Copyright: nomadsoul1 / 123RF Stock Photo
By Dmitriy Fomichenko
Real Estate Investing with Solo 401k can be very powerful!
Many people mistakenly believe that their retirement accounts must be invested in stock or mutual funds. Intelligent educated investors realize that the IRS has always permitted real estate to be held inside retirement accounts. Real Estate investing with a Solo 401k are fully permissible under the Employee Retirement Income Security Act of 1974 (ERISA). IRS rules allow you to engage in almost any type of real estate investment, except from any investment involving a disqualified person.
Real Estate Investments Types
- Single Family Rental Property
- Commercial property
- Town-homes and Condos
- Mobile homes
- Real estate purchase options
- Mortgage notes
- Tax deeds & Tax liens
Copyright: fantasista / 123RF Stock Photo
Benefits of Using a Solo 401k to Purchase Real Estate
All of the income or gains generated by a Solo 401k produce tax-deferred (tax-free in case of Roth) profits. Using a Solo 401k Account to purchase real estate allows the plan to earn tax-free gains and income and pay taxes at a future date, instead of in the year the investment income is realized. With a Solo 401K, you can invest tax-free and in most cases deffer paying taxes for many years, which allows your retirement funds to grow tax-free! All the profits from your real estate transactions flow though to your 401k account tax-free!
Quick and Simple Way to Invest in Real Estate using Solo 401k!
Investing in real estate with a Solo 401k is basically the same as buying real estate personally.
- Set-up a Self-Directed Solo 401k Plan with the Sense Financial
- Identify your investment and conduct due diligence on the property to ensure it fits your criteria
- Purchase investment property with the Solo 401k Plan – no need to have custodian approval, with a Solo 401k Plan you serve as Trustee of the Plan and as Plan Administrator
- Title to the investment property and all transaction documents should be in the name of the Solo 401k Plan
- Documents pertaining to the property investment must be signed by you as Trustee of the Trust
- All expenses paid from the investment property go through the Solo 401k Plan. Likewise, all rental income must be deposited directly in to the Solo 401k Plan bank account. No 401k related investment checks can be deposited into your personal accounts
- All income or gains from the investment flow through to your 401k tax-free!
Organizing Real Estate Purchase with a Solo 401k Plan
When using a Solo 401k to make a real estate investment there are several ways you can organize the transaction:
1. Use your Solo 401k funds to make 100% of the investment
If you have sufficient funds in your Solo 401k to cover the entire real estate purchase, including closing costs, taxes, fees, insurance, you may make the purchase outright using your Solo 401k. All ongoing expenses relating to the real estate investment must be paid out of your Solo 401k bank account. In addition, all income or gains relating to your real estate investment must be returned to your Solo 401k bank account.
2. Partner with Family, Friends, Colleagues
If you don’t have sufficient funds in your Solo 401k to make a real estate purchase outright, your Solo 401k can purchase an interest in the property along with a family member (non-disqualified person), friend, or colleague. The investment would not be made into an entity owned by the 401k owner, but instead would be invested directly into the property.
Your Solo 401k Plan, for example, could partner with a family member, friend, or colleague to purchase a piece of property for $100,000. Your Solo 401k Plan could purchase an interest in the property (i.e. 50% for $50,000) and your family member, friend, or colleague could purchase the remaining interest (i.e. 50% for $50,000).
All income or gain from the property would be allocated to the parties in relation to their percentage of ownership in the property. Likewise, all property expenses must be paid in relation to the parties’ percentage of ownership in the property. Based on the above example, for a $1,000 property tax bill, the Solo 401k would be responsible for 50% of the bill ($500) and the family member, friend, or colleague would be responsible for the remaining $500 (50%).
Isn’t Partnering with a family member in a Real Estate Transaction a Prohibited Transaction?
Likely not if the transaction is structured correctly. Investing in an investment entity with a family member and investing in an investment property directly are two different transaction structures that impact whether the transaction will be prohibited under Code Section 4975. The different tax treatment is based on who currently owns the investment. Using a Solo 401k Plan to invest in an entity that is owned by a family member who is a disqualified person will likely be treated as a prohibited transaction. However, partnering with a family member that is a non-disqualified person directly into an investment property would likely not be a prohibited transaction. Note: If you, a family member, or other disqualified person already owns a property, then investing in that property with your Solo 401(k) would be prohibited.
3. Borrow Money for your Solo 401k
Copyright: maxxyustas / 123RF Stock Photo
You may obtain financing through a loan or mortgage to finance a real estate purchase using a Solo 401k. Solo 401k participants can also borrow up to either $50,000 or 50% of their account value – whichever is less to help finance a real estate investment.
If using financing through a third-party loan to purchase real estate (other than a loan from the 401k Plan), one important point must be considered when selecting this option:
- Loan must be non-recourse – A “prohibited transaction” is a transaction that, directly or indirectly involves the loan of money or other extension of credit between a plan and a disqualified person. Normally, when an individual purchases real estate with a mortgage, the traditional loan provides for recourse against the borrower (i.e., personal liability for the mortgage). However, if the 401k Plan purchases real estate and secures a mortgage for the purchase, the loan must be non-recourse; otherwise there will be a prohibited transaction. A non-recourse loan only uses the property for collateral. In the event of default, the lender can collect only the property and cannot go after the 401k Plan itself.
Note: Unlike a Self-Directed IRA LLC (also known as Checkbook IRA), pursuant to Internal Revenue Code Section 514(c)(9), in the case of a Solo 401k Plan, the Unrelated Business Income Tax (UBTI) does not apply when using non-recourse leverage as part of a real estate transaction (unrelated debt-financed income – UDFI). Therefore, unlike a Self-Directed IRA LLC, using a Solo 401K to finance a real estate investment will not trigger UBTI – which imposes a tax in the range of 35% on all income and gains relating to the debt financed portion of the investment.