What do I Need to Know About Buying Real Estate with a Solo 401(k) and Using a Loan?
One of the primary benefits of using retirement funds, such as a solo 401(k) plan to make investments is that, in most cases, all income and gains from the investment will flow back to the solo 401(k) plan tax-deferred or tax-free in the case of a Roth. This is because a 401(k) plan is exempt from tax pursuant to Internal Revenue Code (IRC) Section 401. In addition, IRC Section 512 exempts most forms of investment income a 401(k) generates from taxation. Some examples of exempt type of income include:
- Interest from loans
- Most rentals from real estate
- Gains/losses from the sale of real estate
About the Solo 401(k) Plan
The solo 401(k) plan (also known as an individual 401(k) plan or self-employed 401(k) plan) has been around for several years. A solo 401(k) plan is like an employer-sponsored 401(k) plan, but it covers only one employee. However, the rules and requirements of both 401(k) plans are generally the same. Interest in the Solo 401(k) retirement plan grew as a result of the EGTRRA tax law, which became effective in 2001. The law included features in the solo 401(k) plan that gave self-employed individuals the ability to put away additional amounts toward their retirement, in pre-tax and Roth.
In order to be eligible to establish a solo 401(k) plan one must be self-employed or have a business with no full-time employees (over 1,000 hours) other than the owner(s) and their spouse(s). The business can be a sole proprietorship or in any business form.
Nonrecourse Solo 401(k) Loan
For real estate investors, making high annual contributions in pre-tax or Roth, a $50,000 loan option, and the ability to buy real estate using a nonrecourse loan without tax is a major benefit. A nonrecourse loan is a loan not personally guaranteed by the plan participant. Whereas, if an individual uses a self-directed IRA to buy real estate with a nonrecourse loan, a tax called the unrelated business taxable income (UBTI or UBIT) would be imposed on the pro rate share of income associated to the nonrecourse loan. The UBTI tax can go as high as 37% for 2019.
Internal Revenue Code 514
Internal Revenue Code Section 514(c)(9) permits a few types of exempt organizations to make debt-financed investments in real property without becoming taxable under Code Section 514. Note – the exemption only applies to real estate and not other types of nonrecourse financing.
The Section 514 exemption applies to any “qualified organization,” a term that includes:
- Schools, colleges, universities, and their “affiliated support organizations”
- Qualified pension, profit sharing, and stock bonus trusts
- Title holding companies exempt under § 501(c)(25)
Generally, indebtedness that a qualified organization incurs by acquiring or improving real property is not acquisition indebtedness if the transaction navigates through a long list of prohibitions. In other words, a 401(k) Plan or a Solo 401(k) plan can use nonrecourse leverage when purchasing real property with 401(k) Plan assets. It will not be subject to the Unrelated Debt-Financed Income rules, which in-turn triggers an Unrelated Business Taxable Income tax (approximately 37%).
Note – only nonrecourse leverage can be used when acquiring property by a 401(k) or Solo 401(k) Plan.
This is because a disqualified person (401(k) plan participant or trustee) cannot personally guarantee the loan (recourse loan) since that violates the prohibited transaction rules pursuant to Internal Revenue Code Section 4975. As a reminder, it is important to remember that this exemption will not apply to an IRA since an IRA is not a qualified pension, profit sharing, and stock bonus trust.
How to Satisfy Internal Revenue Code 514
To satisfy the exemption under Internal Revenue Code Section 514, the price the organization pays for the property or improvement must be fixed when the property is acquired or the improvement is completed. Neither the amount nor the due date of any payment under the indebtedness can be contingent on the revenue, income, or profits from the property. Furthermore, the property may not be leased to the person who sold the property to the organization or to any person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b).
If the organization is a qualified pension, profit sharing, or stock bonus trust, the property may not be purchased from or leased to the employer of any of the employees covered by the trust or any one of several persons related to the employer. Financing for the property may not be received:
- From the person who sold the property to the organization
- A person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b)
- If the organization is a qualified employee trust, an employer or related person who is disqualified from being seller or lessee under the rule described in the preceding sentence
The property must usually be owned directly by the qualified organization, except that an interest in a partnership or other pass-through entity qualifies if all of the partners or other owners are qualified organizations. Each partner or other owner is allocated the same distributive share of every item of partnership income, deduction, and credit.
When § 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities.
Solo 401(k) and IRAs
Many people ask why this exemption only applies to 401(k) Plans and not IRAs (individual retirement accounts). The only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.” The provision was originally limited to qualified employee trusts on the theory that the income would eventually be taxed to employees and their beneficiaries.