A 401(k) plan is an IRS approved plan that is often referred to as a cash or deferred arrangement (CODA). A 401K Plan is an employer-sponsored employee benefit arrangement established for the purpose of providing retirement income for eligible employees. In lieu of receiving cash payments for compensation for services, a 401K Plan participant may elect to have a portion of his salary paid as a contribution to an account established on the participant’s behalf within a qualified retirement plan.
Almost any employer with a business and at least one employee (can be the owner) can adopt a qualified retirement plan., including a sole proprietorship, corporation, partnership, or limited liability company.
Prior to 2002, a sole proprietor with no employees would not have been a suitable candidate for a 401K Plan. Now a sole proprietor can enjoy the same benefits as those offered by a 401(k) Plan by simply maintaining a profit sharing plan and determining the contribution amount each year.
When it comes to making investments with a 401K or Solo 401K Plan, the IRS only identifies the type of transactions that are not allowed- or prohibited. In other words, as long as the investment is not prohibited by the IRS it can generally be made by the plan.
Real estate has always been a permitted investment when it comes to a 401K or Solo 401K Plan.
The Real Estate 401K Solution
The IRS has always permitted a 401(k) Plan to purchase or hold real estate or raw land. Furthermore, with a Solo 401K or Individual 401K Plan, making a real estate investment is as simple as writing a check. With a Self Directed or Solo 401K Plan, since you are the trustee of your Solo 401(k) Plan, you have the authority to make investment decisions on behalf of your 401(k) Plan. This is not always the case with a Traditional 401K Plan since the trustee has a fiduciary responsibility to all employees, not just hi or herself. This is one reason why most businesses with more than one employee will not permit the plan participants to invest in real estate. It generally comes down to a trustee liability issue.
One major advantage of purchasing real estate with a Solo 401K Plan is that all gains are tax-deferred until a distribution is taken.
For example, if you purchased a piece of property with your Solo 401(k) Plan for $75,000 and later sold the property for $100,000, the $25,000 of gain would generally be tax-free.
Another advantage of using a 401K or Solo 401K Plan to purchase real estate is that non-recourse leverage can be used without triggering a tax penalty. Unlike a Self Directed IRA LLC, when a 401K Plan or Solo 401K Plan buys real estate that is leveraged with mortgage financing it is exempt from paying any Unrelated Business Taxable Income (UBTI or UBIT) tax on the income or gain generated. With the UBTI tax rates at approximately 35%, the Solo 401(k) Plan offers real estate investors looking to use non-recourse financing in a transaction a tax efficient solution.