Real Estate Investing with a Solo 401(k)
Many people believe that they cannot use their 401(k) to invest in real estate or rental properties. As a result, individuals who are self-employed frequently assess the benefits of a 401k vs. real estate investments. While you cannot invest in real estate with a traditional employer sponsored 401k, you can invest your 401(k) in real estate when you establish a Self-Directed individual retirement account, such as a Solo 401(k) or a Roth Solo 401(k) for real estate. When we say, “invest your 401(k) in real estate”, we are not referencing a traditional, employee sponsored 401(k). In fact, you cannot use your 401(k) to invest directly in real estate. You can use your Solo 401(k) to invest in real estate, under certain conditions. In order to use your Solo 401(k) to invest in real estate, you must first ensure that your Solo 401(k) plan allows this option. IRA Financial is one of the few Solo 401(k) companies that allows individuals to invest in alternative investments, including real estate. Individuals eligible for a Solo 401(k) include:
- The self-employed
- Individual who actively generate a portion of their income through self-employment activities
- Small business owner with no employees (except for themselves or a spouse)
If you are not self-employed or do not qualify for a Solo 401(k) you can still use retirement funds to invest in real estate. For more information see: Real Estate IRA
Why Invest in Real Estate?
Real estate is the most popular alternative investment among retirement account holders. The IRS has always permitted Solo 401(k) participants to engage in virtually any type of real estate investment as long as it not prohibited or involves a disqualified person. However, after the 2008 financial crisis, many people became wary of Wall Street. They didn’t feel comfortable making traditional investments they didn’t fully understand. Individuals, particularly those in the middle class, didn’t know what was happening in Wall Street. As a result, they became skeptical investing their retirement funds in traditional assets.
Most retirement investors are attracted to real estate because it provides a steady stream of income and has become a popular way to diversify one’s retirement portfolio. Additionally, it is a hard asset that acts as a hedge against inflation, since the value of real estate often increases as inflation increases. However, real estate, is something most us feel comfortable with – lower class, middle class and upper class alike.
Many people worry about inflation, which is another reason they turn to real estate investments. Even if the risk of inflation isn’t real (it may or may not be), inflation can seriously hurt a retirement portfolio. The value of currency today may be worth significantly less tomorrow. Investing in alternative assets, such as real estate offers your retirement accounts a great way to diversify from the equity markets and gain access to a hard asset that can offer steady cash flow as well as asset appreciation. Hard assets (real, touchable assets) are a way to protect your retirement plan against inflation. In a way, hard assets act as a buffer against your retirement assets and the havoc of inflation.
When using a retirement account such as the Solo 401k to invest in real estate, investors can take advantage of tax benefits they would not receive when using personal funds to make an investment. The beauty of using a retirement plan to purchase real estate is compounding. When the real estate investment generates high returns, rather than paying tax on those returns, tax is deferred to a later date. This allows you to use the Solo 401(k) for the purchase of real estate and watch as the real estate investment grows unhindered. With a 401(k) retirement plan, you can defer the tax until 72 and with a Roth (after-tax), you never pay tax on the investment.
Types of Real Estate You Can Purchase with Your Solo 401(k)
Below is a partial list of domestic or foreign real estate-related investments that you can make with a Solo 401(k):
- Raw land
- Residential homes
- Commercial property
- Mobile homes
- Rental Properties
- Real estate notes
- Real estate purchase options
- Tax liens certificates
- Tax deeds
For more information on the types of real-estate you can purchase with retirement funds see: Real Estate IRA Investments
Purchasing Real Estate with a Solo 401(k)
Let’s go straight to the benefits.
Real Estate Leverage with the Solo 401(k)
Here is the primary reason to use the Solo 401(k) for all types of real estate investments: the use of leverage.
We are often reminded about the advantage of owning property, whether it’s a piece of land or a multi-family real estate property. However, the purchase of real estate requires large capital and as a result, many investors choose to purchase real estate with leverage. In the case of an IRA, when you purchase real estate using leverage (non-recourse loan) this will be considered “debt-financed property” and will be subject to the Unrelated Business Taxable Income (UBTI) tax. If you use a nonrecourse loan with an IRA to purchase half of the real estate property, the income generated from the financed portion of the real estate property will be taxed at the UBTI tax rates, which can be as high as 37%.
Whereas the Solo 401k is not subject to the same UBTI rules as an IRA, which is the main advantage of using the Solo 401(k) to buy real estate. Internal Revenue Code Section 514(c)(9) permits a few qualified organizations to be exempt from the UBTI tax, including qualified retirement plans. Thus, the plan will be removed from the UBTI tax. This is an attractive feature among real estate investors who do not have the finances to purchase the real estate property on their own, or prefer to use less of their retirement funds to make the real estate investment.
When compared to an IRA, the Solo 401(k) is more advantageous for real estate investors who want to purchase real estate property with a portion of their funds and combine that with a loan to gain the ability to purchase more real estate without paying tax on the leverage.
Establish a Solo 401(k) Retirement Plan
Prior to purchasing real estate, you must first establish a self-directed Solo 401(k) plan. Establishing a Solo 401(k) plan with IRA Financial is easy. Simply download our app or contact us directly. Before deciding on a Solo 401(k) custodian and opening an account, it is imperative that you assess whether the custodian is regulated. Furthermore, you should also consider what type of alternative investments you can pursue. For example, IRA Financial allows you to invest in real estate, cryptocurrencies, private companies, gold, precious metals, hard money loans, and more! While IRA Financial allows you to invest in different types of assets, not all Solo 401(k) plans offer similar options. Hence, it is important to ask what you can invest in before attempting to purchase real estate in a Solo 401(k).
Learn More: Beginners Guide to Alternative Investments
Individuals interested in opening a Solo 401(k) should also consider how they plan to fund their new account. Some individuals may be eligible to roll their 401(k) into a Solo 401(k). However, this option is only available under certain conditions. Alternatively, you can fund your new account directly with your self-employment income.
Learn More: Funding Your Solo 401(k) or Self-Directed IRA
How to Open a Solo 401(k) for Real Estate
- Open your Solo 401(k) online, through our app, or over the phone with one of our dedicated professionals.
- You will then be assigned Solo 401(k) plan tax specialist will work with you to customize your Solo 401(k) plan based on your investment, tax, and retirement goals
- The new Solo 401(k) plan account can be opened at Capital One Bank
- Fund the Solo 401(k) plan with a rollover of any pretax retirement funds, or by making a tax-deductible or after-tax (Roth) contribution directly to the new plan account
- All income and gains generated by the Solo 401(k) plan investment will generally flow back to your Solo 401(k) plan without tax
- No annual IRS reporting or filing requirements if your plan assets are below $250,000
- We will handle all IRS plan administration
- No transaction fees
- No asset valuation fees
- Investing is as easy as writing a check!
- No plan termination fee
Advantages of Buying Real Estate with a Roth Solo 401(k)
Power of Tax-Free Investing: One of the main attractions to the self-directed Roth Solo 401(k) for real estate is based on the fact that qualified distributions of Roth earnings are tax-free.
However, you must meet certain conditions and the distribution has to be qualified. Roth Solo 401(k) plan participants will never pay tax on Roth distributions. When you contribute to a Roth Solo 401(k) plan, income and gains you generate will be tax and penalty-free. This is among the main advantages of a Roth Solo 401(k).
Unlike with a pretax Solo 401(k) plan, contributions to a Roth Solo 401(k) are not tax deductible. Take a look at the following examples to better understand the power of tax-free investing.
Solo Roth 401(k) The Perfect Retirement Account for the Self-Employed
A Roth Solo 401(k) combines features of the traditional 401(k) with those of the Roth IRA. Like a Solo 401(k) Plan, the Roth Solo 401(k) Plan is perfect for self-employed individuals or small business owners with no employees.
It contains the same advantages of a Solo 401(k) Plan. However, as with a Roth IRA, contributions are made with after-tax dollars. While you don’t get an upfront tax-deduction, the Roth 401(k) account grows tax-free, and withdrawals taken during retirement aren’t subject to income tax if you’re 59 1/2. Additionally, you must have the account open for five or more years.
Advantages of a Solo 401(k) LLC to Purchase Real Estate
- Created by the IRS specifically for the self-employed or small business owner with no full-time employees
- Receive a customized IRS approved open architecture self-directed solo 401(k) plan
- Gain the ability to make traditional investments, such as stocks, but also all IRS approved alternative asset investments, such as real estate.
- Help build your retirement nest egg by contributing up to $61,000 per year ($67,500 if age 50 or older) – almost 10 times the maximum contribution amount of an IRA
- Contribute to your plan using pretax or Roth (after-tax) funds. Below, please find a link that discussed the benefits of using Roth funds to purchase real estate
- Borrow up to $50,000 tax- and penalty-free and use those funds for any purpose, whether personal or business
- Invest in what you know and understand without tax, such as real estate, precious metals, tax liens, hard money loans, private businesses, and much more.
- As trustee of the plan, making an investment is as easy as writing a check or executing a wire transfer.
- Generate tax-deferred or tax-free income or gains on your plan investments
- Open your Self-Directed Solo 401(k) plan at Capital One Bank – no need for a special custodian
- Asset & creditor protection
- Purchase real estate with leverage without triggering tax
- Receive an IRS opinion letter confirming the legality of the plan
While there are multiple benefits of opening a Solo 401(k) to purchase real estate, not all custodians allow this feature. Furthermore, many charge transaction and asset valuation fees. If you are looking to establish a Solo 401(k) to purchase real estate, or other alternative investments, we recommend asking about transaction and asset valuation fees before selecting a Solo 401(k) provider.
Learn More: Tips for Making Investments with a Solo 401(k)
Do I Need an LLC to Purchase Real Estate with my Solo 401(k)?
Of course, you don’t need an LLC for your Self-Directed 401(k) to buy real estate. The Solo 401(k) Plan itself can take title of the property. In other words, the plan can own the property.
There is no requirement to establish an LLC with your Solo 401(k) Plan funds. However, buying real estate under an LLC provides asset protection. Solo 401(k) owns the LLC, and the LLC will own the property and you’re the manager of the LLC. As manager, you have full control over your investments.
Maintaining a Property with a Solo 401(k)
One of the primary advantages of purchasing real estate with retirement funds is that all gains are tax-deferred until a distribution or tax-free in the case of a Roth account (after-tax). Aside from navigating the IRS prohibited transaction rules, the following are a handful of helpful tips for making real estate investment using retirement funds:
- The deposit and purchase price for the real estate property should be paid using retirement account funds and not from any disqualified person
- All expenses, repairs, taxes incurred in connection with the retirement account real estate investment should be paid using retirement funds – no personal funds from any disqualified person should be used
- If additional funds are required for improvements or other matters involving the retirement account owned real estate investment, all funds should come from the retirement account or from a non “disqualified person”
- Partnering with yourself or another disqualified person in connection with a retirement account investment could trigger the IRS prohibited transaction rules.
- If financing is needed for a real estate transaction, only non-recourse financing should be used. A non-recourse loan is a loan that is not personally guaranteed by the retirement account holder or any disqualified person and whereby the lender’s only recourse is against the property and not against the borrower.
- If using a non-recourse loan to purchase real estate with a self-directed IRA, the unrelated business taxable income (“UBTI”) rules could be triggered and a tax rate reaching as high as 40 percent could apply. Note – an exemption from this tax is available for 401(k) plans pursuant to IRC 514(c)(9). If the UBTI tax is triggered and tax is due, IRS Form 990-T must be timely filed.
- No services should be performed by the retirement account holder or any “disqualified person” in connection with the real estate investment. Please see:
- Title of the real estate purchased should be in the name of the retirement account. For example, if Joe Smith established a Self-Directed IRA LLC and named the LLC XYZ, LLC, title to the real estate purchased by Joe’s Self-Directed IRA LLC would be as follows: XYZ LLC. Whereas, if Joe Smith established a Self-Directed IRA with ABC IRA Trust Company (custodian), and the custodian purchased the real estate directly on behalf of Joe without the use of an LLC, then title would read: ABC IRA Trust Company FBO John Doe IRA.
- Keep good records of income and expenses generated by the retirement account owned real estate investment
- All income, gains or losses from the retirement account real estate investment should be allocated to the retirement account owner of the investment
- 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.
- Beware of fraud if purchasing real estate from a promoter.
- If using a Self-Directed IRA LLC to buy real estate, it is good practice to form the LLC in the state where the real estate will be located to avoid any additional filing fees. Also, be mindful of any annual state LLC filing or franchise fees.
Using retirement funds to buy real estate can offer retirement account holders a number of positive financial and tax benefits, such as a way to invest in what one knows and understands, investment diversification, inflation protection, and the ability to generate tax-deferred or tax-free (in the case of a Roth) income or gains. The list of helpful tips outlined above should provide retirement account investors looking to buy real estate with a guideline of how to keep their retirement account from running afoul of any of the IRS.
Solo 401k Real Estate Tips:
- 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 non-recourse financing should be used. A non-recourse 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, Cherwenka 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.
Cherwenka 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.
This is a popular investment that can allow investors to build retirement wealth. If you would like to use the Solo 401k for real estate investments, it is important to perform due diligence on the property, neighborhood and comparative market analyses, as you do not receive investment advice with a truly self-directed retirement plan.
At IRA Financial, we do not tell our clients what investments to make or offer any kind of investment advice. However, we will be of assistance throughout the process to ensure you do not trigger a prohibited transaction, which will result in high penalties and possibly the disqualification of your retirement plan.
Did You Know?
There are many opportunities for investment with a Solo 401(k), including cryptocurrency and precious metals. You can also contribute as both employer and employee – the Solo 401(k) offers higher contributions than other accounts; and you can invest more money for your future! Contact IRA Financial today to learn more.