Tips For Buying Real Estate With A Solo 401(k) Plan And Staying Out Of IRS Trouble
IRA Financial Group’s Self-Directed Solo 401(k) Plan offers one the ability to use his or her retirement funds to make almost any type of investment on their own without requiring the consent of any custodian or person. The IRS and Department of Labor only describe the types of investments that are prohibited, which are very few.
What is a Solo 401(k) Plan?
As the name implies, the Solo 401(k) Plan is an IRS approved qualified 401(k) Plan designed for a self-employed individual or the sole owner-employee of a corporation.
The “one-participant 401(k) Plan” is not a new type of plan. It is a traditional 401(k) Plan covering only one employee. The plans have the same rules and requirements as any other 401(k) Plan. The surging interest in these plans is a result of the EGTRRA tax law change that became effective in 2002.
It works best when there are no other employees or a very small number of employees. A Solo 401(k) Plan may be used by any individual who is already a business owner or who will be establishing a business and does not have, or plan to have, full-time employees. The Solo 401(k) Plan is perfect for independent contractors, such as consultants, home businesses and real estate agents. The owner’s spouse may also contribute to the plan as long as he or she is an employee of the business.
Solo 401(k) Plan & Real Estate
The IRS permits using a solo 401(k) Plan to purchase real estate or raw land. Since you would be the trustee of the Solo 401(k) Plan, making a real estate investment is as simple as writing a check from your Solo 401(k) Plan bank account. The advantage of purchasing real estate with your Self-Directed Solo 401(k) Plan is that all gains are tax-deferred until a distribution is taken (pre-tax 401(k) distributions are not required until the IRA holder turns 70 1/2). In the case of a Roth Self-Directed Solo 401(k) Plan, all gains are tax-free.
For example, if you purchased a piece of property with your Self-Directed Solo 401(k) Plan for $150,000 and you later sold the property for $350,000, the $200,000 of gain appreciation would generally be tax-deferred. Whereas, if you purchased the property using personal funds (non-retirement funds), the gain would be subject to federal income tax and in most cases state income tax.
- Be cognizant of the IRS prohibited transaction rules. The foundation of the prohibited transaction rules is based on the premise that investments involving IRA and related parties are handled in a way that benefits the retirement account and not the plan participant. The rules prohibit transactions between the plan participant and certain individuals known as “disqualified persons”. The outline for these rules can be found in Internal Revenue Code Section 4975. In general, the definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the 401(k) Plan participant, any ancestors or lineal descendants of the 401(k) Plan participant, and entities in which the 401(k) Plan participant holds a controlling equity or management interest. When it comes to real estate, a 401(k) Plan participant or any disqualified person may not be directly or indirectly personally involved or personally benefit directly or indirectly from the real estate transaction. For example, a 401(k) Plan participant cannot purchase home and personally live in it or have any disqualified person (i.e. parent, child, spouse, daughter/son-in-law, etc.) personally use it.
- The deposit and purchase price for the real estate property should be paid using Solo 401(k) Plan funds or funds from a non-disqualified third-party.
- No personal funds or funds from any “disqualified person” should be used.
- All expenses, repairs, taxes incurred in connection with the Self-Directed Solo 401(k) Plan real estate investment should be paid using retirement funds - no personal funds should be used
- If additional funds are required for improvements or other matters involving the real estate investments, all funds should come from the Solo 401(k) Plan or other retirement funds or from a non “disqualified person.”
- If financing is needed for a real estate transaction, only nonrecourse financing should be used. A nonrecourse loan is a loan that is not personally guaranteed and whereby the lender’s only recourse is against the property and not against the borrower.
- No services should be performed by the Solo 401(k) Plan holder or “disqualified person” in connection with the real estate investment by the retirement account. In general, other then typical trustee type of services (necessary and required tasks in connection with the maintenance of the plan), no active services should be performed by the plan participant or a “disqualified person” with respect to the real estate transaction.
- Title of the real estate purchased should be in the name of the Self-Directed Solo 401(k) Plan. For example, if Joe Smith established a Self-Directed Solo 401(k) Plan and the plan was named ABC LLC 401(k) Plan, title to real estate purchased by Joe’s Self-Directed Solo 401(k) Plan LLC would be as follows: Joe Smith Trustee of the ABC LLC 401(k) Plan.
- Keep good records of income and expenses generated by the real estate investment.
- All income, gains or losses from the Self-Directed 401(k) Plan real estate investment should be allocated to the 401(k) Plan.
- Make sure you perform adequate diligence on the property you will be purchasing especially if it is in a state you do not live in.
- Make sure you will not be engaging in any self-dealing real estate transactions, which would involve buying or selling real estate that will personally benefit you or a “disqualified person.”
A Blueprint for What a Self-Directed 401(k) Plan Real Estate Investor Can and Cannot Do
The Cherwenka case (In Re Cherwenka (113 AFTR 2d 2014-2333) (508 B.R. 228), (Bktcy Ct GA), 03/06/2014) involved a Georgia statutory bankruptcy estate exemption for IRAs, which covered a Self-Directed IRA held by Michael Cherwenka, who was in business of “flipping” houses. Michael Cherwenka established a Self-Directed IRA to buy real estate. The Cherwenka case is really the first case that offers a detailed framework about the type of activities or tasks a Self-Directed IRA real estate investor can perform without triggering the IRC 4975 prohibited transaction rules. In the case, Cherwekna was not compensated for any real property research he performed, nor was he compensated for any recommendations, management or consulting services he provided relating to how the IRA properties were improved before resale. Cherwekna explained his role in buying and selling of these properties as being limited to identifying the asset for purchase and later selling the asset. Cherwenka engaged contractors to decide or oversee the scope of work with improved properties. Cherwenka testified that he “read and approved” the expense forms prior to the IRA custodian paying funds to reimburse the submitted expenses. Contractors were paid by the job, which accounted for labor costs, but no management fee or additional cost was included in the expenses submitted to the IRA custodian. Cherwenka stated he would inspect or confirm that work was completed through site visits or communication with his “team” before he would approve expenses to be paid by the IRA custodian.
Because most Self-Directed IRA or 401(k) Plan real estate investors tend to perform the same sort of tasks that Cherwenka performed, such as locating the property, reviewing transaction documents, engaging contractors to perform property improvements, inspection of improvements, approval of expenses, and coordinating with the IRA custodian regarding the real estate, the case offers a clear blueprint for the type of activities or tasks that a Self-Directed IRA real estate investor can do without violating the IRC Section 4975 prohibited transaction rules.
To learn more about using a Self-Directed 401(k) Plan to purchase real estate, please contact a Self-Directed 401(k) Plan expert at 800-472-0646.