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Why Use a Solo 401k to Buy Real Estate

solo 401(k) to buy real estate

Using a Solo 401k to buy real estate may be more advantageous than a Self-Directed IRA if you meet the eligibility requirements for the plan and wish to use a nonrecourse loan. In this article, we’ll take a look at real estate investments with the Solo 401k .

The Solo 401k

A Solo 401k is a qualified retirement plan that is similar to a traditional 401(k), except this retirement plan covers one person. There are two eligibility requirements for establishing a Solo 401k plan, but if you meet them, the individual retirement plan can’t be beat. (1) You must  generate a form of self-employment income (passive income is excluded) which can be part-time, such as Uber driving or a freelance gig. (2) The absence of full-time employees (someone who works more than 1,000 hours/year), excluding your spouse if he/she is involved in the business, and your business partner. An added benefit of this eligibility requirement is that it allows you to avoid ERISA.

The Solo 401k is a type of self-directed retirement plan, which an IRA custodian will custody and administer. The IRA custodian of a self-directed retirement plan offers no investment advice, hence the name “self-directed,” therefore as trustee of the retirement plan, you must perform due diligence on all investments you wish to pursue.

The primary advantage of a self-directed retirement plan over a traditional plan is the ability to purchase alternative asset investments, such as real estate. You gain more control over your investment decisions, and when you opt for checkbook control, you do not need the consent of a custodian. This is the ideal retirement plan for investors who do not want the assets within their retirement account to move in the same direction, or do not feel comfortable investing in Wall Street.

Real Estate as an Investment

Real estate is the most popular alternative investment among retirement account holders. The IRS has always permitted Solo 401k participants to engage in virtually any type of real estate investment as long as it not prohibited or involves a disqualified person.

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.

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 401k 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 70 1/2 and with a Roth (after-tax), you never pay tax on the investment.

Real Estate Leverage with the Solo 401k

Here is the primary reason to use the Solo 401k 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 401k 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 401k 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.

Due Diligence

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. When you have questions, we have answers. Contact IRA Financial directly at 800-472-0646.

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