Matt Lewis 0:04
I'm Matt Lewis, your host, and this is Wealth Bootcamp. We're a weekly program serving global entrepreneurs and cross border families. You know, entrepreneurs, they can be great at creating wealth, but not necessarily good at preserving it. Many are so busy building a business that they neglect their personal finances. It doesn't have to be that way. At Wealth Bootcamp, we'll show you how to build personal wealth alongside your growing business. We'll look at the unique risks and opportunities that entrepreneurs face in their financial lives. And we'll explore how you can immunize your lifestyle from the risks you bear in your business. I'm Matt Lewis, private wealth advisor to entrepreneurs and founder of Westbridge Wealth Management. You may already be building a successful business, but how about designing a successful life around the things value most. Sound good? This is the place to make it happen. Let's get started.
Approximately $10 trillion are held in individual retirement accounts, and of that about 1% are self directed. While self directed IRAs could still be considered a niche, the people who take advantage of them tend to be educated and affluent. In fact, the largest IRAs are self directed. We're talking 100 million dollars and up. And they're held by people with names you'll probably recognize: Mitt Romney, Peter Thiel, Max Levchin. Today we're going to get acquainted with self directed IRAs, their benefits, their risks, and the different kinds of people who are drawn to them. We'll be learning this and more from Mat Sorensen, the award winning author of the most popular book on the subject, the self directed IRA handbook.
Now if you're in front of your computer, or have a big screen on your smartphone. This might be a good time to check out the show notes for this episode at westridgewealth.com. This will give you a bird's eye view of the material we're covering. And if you see a particular part that piques your interest, you'll know just where to drop in to get that piece of information.
Now before we dive into today's episode, we have an important message to share with you: our disclaimer. Please be aware that the information provided in today's episode is for educational purposes only. Unfortunately, I haven't had the opportunity to get to know you. So I'm not in a position to give advice that will suit your particular needs. I do provide investment advice to my clients as a fiduciary at Westbridge Wealth Management. But there I'm able to tailor my advice to their unique circumstances. I encourage you to use Wealth Bootcamp as a learning platform. But please do bear in mind: this is education, not investment, legal or tax advice. And with that, let's return to our program.
Our special guest today is Mat Sorensen. I think of Mat as the guru of self directed IRAs. He's written what it considered the best book on the subject, the Self Directed IRA Handbook. He's a partner at KKOS lawyers, CEO of Directed IRA and Directed Trust Company. And he and his partner, Mark Kohler, co-host the Refresh Your Wealth Podcast. This is a podcast chock full of tax tips, legal advice, and some silly jokes. Matt, it's such a pleasure to have you on the show. Could you tell us a little bit about yourself and how you found the path to becoming an expert on self directed IRAs?
Mat Sorensen 3:49
Yeah, well, my pleasure. Thanks for having me on. We got two Matts here. Let's keep it straight, who's who. For us, it's easy, we just call the other guy Matt.
Matt Lewis 4:00
Yeah, it's confusing for everybody else.
Mat Sorensen 4:03
Okay. Right. Well, my background: so I'm CEO and founder of a company called Directed Trust Company and Directed IRA. You can find it at directedIRA.com. We're a custodian for IRAs, people who want to invest in alternative assets. Most of our clients are using a retirement account, like an IRA or even a 401k, Roth IRA to buy real estate, invest in a private company, private equity fund, a start up, -whatever, you know. They just don't want to buy a publicly traded stock or mutual fund. So we help them use the retirement account funds to do that. It's a little unique on how you do that. But before that, and and even a little bit still, I I've been a lawyer in this field since 2006. I wrote the #1 book in the industry called the Self Directed IRA Handbook. It's sold over 25,000 copies. All my competitors use it to train their employees
Matt Lewis 4:59
And it Is that how most people find you? That's how I found you on Amazon - looking for the right book.
Mat Sorensen 5:04
Yeah, you know, and to your other question, it is what I'm known for. And I spend years writing it, because in this field, there's so much garbage out there, quite honestly. I mean, I hate to say it, but there's a lot of hype. And there's a lot of people, you know, speaking at a Holiday Inn on the weekend about how you can do this with your IRA, you know, and....
Matt Lewis 5:26
That's one of our sponsors, by the way. So.
Mat Sorensen 5:28
I wasn't sure if that was a plug for them or... They're not going to appreciate that. Well, so and your other question was how I got into this, which, and it was really why I wrote the book. I mean, this this story ties together is in 2006, I had a real estate developer client, very successful. And we kind of been working with them and doing 1031 (exchanges), you know, he's doing all the typical tax strategies and planning 1031 exchanges where he could, and we're doing a lot of tax planning on how to do real estate development and minimize taxes and such like tha. But over time, he was like: "I want to use a Roth IRA to go buy real estate." And so he wanted to do an option contract deal. And he had a piece of property that he could get for, you know, $400,000, approximately. But he knew that this property was going to be worth over 1 million within three years, because it was freeway commercial property. That was, sorry, agricultural property, but there was a freeway exit being planned. So it's going to turn into freeway commercial later. So he goes to the landowner. He says, "Hey, I'll buy this property from you for 450 grand. I'm not gonna buy it now. But I want an option to be able to do that in the next three years. I'll give you 10,000 bucks now, but for three years, you got to give me the option to buy it for 50K. The landowner is like" "It's worth 250K. Now, frankly... Sure, you're crazy." And now he did this with his Roth IRA though, so his Roth IRA got the option. It gave him, the landowner, the 10,000 bucks. And sure enough their freeway exit comes in. And this property goes from agricultural to freeway commercial. And it's worth over one and a half million now. Now he's got the right to buy it for 400K.
Matt Lewis 7:12
Can I jump in with a question? Yeah. So what was his balance in that Roth? IRA when he started these discussions? It was, I mean, he barely had 10K. Well, and he had to pay what 400,000? That was the option.
Mat Sorensen 7:29
Correct. If he was going to exercise the option. Well, what he's going to do is... He doesn't want to buy it. He sells the option.
Matt Lewis 7:36
Oh, beautiful, beautiful.
Mat Sorensen 7:38
option to another developer. That's fantastic. I love it. So he sells it for over a million dollars and gets that million dollar gain back into his Roth IRA. And so it was it was a great deal. And then for this client, it was interesting, because for me, I was like: "Well, that was cool. And I kind of saw this happen over a few years, and I'd been working with other clients on self directed type stuff. But when this one came through, I was like: "That was really cool!" And this client, he was he was a good guy. I got to know him very well. He's got a very large account now, and I still work with him. But he was really pissed off, quite honestly, with all the other financial advisors, the accountants, the lawyers, everything. He made a lot of money. He had the top people, he wasn't like, you know, using some people didn't know their stuff. But he was like: "These people know my stuff. They know how I make money. They know that I'm great at real estate, and then I have so much opportunity, but no one told me I could use my retirement account to invest in real estate!"
Matt Lewis 8:40
Mat Sorensen 8:40
So for him, it was this kind of big eye-opening thing of: "Wow, I can invest in what I know and what I'm good at. And I can use even a Roth IRA, which is the only way to make money tax free left in America." ....and I loved it too. And I was like, man, this is great and, but there's no one who was really good at it.
Matt Lewis 8:58
Well, that option, that option is brilliant. That's that's a great mechanism to get that uplift.
Mat Sorensen 9:05
Yeah, and not everybody can do that, you know, but for those that have those opportunities, and, you know, this is a guy that sees 100 deals a year, and so he can find one and be like: "Oh, I could just do an option on that with my Roth IRA." So, right. So that was the impetus to the book. I decided, I just got to be an expert in this. There's no one else is really doing it. They're doing a good job about it. So I'm just going to be the expert and write the book.
Matt Lewis 9:28
That's great. And what were you doing up to that point?
Mat Sorensen 9:30
So I just did a lot of business and tax planning, a lot of real estate work. That type of stuff.
Matt Lewis 9:36
Great, great. Now, in the beginning, you mentioned that your clients want to invest in real estate or precious metals or private company shares. Is it is it a strange subset of people who are turned off by public markets all together?
Mat Sorensen 9:57
Yeah, you know, it's kind of three categories of people. It's like the client I just gave the example of. He was one that kind of just is an expert in something, and when he looks at the stock market, or the typical stuff people buy with their retirement account, he's like: "Man, I have no idea. I don't know!" But he knows he's good at something. And he's like: "Why am I not putting my money into what I'm good at?" So there's that category people. And those, frankly, are the best clients, those clients always do the best and have the best accounts. The other subset of them is just clients and that's just where all their money is. You know what I mean? A lot of Americans now, you know, it's like, well, do you have $200,000 to invest into something? Nope, I have like $10,000 in my savings account, but I got $500,000 in my IRA or 401k. And so there's a lot of people and that's just where their money's at, and as alternative investments and become more and more popular, and the information on them is becoming more and more available. And so that's just where their money is. And they're just running into, you know, a startup company or a real estate deal or some opportunity where they want to just use where their money is, you know. And then the last group is the people that just think that Wall Street's crooked, and they're gonna screw 'em. And they just, you know, they want to...
Matt Lewis 11:16
People who are buying gold.
Mat Sorensen 11:17
Yeah, they'll buy gold or even real estate. They just want hard assets, you know, right? And so, um, but we help them all I mean, My expertise is in not what to invest in, but if you know what you want to invest in, I just know the technical rules, and we have the capability to do it with a retirement account.
Matt Lewis 11:35
For most people who are interested in using self directed IRAs, is it difficult for them to get the balance up to a reasonable level if they can't use options like that first client you mentioned? As the contribution limits are just what? $6000 a year?
Mat Sorensen 11:50
Yeah. Now laws have changed from that client since, because you can convert now, you know, I think in 2009 or 2010, 2011, somewhere in there. You're able to convert. So anybody can convert. Even if you're high-income, if you have traditional IRA dollars or an old 401k, you know, you can convert that to Roth dollars. And not everyone goes Roth, but you can always convert to Roth. But most people who self direct are kind of the baby boomer generation, or they're in their 40s or 50s. They've been saving in retirement accounts for years. They just want to do something different. So the money's already there. They just need to get it from Charles Schwab or, or wherever they're at right now over to someone like us, like Directed IRA. That's really what a self directed IRA is, by the way. It's just your IRAs with a custodian who's going to let you buy whatever you want. As long as it fits the rules, you can buy an investment allowed by law. But most self directed, people aren't starting from zero. They're using an old retirement account. They've been doing stocks or mutual funds, but just want to do something different.
Matt Lewis 13:01
Welcome to the Wealthy and Wise segment of today's show - where we share with you a tip related to today's subject. In this episode, we've been talking about self directed IRAs. So I thought it would be helpful to give you an overview of what's known as the Backdoor Roth IRA. This is a mechanism that allows high income earners an indirect way into the Roth.
Your biggest expense in life is taxes. Roth IRAs can be a wonderful way to shield yourself from taxes and really build wealth. If you follow the rules, the dollars in a Roth IRA are never taxed again, not taxed on the investment earnings and not even when you take the money out. Sadly, many high income earners mistakenly believe that they are shut off from Roth IRAs on account of income limits. While it may be true that you can earn too much to qualify for a direct Roth IRA contribution, you could always use what's become known as the backdoor - by taking advantage of a process known as a Backdoor Roth IRA. The Backdoor Roth became a reality in 2010 when income limits on IRA conversions were lifted. In a nutshell, this is a process, a one-two process, of opening a traditional non-deductible IRA and then converting it to a Roth IRA. However, there is sometimes a catch that comes into play and takes people off guard. It's called the Pro Rata Rule. When a traditional IRA is converted into a Roth, the IRS runs a calculation to determine how much of the converted amount will be considered pre tax and how much post tax. In this calculation the IRS treats all your traditional IRAs as one big IRA account. Here's a formula to figure out how much of the amount destined for your Roth IRA will end up as taxable income on your tax return. You take the pre tax money in all your traditional IRAs, you divide it by the total value of those IRAs. Once you have this ratio, you use it and multiply it against the amount you're trying to bring into your Roth IRA through the backdoor. This will give you the pre tax contribution now exposed to tax. I know it can be hard to follow a formula on a podcast so please go to westridgewealth.com. Look up the article on backdoor Roth IRAs. There you'll find a formula and a cheat sheet that helps you visualize the whole process.
If you'd really like to avoid the consequences of the Pro Rata Rule, there may be a workaround available. That's because the IRS doesn't apply the Pro Rata Rule to balances in employer plans such as a 401(k) 403(b) or solo 401k. If you have such a company retirement plan available to you, check to see whether roll-ins of IRA funds are allowed. If the answer is 'yes', and the company retirement plan is of sufficient quality, you could roll all your IRA funds into your your company retirement plan and complete your backdoor Roth IRA without increasing your taxable income. Again, go to westbridgewealth.com. You're going to find a really helpful cheat sheet on this process. Alright, everybody, that concludes our Wealthy & Wise tip for this week. And now back to our main attraction, the interview with Mat Sorensen.
Matt Lewis 16:25
I was looking into some of the custodians that that run self directed IRAs. And I don't know what the reason is, but there seems to be quite a few complaints. Maybe there's just some really vocal people who don't understand the requirements and they get into trouble. But it seems like it takes some time. You give instructions to the custodian, and then you have to wait for them to come back and approve them. And there are some people who are switching custodians and, frankly, I don't know which which ones are the good ones?
Mat Sorensen 16:56
Yeah. Yeah, it's a tricky.You know, a lot of people have gotten used to: "Hey, I got my brokerage account, I just click a couple buttons online and I just bought, you know, $300,000 worth of XYZ stock!" You can't do an alternative asset purchase like that. Whether you're investing in a private equity fund or a real estate deal, there are going to be documents. It's going to go through compliance, you're gonna have to sign off on stuff. And so it's a little different process. I think so some people's expectations are a little, you know, they're just not used to that. And that's just a structural issue. But the other thing is, honestly, a lot of our competitors suck.
Matt Lewis 17:42
Are you a custodian yourself?
Mat Sorensen 17:43
Yeah. So we are a custodian for IRAs, you know, and Directed Trust Company, that's our Trust Company. And, you know, my Trust Company, I'm CEO of... We custody IRA accounts. And so when you go look us up and see our reviews it, you know, just Google Directed IRA / Directed Trust Company, But we care. I self direct myself, you know. And so I do this and I and a lot to a lot of people. I mean, you should go to someone who does this themselves, they can appreciate the process. But I've also been on the side advocating for clients for 12-14 years before we did it, where I try figured out why these companies do it that way. And we're just trying to be smart about it. And we have the expertise here to to make sure it's done right. So, but yeah, there it is. I hear you on that point. There is a lot of dissatisfaction with it. I think for a number of reasons, like I mentioned, but the other thing I'll say on it, too, is self directing, where I tell clients and some people get overwhelmed by it. Some people are like: "Man, this seems so complicated. Mat tells me all these rules I gotta follow. Seems way more complicated than just investing in a mutual fund or stock." Yeah, it is. But I tell people it's like learning a new board game. A lot of people, you know, they just start moving pieces on the board, rolling the dice, they don't know what the heck they're doing. They're going to screw it up.
Matt Lewis 19:07
Well, you, as the custodian, are going to prevent that.
Mat Sorensen 19:10
Matt Lewis 19:11
No, I'm going to put you down the right channel. But in the end, I don't know what you're doing. You know, I know pieces of it, what documents I see, but I don't know what your plan is. And, and so what we tell clients is self directing your IRA is like learning a new board game. You've got to...
I didn't mean choosing investments. I meant, if I'm your client, and I send you an agreement, I want to buy shares in a private company. You have to look through that and make sure it's in accordance with the laws and I'm not, you know, making any violations. Isn't that the way it works? You would review the contract and say, "This looks all right".
Mat Sorensen 19:51
Matt Lewis 19:51
Mat Sorensen 19:52
Yeah, because the custodian's role in the self directed world is... I mean, I'm going to look at the document, make sure you put the names on it, right, you know?
Matt Lewis 20:02
Spell my name correctly?
Mat Sorensen 20:02
Yeah, and the, you know, your accounts listed properly and stuff, but we're not reviewing those documents in terms of was this, you know, company raising the money doing it right. So that's not our role. There's no way charging 350 bucks and account, you know, we could do that. And we're just a trust company, too. I don't have the ability to give people advice on that and say, you know, this is a problem, these documents are not sufficient. And I see that all the time, as a lawyer, you know. So if clients want that, they can come to the law firm and get that advice, but they pay more for it. If you just want your account, and you want the custodian process to your investments. It's kind of like, when you're self directing, it's like you're a captain of the ship, but you need to know what you're doing. And so, that's for good and bad. And people love that. They love being captain of their own ship, seeking out professionals, advisors, attorneys, accountants as needed. But some People just go it alone. And they can do fine, they can fail, but it's on them really. So that's kind of how the self directed world works. So you got to learn the rules, it's really down to the client, themselves, the account owner. And otherwise, given the board game analogy, is, as I tried to tell you. It's not hard. Playing a board game is not hard. It's just new. When you play it the first couple times, you don't know what you're doing. So you play with someone, you know, who knows the rules, or you read the rulebook. And so they can read my book, if they don't know someone, or do it with some other investor or an attorney or some other professional that knows how to do these types of deals, instruction with an IRA. But once someone has done it a couple of times, most self directed investors just keep doing the same type of stuff over and over again. And, you know, they're they're kind of investing in what they're good at. So, you're doing the same things over and over. The rules are the same. It's not hard.
Matt Lewis 21:57
Yeah. The perception of self directed IRA's is that they're very exotic, and there's an element of danger. I think the the large custodians, the wire houses, the big banks, they make those suggestions. And after reading your book and listening to a few episodes of your podcast, I'm much more comfortable with the idea of self directing IRAs.
Mat Sorensen 22:21
Yeah, and it's not for everyone, too. I'll say that. You know, it's not like everyone should self direct. Some people will be like: "Hey, I heard about self directing. I want to do it." I'm like, Okay, well, what do you want to invest in? Well, I don't know. Well, you're not ready then!
Matt Lewis 22:22
Yeah. Why are you interested at all if you don't know what you're going to buy?
Mat Sorensen 22:41
Right. And so, you have to have the right investment, because, you know, the account's not going to get you anywhere. You got to put something in it. But it is (a good fit) for a lot of people, and there's a lot more people out there that should be utilizing it. They just don't know about it. I mean, I can't tell you the very high level people in the investment world that I run across that have very large accounts and they're like: "I didn't know I could do this, how come no one's told me about this?" I'm like: "You've been able to do it for 30 years. It's just that you finally stumbled into it." And so, it's a great fit for for many people, but not for everyone.
Matt Lewis 23:15
And it's not really anything special, right? It's just a typical IRA. It's just the custodian will accept these other assets.
Mat Sorensen 23:25
Exactly. If you're at a Fidelity or a Merrill Lynch, wherever, and you say: "Hey, I want to buy a real estate deal, or I want to invest in a private equity fund or invest in this startup." You know, common self directed things. They'll say you can't do it. And it's not because an IRA can't own those assets. It's because those custodians don't want to do it, you know, it's a pain in their butt. Now, if you're an ultra high net worth client of some of those places, they'll do it for you and they have departments for it, actually. But most people are not ultra networth that are so directing. And so you're not you're not able to do it. So you gotta move your account to a self directed custodian. There's about 30 of them out there in the industry. Ours, of course, directed IRA.
Matt Lewis 24:10
There are (just) 30 in the entire country.?
Mat Sorensen 24:13
30 self directed IRA custodians.
Matt Lewis 24:16
Wow. Doesn't seem like very, very many at all.
Mat Sorensen 24:20
They're out there. You only need to know one: directira.com. That's it.
Matt Lewis 24:24
Ha-ha. Ok, when people get into trouble, how typically does that happen? And what should one try to avoid?
Mat Sorensen 24:35
There are really two main rules people need to know when they self direct an IRA. So when someone's new to this, they gotta understand two new rules. And these are out of the tax code, so bear with me. I want to make it simple. The first one is called Prohibited Transaction Rules. And that's a rule that Congress created, basically, to say, hey, retirement accounts are special accounts - they're tax favored accounts. So we don't want to let you just transact that account with anybody, like the IRS is concerned if Mat Sorensen is transacting and buying and selling assets between Mat Sorensen himself personally and Mat Sorensen's IRA. So they're like, no, Mat Sorensen, you can't sell property from yourself to your own IRA. We don't know what value you're going do is going to be right. You might be doing it to avoid taxes, personally. So you can't transact with yourself.
Matt Lewis 25:28
They should be arm's length transactions, then. Is that the idea?
Mat Sorensen 25:33
Exactly, so you can't transact with yourself. You can't transact with your spouse, your kids, your parents, but other third parties, you know, like Mat Sorensen's IRA could transact with Matthew Lewis, that's fine. You know, you want to sell me an investment or, you know, sell me, well, I don't know whatever I'm interested in buying with my IRA, I can transact with you. So it's not a restriction on really what you can buy without an IRA in terms of the asset type. It's who the account transacts with - like, who's on the other end of the transaction with my IRA. That's what that rule is focused on. And really just can't be with yourself, you know, or your spouse, kids, parents.
Matt Lewis 26:15
It's unfortunate they call it prohibited transactions, because that seems to be a misnomer. It's really prohibited parties.
Mat Sorensen 26:22
Exactly.Yeah. Really. And they technically call that 'disqualified persons'. That's what the word is that they use in the code. This is Section 4975. It's in the Internal Revenue Code. It's my favorite section, but, it's very confusing.
Matt Lewis 26:39
At the core of it, it's pretty straightforward. It should be an arm's length transaction. It shouldn't be (with) your spouse or your parents or your kids, you know? (duh)
Mat Sorensen 26:49
Yeah. And I think it's just logical. It's easy to understand why the IRS would want that. So just stay away from those close family members. Okay, so the second rule you have to know... And by the way, if you had a prohibited transaction, you lose your account. So if I have a million dollar account, and I have a $5,000 prohibited transaction, the consequence is distribution of the whole account. So the whole thing is distributed, I'll get a 1099-R or if I'm under 59 I pay at 10%. early withdrawal penalty. So it's it's a very severe consequence.
Matt Lewis 27:25
That's draconian. Okay, just a piggyback question there. Would it make sense to open up a number of self directed IRAs. If you make a mistake, you don't want the whole thing to go up in smoke.
Mat Sorensen 27:37
Great question. Usually what we do... Every once in a while we'll have a client where I'm consulting them (and this is me as a lawyer, now). I'm consulting a client, and they've kind of got a transaction that's in a gray area. It's like: "I don 't know. That could be prohibited. There's kind of cases going both ways. And what we'll do in that scenario is, say, open up a separate IRA for that deal. That way if it does go bad, it's only that account that's affected. All your other stuff you're doing is all clean. And you know, you don't have to worry about being affected by the previous transaction. But yes, that's a good strategy and a lot of people with large accounts. I mean, I've clients with nine figure IRA Roth IRA accounts. You know, so the lot of them are definitely using multiple accounts.
Matt Lewis 28:23
That's amazing that they reach that kind of level in a Roth IRA.
Mat Sorensen 28:28
Yeah, 10s of millions. There's a lot more of those. And in fact, the GAO (General Accounting Office) did a report on self directed IRAs. They did a report on what they called mega IRAs, and one on self directed IRAs. I helped out this consultant on multiple times on the self directed IRA report, but they found that in the largest accounts people are self directing. And that, you know, shouldn't surprise people. You're not going to get a very really large account by buying mutual funds. But the easiest example is Peter Thiel, who was one of the first outside investors in Facebook, and he did it with his Roth IRA. Reportedly, his Roth IRA is worth a billion dollars now.
Matt Lewis 29:10
Are you serious? And Max Levchin is in company with him as well. So the PayPal mafia that apparently knows something. That's impressive!
Mat Sorensen 29:19
So, they're investing what they know. And he knows tech and startups, and that's, that's what he did and saw the opportunity and - "Why not do it in my Roth IRA and I can have all the money come out tax free?"
Matt Lewis 29:31
do you do you know, the breakdown of industries? Among the super sized IRA holders? Is it mostly private shares? Is it real estate? Is it private equity?
Mat Sorensen 29:42
I would say it's a little bit of both, but most of its going to be private shares - more on the venture capital side. And then real estate. A lot of my clients who have really big accounts are real estate people. So, definitely those two. The venture capital world has gotten hold of the self directed IRAs faster than the private equity world seems to. Private equity is coming around to it and other smaller private equity funds. They use the accounts just to raise money, you know? they're just using it to get an LP or, you know, just to get bring in investors.
Matt Lewis 30:24
The use of an option is in your first examples is just such a great mechanism.
Mat Sorensen 30:30
Yeah, that was a classic one that really anybody with a small account could do if you have the deals right. You gotta have the deal flow.
Matt Lewis 30:37
Right. You gotta source them.
Mat Sorensen 30:41
Okay, I did get distracted on the second rule though. So the to the second thing you got to know is that there's a tax called a UBIT or UBTI (Unrelated Business Taxable Income). And this one's. Oh, man. I always try to be like: "This is the tax world. Bear with me!"
Matt Lewis 31:02
I'm going to take a swig of coffe before you start.
Mat Sorensen 31:05
Okay, hear me out on this. The easiest way to understand UBIT is ... this is a tax Congress created. It actually first got created for nonprofits. And so, the famous case was NYU, a university, operating as a nonprofit. They were opening up restaurants and other these other things. The restaurant community in New York got upset, and were like: "Hey, that's not fair!" They're a nonprofit. They're not paying tax. I'm a restaurant across the street, and I have to pay tax on my restaurant. So Congress said, "You know what, you're right. We need to create a tax so we can tax them." And so what they did, they created this tax called UBIT (Unrelated Business Income Tax) or (Unrelated Business Tax on Income) UBTI. And they said this tax applies to a nonprofit, that is going outside of their purpose to create revenue, like a restaurant. It has nothing to do with being a university. So they're going to tax the profit that NYU makes on on the restaurant. Now, so that was how that law got created. Now when retirement plans came along, they applied the law in the same way and said: "All right, retirement plans are used to create investment income. So as long as you get investment income into your IRA, you don't pay tax on it, right?" You make money in your IRA, and people are used to, you know, I, I get dividends in my IRA, or I sell stock for profit, my IRA, I don't pay tax, because that's all investment income. But if you get business income in an IRA, the IRS wants you to pay tax on it. And this task is called UBTI or UBIT tax. And so, business income from an IRA, the easiest example would be, let's say your IRA was invested in a startup that was just an LLC, they didn't pay corporate tax, so they weren't paying dividends. You're just getting a K-1 for your share of the profit, and the company didn't pay tax on it. The IRA would have to pay this UBIT tax on the profits.
Matt Lewis 33:00
Luckily, most venture capital deals or startup deals would have a C-Corp.
Mat Sorensen 33:05
And there are many reasons why: this is one of them. Because pension plans run into the same issue as IRAs that the UBIT tax applies in the same way. But you do see a lot of IRAs invest in startups that are LLCs, not taxed as C-Corps. And so they will, they will run into this tax. And there's a whole chapter in my book, and there's ways to get around it - things called blocker corporations and other planning that it's a little too deep for this discussion. But that's the one tax you want to look out for. It's a tax called UBIT or UBTI. Now, there's one other variation of it. The first is I again, I just have business income, right? But okay, that's the first variation of you.
The second variation of it - is there's a tax, there's a part of it called UDFI. And that applies in the real estate context, generally for IRAs, when I use my IRA to buy real estate and I get a loan. What happens there is, like, the IRA says, "Hey". Let's say I bought a $500,000 property with my IRA. 250 grand was the IRAs cash, the other 250 Grand i got a loan from a bank on it, which by the way the loan has to be what's called non-recourse, because I can't guarantee a loan from my IRA (that's another side point). But let's say I get this loan. Buy 500,000 dollar property - half the money came from the IRA, half the money came from the bank on a loan. Well, to the IRS, they're like, well, half of this profit you're making now is not IRA money. Half of this profit is really attributable to the loan. So you have to pay tax on half the profits. We know 50% of this deal is your IRA, so you don't have to pay tax on the money you're making from that - whether it's the rental income cash flow or the gain when you sell it. So that tax, UDFI, will apply when you bring in debt to leverage an acquisition and investment, like real properties, the most common for IRAs. Now, of course, if you're buying real estate without loans, you don't need to worry about it. But any debt you bring on with an IRA will be subject to this this version of UBIT called UDFI.
Matt Lewis 35:06
Are there some clever structuring mechanisms to to get around this.
Mat Sorensen 35:10
Absolutely. Absolutely, we got a lot of good ideas on that. But yeah, there's always a way to try and bring in money so it's not debt: bring a JV partner instead, if you kind of work with private lenders, turn them into JV partners, so its equity as opposed to debt. Also, 401k plans are exempt from this tax called UDFI. Sometimes you can use a 401k count or maybe a Solo K, that's another version that's self directed. There's lots of ways around it, not around it, but there's sometimes a solution to minimize or get out of it entirely.
Matt Lewis 35:44
Yeah. Is there anything like a solo 401k with a with a Roth flavor to it? .
Mat Sorensen 35:51
Yes, you can have a solo 401k with a Roth account, and we do those here. You know, we set them up in the law firm actually. But, yeah, a "Solo (k)" is cool. It's basically a 401(K) plan for someone who's self employed, where you don't have any employees, it's just yourself or maybe you have a partner or spouse. You can do a "Solo K" and it's basically a 401k plan that's supercharged, because you're the only employee - so you make it as generous as possible. You can have Roth dollars in the Solo 401(K).
Matt Lewis 36:20
Does it have the same contribution limits from the employer and the employee as the typical Solo 401 (k)?
Mat Sorensen 36:26
Yeah, it does. Right
Matt Lewis 36:27
Oh, fantastic. Yeah, that's good stuff.
Mat Sorensen 36:30
Matt Lewis 36:32
Well, let me let me ask you a question that I think will be of interest to our audience with regard to acquiring shares in private companies. A lot of people out there are asked to be advisors to a startup. They're providing their labor in return. They're receiving shares. Is that a no-no, for a self directed IRA. How does it need to be structured?
Mat Sorensen 36:59
Yeah, that is a no-no, unfortunately. Because, you know.... I'm okay with you being an advisor or maybe even a board member and your IRA getting shares in the company, but your IRAs get shares in the company's because it invest its money into the company. Okay? The idea is to buy the shares like any other investor. So if you're getting an allocation of shares in the company for being an advisor or maybe on the board for your work, your IRA can't get those. I mean, you can get those personally but your IRA can't get it because your IRA didn't do anything for it, you know? All retirement accounts can do is invest their cash. But maybe you get in on some early rounds with the IRA and you buy some shares that way, and you get some shares for being on the board. I could be okay with that.
Matt Lewis 37:49
So it the litmus test.... So you need to buy the shares. And if it's a market transaction, then the price of the shares should be equal to what everybody else is paying in that particular round.
Mat Sorensen 38:03
Right? Yeah, you can't get any special treatment just because you're on the board or an advisor or even an executive. The IRA can't get a benefit from you, you know what I mean? I mean, it can get a benefit from from you in finding the good deal and deciding to make the good investment and getting the opportunity, but it can't get a special price. It's got to be what other people are paying for it.
Matt Lewis 38:25
Hmm. Okay, that makes good sense. And do you have many clients from Silicon Valley?
Mat Sorensen 38:32
Oh, yeah, absolutely.
Matt Lewis 38:35
And you're based, where was it? Arizona?
Mat Sorensen 38:38
Yeah. So I'm in Phoenix. And that's where Directed Trust Company is. We're an Arizona Trust Company, regulataed by the Banking Department here (now called the Arizona Department of Financial Institutions), but we do accounts nationwide. And as for our law firm, we have an office in California in Irvine in Southern California. But yeah, I'm in Phoenix. The Phoenix office.
Matt Lewis 38:56
Okay, and I imagine then, being in Phoenix, you have a lot of real estate investors, because that seems to be a market that's attracting a lot of attention lately.
Mat Sorensen 39:05
Yeah, for local clients. I mean, most of my clients aren't here. Quite honestly, I live here and we certainly have a lot of Arizona clients, but we probably got more clients in California than anywhere else just because of the population. So our clients are all over the place. People come to us for our expertise more than locale.
Matt Lewis 39:25
So you're reaching them through your your book, your podcasts, your YouTube channels. What else are you doing? You seem to be everywhere.
Mat Sorensen 39:33
I speak quite a bit. Like, next week I'm speaking at Wealth Council in Boston, which is a conference with about eight hundred lawyers in the estate planning field, and I'm, just teaching about self directed IRAs. So I'm kind of a one trick pony. I'm really good at one thing: Self Directed IRAs. I try and stay in that lane. I like being the expert in that. And I just go around the country and speak. Usually twice a month I'm speaking somewhere at some event.
Matt Lewis 39:59
That's great. And and your co-host on your podcast. Wealth Refresh?
Mat Sorensen 40:05
Refresh your Wealth. It's on iTunes everywhere else, but, yeah, my partner's Mark J. Kohler. He's an attorney and CPA. He's on TV quite a bit for tax commentary. He's an author. He's the tax legal contributor for Entrepreneur Magazine. He's out there more than I am actually.
Matt Lewis 40:24
Nice. You guys have a good time. I enjoyed listening. You're a bit irreverent sometimes.
Mat Sorensen 40:32
You got to, man. Talking tax legal topics, you gotta try a little bit.
Matt Lewis 40:40
Somebody a musician, is it you?
Mat Sorensen 40:41
Yes, right. Yeah.
Matt Lewis 40:43
You have a guitar riff.
Mat Sorensen 40:44
Yeah, it's not me though. You know, we bought that little jingle, which we need to change. It's a little dated, I think but, yeah, I played in a classic rock cover band for a while. I had a band in high school, you know? But it's fun... I'm not in a band right now. I'm searching. I'm searching.
Matt Lewis 41:05
What bands were you covering?
Mat Sorensen 41:07
So in the classic rock cover band, we did a lot of Fleetwood Mac, the Eagles. But then we did a lot of at 80's stuff, like, In Excess... '
Matt Lewis 41:14
You strike me as younger, actually.
Mat Sorensen 41:16
I was the youngest guy in the band, actually. So, I'm 39 though.
Matt Lewis 41:20
Your parents' music, okay.
Mat Sorensen 41:22
Yeah, no, it's the other guys in the band. They're just, they're just like about five to 10 years older than me. It's kind of more their generation of music, but I like I love classic rock. I mean, psh.
Matt Lewis 41:31
That was a great period for music.
Mat Sorensen 41:32
Yeah, a lot of great music. We played all that 80's stuff and now
Matt Lewis 41:37
Excellent. Well, great stuff here. I learned a lot and right out of the gates hearing about that option. Wow, that's fantastic. That's predominantly used in real estate. Do you ever see that used in, in in private shares?
Mat Sorensen 41:54
Conceivably, you could in private shares, but I don't see it. We see it more in real estate, at least in our accounts. Clients I'm working with. But there's, I mean, man, there's so many cool things that clients are doing and being successful at. I'll say the one thing is, is if someone's going to self direct and someone's thinking, oh, I've never heard of this, this sounds interesting is...
Matt Lewis 42:19
I'm definitely going to self direct. Yeah,
Mat Sorensen 42:21
Just think of what, like, what do you want to invest into? And don't think of your IRA as having to buy stocks, bonds and mutual funds. Just think of .... the next thing I want to invest into might be a startup, it might be a private equity fund, it might be, I don't know, you know, whatever, someone's into .... maybe they're good at real estate, or they're learning about real estate... or that's where they've had most success in their investment portfolios, real estate, you know, and so, just look to what you're good at and what you like and, and that's where you should be putting your money in my mind. That's where we see clients have the most success self directing - it's investing in what they know.
Matt Lewis 42:57
Oh, I should ask you one more thing. With regard to real estate, if you use the real estate or you're providing any service to that real estate if you touch it in any way as an individual, that gets you into trouble, right?
Mat Sorensen 43:09
Yeah. Good point. Yeah, it needs to be investment real estate. It's not real estate you're buying for yourself. Yeah.
Matt Lewis 43:18
That's, that scares me actually, you know, I could see myself inadvertently getting involved with the real estate and then having a problem.
Mat Sorensen 43:24
Well, we've had a lot of clients buy Airbnbs with their self directed IRAs, you know, like: "Hey, no one's using it this week. Can I go stay at it?" "No! It's your IRA's. It's not yours!" So usually the property and even repairs, you know, I don't want you repairing the property, or you know, putting on the tool belt and remodeling the kitchen. There are restrictions on that in the code. So what you can do is administrative and investment oversight tasks. You can check on things, you can even do the tenants and screenings and all that stuff. You know, that's cool, the paperwork, receive the money, pay the bills, that's all fine and dandy.
A lot of people use what's called an IRA LLC, too. Where, just briefly, their IRA owns an LLC. And their LLC has a bank account, and they can manage that bank account as the manager of the LLC. And then the LLC owns the property. And so, they're kind of transacting out of their LLC with they're owning the real estate, but no physical work. However, you can provide kind of administrative tasks and, obviously, other investment oversight and decision making.
Matt Lewis 44:25
Yeah, it seems to me that real estate is, in a lot of cases, very hands-on. And as soon as you put your hands on it, you're in trouble!
Mat Sorensen 44:34
Right? Yeah, you just can't. I mean, honestly, I invest in real estate inside and outside of my retirement account. I'm not the type of person that works on the property. I'm just, I don't know, it's not that I hate it. It's more efficient for me to hire someone else to do it.
Matt Lewis 44:50
Yeah, look what you're doing. You have so many things going on!
Mat Sorensen 44:52
Yeah. And I think people with their retirement accounts. You know, a lot of people... I mean, I live in Arizona, but I'm not buying rentals in Arizona. The rental market here is not that great anymore. The prices are too high. So I'm buying rentals in other places. Well, I need a management company to manage the repairs and stuff anyway, so... But you're right, that's one where we really have to like help clients, you know "Don't be ....." We need a little help and encouragement
Matt Lewis 45:20
Mat Sorensen 45:22
Yeah, reminders. That's a good way to say it.
Mat Sorensen 45:23
All right. Well, Mat, I learned a lot. Thanks so much for joining us in Wealth Bootcamp.
Mat Sorensen 45:28
Yeah, my pleasure. Thanks, Matt.
Matt Lewis 45:31
Thank you for tuning into this episode of Wealth Bootcamp. We're a community for entrepreneurs where we make sure you're building personal wealth, even as you build your company. If there were any parts of today's show you'd like to revisit, you can locate them quickly by running a search of the show's written transcript. You'll find all our transcripts at westbridgewealth.com on the podcast page, as well as show notes and links to all the authors and books we've mentioned.
Be sure to tune in next week when we'll be discussing how you can prepare for a move to Silicon Valley. In the meantime, have a great week. And thanks again from Wealth Bootcamp.
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