When using a Solo 401(k) to make a real estate investment there are a number of ways you can structure the transaction:
1. Use your Solo 401(k) funds to make 100% of the investment
If you have enough funds in your Solo 401(k) to cover the entire real estate purchase, including closing costs, taxes, fees, insurance, you may make the purchase outright using your Solo 401(k). All ongoing expenses relating to the real estate investment must be paid out of your Solo 401(k) bank account. In addition, all income or gains relating to your real estate investment must be returned to your Solo 401(k) bank account.
2. Partner with Family, Friends, Colleagues
If you don’t have sufficient funds in your Solo 401(k) to make a real estate purchase outright, your Solo 401(k) can purchase an interest in the property along with a family member (non-disqualified person), friend, or colleague. The investment would not be made into an entity owned by the 401(k) owner, but instead would be invested directly into the property.
For example, your Solo 401(k) Plan could partner with a family member, friend, or colleague to purchase a piece of property for $150,000. Your Solo 401(k) Plan could purchase an interest in the property (i.e. 50% for $75,000) and your family member, friend, or colleague could purchase the remaining interest (i.e. 50% for $75,000).
All income or gain from the property would be allocated to the parties in relation to their percentage of ownership in the property. Likewise, all property expenses must be paid in relation to the parties’ percentage of ownership in the property. Based on the above example, for a $2,000 property tax bill, the Solo 401(k) would be responsible for 50% of the bill ($1000) and the family member, friend, or colleague would be responsible for the remaining $1000 (50%).
Isn’t Partnering with a family member in a Real Estate Transaction a Prohibited Transaction?
Likely not if the transaction is structured correctly. Investing in an investment entity with a family member and investing in an investment property directly are two different transaction structures that impact whether the transaction will be prohibited under Code Section 4975. The different tax treatment is based on who currently owns the investment. Using a Solo 401(k) Plan to invest in an entity that is owned by a family member who is a disqualified person will likely be treated as a prohibited transaction. However, partnering with a family member that is a non-disqualified person directly into an investment property would likely not be a prohibited transaction. Note: If you, a family member, or other disqualified person already owns a property, then investing in that property with your Solo 401(k) would be prohibited.
3. Borrow Money for your Solo 401(k)
You may obtain financing through a loan or mortgage to finance a real estate purchase using a Solo 401(k). Solo 401(k) participants can also borrow up to either $50,000 or 50% of their account value – whichever is less to help finance a real estate investment.
If using financing through a third-party loan to purchase real estate (other than a loan from the 401(k) Plan), one important point must be considered when selecting this option:
- Loan must be non-recourse – A “prohibited transaction” is a transaction that, directly or indirectly involves the loan of money or other extension of credit between a plan and a disqualified person. Normally, when an individual purchases real estate with a mortgage, the traditional loan provides for recourse against the borrower (i.e., personal liability for the mortgage). However, if the 401(k) Plan purchases real estate and secures a mortgage for the purchase, the loan must be non-recourse; otherwise there will be a prohibited transaction. A non-recourse loan only uses the property for collateral. In the event of default, the lender can collect only the property and cannot go after the 401(k) Plan itself.
Note: Unlike a Self-Directed IRA LLC, pursuant to Internal Revenue Code Section 514(c)(9), in the case of a Solo 401(k) Plan, the Unrelated Business Income Tax (UBTI) does not apply when using non-recourse leverage as part of a real estate transaction (unrelated debt-financed income – UDFI). Therefore, unlike a Self-Directed IRA LLC, using a Solo 401K to finance a real estate investment will not trigger UBTI – which imposes a tax in the range of 35% on all income/gains relating to the debt financed portion of the investment.