When it comes to real estate, leverage is often the trick to success. That is, using other people’s money to increase your purchasing power and, over the long term, use that invested money to create more. Indeed, one of the biggest lessons any novice real estate investor must learn very early on is that the more you can manage risk, the greater the steadiness of your real estate investment ship.
One thing intelligent investors do is buy real estate through retirement accounts. Real estate is considered an alternative investment, meaning it can be owned by a retirement account. A Self-Directed Individual Retirement Account or Self-Directed IRA (SDIRA) is often used to make real estate investments, the advantage of this being that the gains from this investment aren’t taxed until a person’s retirement and withdrawal. This is why real estate purchases using retirement accounts are often used as a tax strategy.
If you’re self-employed or have a solo business, the Solo 401(k) plan, which is also sometimes referred to as Self-Directed 401(k), Individual 401(k), or One Participant 401(k), can provide a vehicle through which to purchase real estate.
What is a Solo 401(k)?
As a small business owner, you can use a Solo 401(k) or Roth Solo 401(k) to invest in real estate. It’s important to note that traditional company-sponsored 401(k) plans do not offer this option, and the perks of real estate investing are limited to Solo 401(k) retirement plans alone. With a self-directed retirement plan, you can invest your retirement savings in various investment vehicles in addition to real estate, some of which include precious metals, bonds, stocks, mutual funds, tax deeds, tax liens, etc.
A variety of real estate property types can be bought using the funds from a Solo 401(k), such as apartments, single-family homes, multifamily buildings, commercial properties, condos, and mobile homes. Generally, most real estate investments are permitted, except those that are prohibited or involve a disqualified person.
The expenses related to the purchase and maintenance of the real estate must come from the Solo 401(k) bank or brokerage account. These expenses include mortgage, property taxes, insurance, and HOA dues and repairs. Using funds from personal finances is considered an early distribution and has tax implications. It’s also important to remember that depreciation from real estate held by a retirement account is not allowed.
To invest in real estate using your Solo 401(k), you first need to ensure that your Solo 401(k) plan gives you the option to invest in alternative investments. To be eligible for a Solo 401(k), you must be one of the following:
- Self-employed
- Actively generating a portion of your income through self-employment activities
- Small business owner with no employees (except for yourself or a spouse)
- Independent contractor with part-time employees
Why use a Solo 401(k) to invest in real estate?
There are several advantages to using your Solo 401(k) to purchase real estate. Some of these include:
Tax deferment
One of the biggest benefits of using a retirement account, such as the Solo 401(k), to invest in real estate is the tax benefits that come with this strategy. The devil, as they say, is in the details. And the details are in the compounding. When your real estate investment generates returns, instead of having to pay tax on those returns right away, you can defer the taxes, allowing your investment to grow unhindered and tax-free.
Non-recourse business loans
A real estate non-recourse loan is a loan secured by a specific property and repaid using the cash flow generated from that collateral property. This cash flow includes rent income and proceeds from the sale of the property. When borrowers purchase an investment property through their Solo 401(k), they can use non-resource business loans.
Under the IRS prohibited transaction rules, you can only use a non-recourse loan from a non-disqualified person, such as a bank.
Leverage
Remember that leverage we talked about earlier? That’s what a Solo 401(k) can give you. Investing in real estate requires capital, and the more you want to buy, the more you’ll need to come up with. When you buy real estate using a non-recourse loan (your leverage), it’s considered “debt-financed property” and is subject to the Unrelated Business Taxable Income (UBTI) tax, which can be as high as 37%. That’s where the beauty of the Solo 401(k), which is not subject to the same UBTI rules as an IRA, comes in. The IRS rules, specifically Internal Revenue Code Section 514(c)(9), permit a few qualified organizations to be exempt from the UBTI tax, including qualified retirement funds and plans. Real estate investments are also not subject to the Unrelated Debt Financed Income (UDFI), which at 40% can be quite substantial.
Finally, the asset protection it offers makes the Solo 401k an excellent tool for real estate investment—the Solo 401k is protected against bankruptcy and creditor claims.
Ways to purchase property through a Solo 401(k)
A few different investment options can be used to purchase real estate through a Solo 401(k). Here are some of the most common ones:
All-cash purchase
This is the simplest way to use your Solo 401(k) to make a property investment and involves using cash only from the Solo 401(k) to fund the purchase of the real estate property. Effectively, this means that once the property is purchased, the Solo 401(k) owns the property free and clear with no debt financing.
Non-recourse loan
As discussed above, a non-recourse loan can be used for buying a real estate property through a loan from a bank or other lender. You cannot borrow from relatives, including a spouse, natural or adoptive parents, or any business owned by the Solo 401(k) owner or family members.
Limited Liability Company (LLC)
While a real estate purchase can be made directly through the Solo 401(k) account, you can also opt to make the purchase through a special trust company. You’ll need an Employer Identification Number or EIN for the LLC, allowing you to open a bank account. This account can then be funded using money from the Solo 401(k).
Tenants in Common purchase
This is a way to purchase property through a mix of personal funds and Solo 401(k) funds. This method allows you to partner with other investors, including family members, to purchase the property, with the ownership split based on terms that have been agreed upon. Expenses for the property are also shared between the owners.
The 6-Step Process
Here are the steps you’ll need to follow when using your self-directed Solo 401(k) to make a real estate purchase.
Step 1: Open the Solo 401(k)
The first step, of course, is to open a Solo 401(k) account. When you buy a property using this Solo 401(k), the property will be registered in the name of the Solo 401(k) plan. You’ll want to ensure that your plan provider offers the option to invest in alternative investments such as real estate.
Step 2: Fund the Solo 401(k)
Once you’ve opened a Solo 401(k), the next step is to fund this account. You can make annual contributions, transfer from other qualified plans, or do a direct rollover from traditional IRAs, SEP IRAs and SIMPLE IRAs. Rolling over pretax retirement funds or making a tax-deductible or after-tax Roth IRA contribution is a common way to fund the Solo 401(k). You’ll want to plan this in advance because processing transfers between accounts takes a week or two.
Step 3: Choose the method you’ll use to purchase the property
As discussed above, there are multiple ways in which you can choose to buy a property, including an all-cash purchase, debt financing, forming an LLC, or with a TIC (Tenants in Common) purchase. Decide which method you’ll be using so that you can get the paperwork and details ready.
Step 4: Put together offer
This next step will depend on which of the methods you’re using to make the property purchase. In the case of an all-cash offer, you’ll need to ensure that you list the Solo 401(k) as the buyer and not you personally. The Solo 401(k) is considered a separate investor and legal entity from you, and the ownership of the property will be in the name of the Solo 401(k).
Step 5: Earnest deposit
You’ll need to make a deposit for the property, again, using Solo 401(k) funds.
Step 6: Closing
Once the deal is finalized, the trustee of the Solo 401(k) and the account holder, which is you, will approve and sign off the property purchase documents and submit them to the closing agent. Assuming this is an all-cash purchase, you will transfer the remainder of the money and pay all closing costs.
The bottom line
The Solo 401(k) is a fantastic way to fund a real estate investment, especially if you’re a solo entrepreneur or small business owner who can benefit from the tax deferment and leverage this option provides.
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