When it comes to using retirement funds, such as a Solo 401K Plan, to make investments, the question arises whether a Solo 401K Plan can utilize a loan as part of the transaction.
The IRS has always allowed a Solo 401K Plan to make traditional as well as non-traditional investments such as real estate. However, the prohibited transaction rules under Internal Revenue Code Section 4975 restrict a Solo 401(k) Plan participant from engaging in certain transactions – prohibited transactions. Under IRC 4975, one of the categories of prohibited transactions involve a disqualified person personally guaranteeing a loan made to a Solo 401K Plan. A Solo 401K plan participant is treated as a disqualified person pursuant to IRC 4975. As a result, a Solo 401K, also known as an Individual 401K or Self Directed 401K Plan, cannot use a recourse loan to purchase property owned by a Plan because a disqualified person (Solo 401K Plan participant) cannot personally guarantee a loan. However, the IRS does allow for the 401K to use a non-recourse loan to purchase real estate. A non-recourse loan is a loan that does not require a personal guarantee on the part of the Solo 401K plan participant. In other words, a loan that would limit a lender’s (bank) ability to go after an individual personally for non-payment of the loan. Instead, the lender’s sole remedy would be to look to the underlying property as satisfaction of the loan. Of course, this type of loan is more difficult to acquire and can be more expensive for a borrower.
In general, 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 to other types of non-recourse financing, such as margin on stock.
The Section 514 exemption applies to any “qualified organization,” a term that includes (1) schools, colleges, universities, and their “affiliated support organizations,” (2) qualified pension, profit sharing, and stock bonus trusts, and (3) title holding companies exempt under § 501(c)(25). In general, indebtedness incurred by a qualified organization in acquiring or improving real property is not acquisition indebtedness if the transaction navigates through a long list of prohibitions. In other words, a Solo 401K Plan can use non-recourse leverage when purchasing real property with Plan assets and not be subject to the Unrelated Debt-Financed Income rules, which in-turn trigger an Unrelated Business Taxable Income (UBTI or UBIT) tax (approximately 40% for 2017). Note – only non-recourse leverage can be used when acquiring property by a 401K or Solo 401K Plan since, a disqualified person (401(k) plan participant or trustee) cannot personally guarantee the loan (recourse loan) since that would violate the prohibited transaction rules pursuant to Internal Revenue Code Section 4975. It is important to remember that this exemption would not apply to an IRA since an IRA is not a qualified pension, profit sharing, and stock bonus trusts.
To satisfy the exemption under Internal Revenue Code Section 514, the price paid by the organization 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, and 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), or, 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 and 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.
Many people ask why this exemption only applies to 401K Plans and not IRAs. 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.