction rules, so I can't necessarily maybe I can't run my business in an IRA. Again, there's another there is a way
to do that, but that's top we're not gonna talk so-called Rob's conversation for another time. but the general rule is I can't have my business in an IRA. But okay, but IRA doesn't pay taxes, so I will have my IRA own my friend's business. And my friend will get a salary. But the business itself will never pay any taxes. and now your friend has a tire shop. Right? And when he does his this is for our accountants, bookkeepers here, he does his P&L and he does his, you know, he does his calculations to figure out his pricing and his forecasting. How much does he have to charge for a tire? Well, one of the biggest expenses he has to think about. his taxes. Right? Taxes are gonna have to be paid. So he builds in you know an a additional hundred dollars into the cost of in his sales price of every tire, because there's gonna be taxes. now the other guy whose other business owned by an IRA, right, they don't need to add that. So they can they they can basically sell tires for fifty dollars less than the other guy and still have a higher margin. So what will eventually happen if that was allowed?
Ami Morgenstern: Yeah, every business will be run through an IRA.
Bernard Reisz: Exactly. And every bus run through an IRA, and every business that was not run through an IRA would be bankrupt. You know, would be out business. Right? That's not what's supposed to happen here. So what we ended up with was, this is the actual story, the Mueller macaroni company was contributed to NYU. So the new NYU's endowment now owns the Mueller macaroni company and they're not paying any taxes. And they're selling pasta and they can basically they would have had a monopoly unless some other pasta company was contributed to a college endowment and can contribute on equal and can compete on equal footing. So we got the rules that said If you're engaged in an active trade or business on an ongoing basis, that income is taxable. So if you're a tax-exempt entity, you will have to pay taxes if you're engaged in active trade or business on an ongoing basis. This applies to IRAs, charal entities. That's one way it gets can get generated.
Ami Morgenstern: And and does that include only like the the corporate taxes or is that also on the individual, like the self employment tax or you know, any other individual income taxes?
Bernard Reisz: Yeah, so ironically you actually can't have corporate taxes. you we're going to way deeper than I figured we would go. so it's what this basically right you're not gonna it's what what this applies to Is income that gets passed through to the IRA. So let's say the IRA owns that so there's no self-employment tax, right? Because it's it's
Ami Morgenstern: Right.
Bernard Reisz: income to have self-employment. So there's no self-employment tax if the business has employees, obviously there's payroll taxes. but the income tax of income that flows through to the IRA is is taxable. That income is taxable in the hands of the IRA. but where does where does that applies only to disregarded entities and pass it to entities? So if it's a partnership, S-Corp, I would say S-Corp, but an IRA is not an eligible shareholder for an S-corp. So that's another thing maybe to touch upon. So it's not that S-Corps are disallowed for IRAs. It's that IRAs are disallowed for S-Corps, if that makes sense. so an S-corp it
Ami Morgenstern: They can be on payroll.
Bernard Reisz: and it's not that. Okay, an S Corp, it helps understand the chronology. We had corporations. Then Congress came up with this new thing called an S Corp, which is a small business corporation, and it gave it a pass-through tax regime. So basically Congress said you can be we're gonna create This new simplified streamlined type of corporate taxation. But if you want to have this, if you want to have it, you have limitations. You can't have more than a hundred owners. You can't have a foreign owner. You can't have a foreign shareholder. You cannot have different classes of stock with regards to rights to distributions. And you cannot have certain So you can't have foreign shareholder, limitation number on types of shareholders, number of shareholders, shareholder categories, and one of those is you can't have an IRA as a shareholder. So basically if you take an IRA in as a shareholder, the IRA is fine. But you just disqualify the S-corp election. so it's the S-Corp is gonna have a problem. It's not the IRA's problem. So, in contrast, let's say you an IRA is not as is you asked, like, what are the rules when an IRA can't invest in? Yes, it cannot invest in R. That's an IRA rule, limitations on IRA. In the IRA sections of the tax code, it doesn't say an IRA cannot invest in S-corps. Right? But
Ami Morgenstern: Got it, yeah.
Bernard Reisz: in the S-Corp rules, it says you can't have an IRA shareholder. So it can be a partnership. Now, if it's not a pass-through, so if it's a C Corp, this tax doesn't apply. So if an IRA owns shears in a C Corp, none of this tax applies. because what in a C Corp, the owner gets a dividend. They don't get passed through. so it's a blocker. wa but I'm gonna t I think we should change gears a little bit. We
Ami Morgenstern: Yeah.
Bernard Reisz: got it we got into like the total the deep end of the pool. what I what
Ami Morgenstern: Other side of things, yeah. So yeah, let's let's pull it back to real estate. if someone so so so someone puts buys real estate to it, is there ever a time when they have to pay is there ever a tax liability for them? on on the income I guess from the the real estate investment, like the rent income or something like that?
Bernard Reisz: Yeah, so the individual will not have the what you have on the real estate side which is very common, you can buy real estate with a loan. And an IRA can take a loan. Now this is where there's some nuance. The return on investment that is related to the loan. Is taxable to an IRA, in most cases not taxable to a 401k. This is very important to understand. Because
you have people thinking that if my IRA takes a loan, it disqualifies the IRA. Not true. An IRA can have a loan. You have people thinking that if an IRA takes a loan, all the income becomes taxable. That is not true. It is only the income attributable to the loan. So if your IRA puts down $250,000 on a property, gets a $750,000 loan, right? The loan piece, the income in that loan piece is potentially taxable.
Ami Morgenstern: So you mean the seven hundred and fifty thousand as you pay off the loan that
Bernard Reisz: No, no, as you have the loan, the potential tax liability goes down. But let's say there's income for the property. Right? So
Ami Morgenstern: Okay.
Bernard Reisz: 75% of the income could be taxable. But very
Ami Morgenstern: Garrett, okay.
Bernard Reisz: importantly, typically, because of depreciation, you don't actually have taxable income. Right? So you have cash flow, but you don't have taxable income. So just like An individual gets buys real estate, gets cash flow, doesn't pay taxes. The same holds true for an IRA.
Ami Morgenstern: Yeah, that that was going to be my next question, which is do you lose the the tax advantages like depreciation and call like cost segregation through an IRA? And then I guess is there any advantage even to 1031 exchange through an IRA, or because it's tax free, you're just going to there's no point.
Bernard Reisz: so we somehow we can't get away for the deep end. so here the answer
Ami Morgenstern: Yeah.
Bernard Reisz: these are good questions. it's here the thing to understand is the IRA is a separate Person in the eyes of the IRS. So if there's depreciation there, it does not flow through to the personal tax return. And then a general rule in taxation is that to the extent an activity generates tax-free income, it can it will not generate a deduction. Right? Again, and and that's that's logical. There's no income, if the if the activity doesn't generate taxable income, Then expenses of activity don't create taxable deductions. It's deductions related to something that could generate taxable income, then if you have expenses, we deduct it. But
Ami Morgenstern: Right.
Bernard Reisz: if the income is completely tax free, then there's no deduction. So to the extent an IRA is generating tax-free income, right, then there is no depreciation. Again, you have something better, right? The whole thing is exempt. But the minute there is this UDFI, you start getting the you get the benefit of deductions. so can you do a tender right portion?
Ami Morgenstern: Only related to that only related to that. It doesn't it doesn't flow through to your personal.
Bernard Reisz: Correct, because it's the own person. the other thing is is that in this context, theoretically, if you were gonna have UDFI, you can do a 1031 exchange in an IRA to avoid it. and 'cause that's tick and incidentally that's typically where it will come up is like okay, all the years that somebody owns the property, because of depreciation, there's
no taxable income. But now they're selling it for twice of what they bought it. Now suddenly it might be a capital gain. okay, you can do a 1031 exchange. Again, these are not common, but yes,
Ami Morgenstern: Right.
Bernard Reisz: it it does have an application.
Ami Morgenstern: Okay, and now is there ever a time when these accounts do not make sense? Well not is there, there definitely is. When is doesn't it make sense for someone to use the IRA for for investments? and when does it? Like who is a good fit for this and who isn't?
Bernard Reisz: So the the driving factor for using these accounts for private investments is it everything really starts from the economics. So if the premise, right, somebody has an investment that they say, hey, based on the risk-adjusted returns of this investment, I want my IRA invested in this. I want my IRA invested in this real estate deal. That is what drives the decision. And then in almost all situations where that applies, it makes sense. Assuming it's not a prohibited transaction. And it you know, then in almost all scenarios it will that's gonna be the way to go. Now where doesn't it make sense? sometimes an account balance is just too low. You can't do the investments that somebody wants to do. again, it varies. And then it also in some scenarios it gets to be a little more nuanced, which is okay, I have taxable money, and I have my IRA account, and I have this investment, I can fund from either one, where should I do it? There's no one size fits all response to that. So if you have two buckets available and you have an investment, where should you do it? So, you know, for people that say, hey, I I am in real estate, I have a real estate angle, I want everything in real estate, okay, it's still easy. Do everything in real estate, including the IRA. For those that have a mix of investments, then it gets to be a question we call asset matching. using each bucket, optimizing each bucket for the investment that fits it best. So I'll tell you where I say the no-brainer zone for retirement accounts is. The no-brainer spaces, something like hard money loans, where there's you somebody invests in hard money, merchant cash advance, things of that nature where there's high amount of income, tax at ordinary rates, With no deduction, there's no depreciation there. Use an IRA 401k, it is an incredible decision to use it in that context. That's very, very clear application. It is pure upside, that is incredibly valuable. Real estate gets to be a little tricky because then we have to know: okay, this guy. If he has the investment as his personal name, maybe he's gonna get a depreciation loss. But then you have to know, will that depreciation loss actually benefit him? Does he have other income to offset? Is it does he have is the depreciation loss gonna be passive or active to him? Is his other income active or active or passive? It gets to be a very, very you know,
Ami Morgenstern: Nuanced question.
Bernard Reisz: nuanced question based on every particular investor's profile.
Ami Morgenstern: Yeah, got it. And now that we summed up all all three services, what would you say it like the cost aggregation, the 1031 exchange and the self-directed retirement accounts? Do you find something that all three of them have in common? Like that one person would come to you for all three? Is are these three separate services? You just happen to know all of them. Like how's that work?
Bernard Reisz: So what ties them together is that is real estate. these are all you know now based on tax code, you know, 1031 exchange is basically restricted at this point to real estate. Cost segregation again, doesn't have to be real estate. The overwhelming majority of cases it relates to real estate. Again, that real estate could be purchased by a company that is primarily in real estate. It could be purchased by somebody that operates skilled nursing facilities, right? But they there's a huge asset component of that where they're buying the facilities. So they may have an opco and a propco, right? And so they're buying but it there's always a huge typically it's gonna be associated with real estate acquisitions, whether that's the primary activity of the business, or it's incidental to their operating business. self direct retirement accounts likewise can be used for just about anything, but The what they're most commonly used for is some angle of real estate, whether that be real estate lending, private money lending, hard money lending, or buying real estate or putting money into a syndicated deal, one form or another, that is definitely by far and away the most popular use of self-directed retirement accounts. now, is there somebody that uses all three? Absolutely, but You know, will there is there typically you're gonna find you know, the person that uses all three somebody that so to speak was born into real estate won't use the self-directed side directly themselves because they never have any taxable income, they're never looking for tax deductions, they have they've done cost segregations and 1031 exchanges, and they're never looking to put money into a retirement account because they're never paying taxes anyway. in contrast somebody that may have had a corporate job for a while, or a real estate agent that had active income, so they've accumulated some you know money in retirement accounts, they will use a self-directed side. Very often it's a passive investor that's using a self-directed retirement account, or somebody that maybe has a you know a job, successful job, they've accumulated funds there, and now they're able to buy a you know, a property in their retirement account. Will they come together? You know, obviously people that raise money for deals, right, can tap into retirement accounts, right? So have they have a potential investor. And he says, like put money in deal. And they're like, okay, you know, but all right, you can use your IRA money. That's a way to tap they so you can use it indirectly. And then it's the people that may have gotten into real estate after the first phase of their career. So they have a retirement account and now they're full-time real estate, those guys will use all three.
Ami Morgenstern: Got it. All right. Thank you so much for coming on and looking forward possibly to the next time to get deeper into the Ouija things for maybe we'll do a bonus episode for the the geeks as he called them. So thank you so much and looking forward to to our continued relationship. Thank you for coming on.
Bernard Reisz: Ami, a pleasure, always a pleasure, and looking forward to the next time whenever that is.
Ami Morgenstern: Yep, thank you. Thank you for listening to Conversations with Ami. If this conversation was helpful, take a moment to like, subscribe, or follow the show. It helps more people find it. New episodes drop on the 1st and 15th of each month. You'll find the links in the description to support today's guests and learn more about their work. Until next time.