Created on Monday, May 27, 2019
Updated on Monday, May 27, 2019
by Land Century
You want to get in on the real estate boom, but you don't have the liquid cash to get started. You may be able to use your retirement options to invest in real estate. Primarily, we're going to be discussing investing using your 401k plan.
What's important to know is that a traditional 401 (k) will not allow you to invest directly into real estate.
Unlike a self-directed IRA, a 401(k) plan doesn't have the ability to invest in real estate. A lot of experts recommend that you rollover your 401(k) into a self-directed IRA. When you do this, you'll be rolling over your investment tax-free, and then you'll simply be using the proceeds to invest in real estate.
But there are a few options to consider that will allow for a 401k to invest in real estate.
Self-Directed 401k Real Estate
Self-directed 401k plans are setup for a company. You'll be making self-directed investments on behalf of your 401k. What this allows is for the investments to be directed by the manager of the company or a Trustee of the company.
Let's say that you decide to open up a business that will be doing all of the investing. A self-directed 401k could be used for real estate investing.
There are a few benefits to this option:
- Traditional 401k plans do not allow for direct ownership of non-traditional and real estate investments. Indirect investments are made through a self-directed fund. Capital funds can be deferred.
- Managers have direct control of the funds and investment decisions.
- Funding can be used as a real estate down payment. Debt financing is not subject to UBIT tax.
- Fees are non-existent because the custodian, you, will be in charge of all of the actions.
Litigation threats are also less of a concern when the investment is placed in a holding company.
But there are drawbacks to a self-directed 401k, too. When you want to form one of these 401k options, you'll also need to create a new business entity. The entity that you create needs to be properly managed, and this may mean that you'll have to pay:
- Legal fees
- Business fees
A lot of fees are associated with business ownership, so this is something to consider for an investor. You'll also only have an indirect investment in the real estate.
Self-directed accounts cannot invest in collections. What this means is that the account cannot invest in a collection, such as art or automobiles.
Individual/Solo 401k Investment in Real Estate
Individual and solo plans allow for certain investors to invest in alternative investments. When we say alternative investments, this will encompass the ownership of real estate. Self-directed plans are the option here because small businesses with just an owner and/or an owner's spouse will fall into this category.
The Solo 401k is a great option because it allows for cash from the 401k to be used to purchase the home.
While this is great, the owner that uses these investment opportunities cannot:
- Directly access the investment income
- Use the funds for the direct benefit of a disqualified person
What does this mean? Let's use an example to see how this all works. For example, let's say that you purchased a small bungalow for $100,000 and now rent it out for $2,000 a month, or $24,000 a year.
This is a great return, but you do not have a legal right to use this money for your own benefit.
Rather, this money must be deposited back into the 401k plan. Rental expenses can be paid with these funds, too. You can even use some of the Solo 401k funds to pay for repairs to fix up a property that will then be rented.
Solo 401k plans also have something called the participant loan option.
What this option allows is for you to purchase a primary residence using your plan. The owner can borrow up to $50,000, or 50% of their 401k – whichever is less.
And the main benefit here is that the loan is tax-free and penalty-free.
It's important to know that this is a loan. Yes, you'll be taking out a loan in this case, so you'll have to pay back the loan in the future (we'll be going more into this in the next section).
The great news is that you won't lose the loan privilege because you took the money from a Solo 401(k). A company-sponsored 401k would require the entire balance of the loan to be paid if you lost your job.
Solo 401k plans are meant for single person entities. You see, when you work for a corporation that offers a 401k plan, they'll be required to follow ERISA regulations. These regulations are what the Solo account allows you to bypass.
When a 401k is formed with only one employee, the ERISA regulations are bypassed, which allow for alternative investments and real estate investments.
401k Withdrawal / Investment Rules
Withdrawals from a 401k come in many forms, and since we just talked about the Solo 401k, let's discuss the investment rules here. What's important to understand is that:
- You're borrowing money from the 401k plan.
Yes, you technically own the money come retirement, but until then, you really don't own the money. When you take money out for alternative investments, you're doing so with the understanding that the money is borrowed.
Using the example above, let’s say that you borrowed $50,000 to invest into a property.
If you borrowed this sum of money, you would be using a participant loan option. Under the terms of this loan option, you must:
- Pay back the 401k on a regular schedule
- Repay the 401k over a five-year period
- Pay interest rates
The interest rate is the current prime lending rate plus 1%. Ultimately, the money is yours when you retire, yet to ensure that you don't dip into the retirement fund due to its tax-free, penalty-free basis, you're forced to pay the loan back.
Investment rules for a 401k are defined under the Internal Revenue Code (IRC). What this code does is dictate what is not allowed to be invested in under 401k terms. What the Code, specifically Section 408 and 4975, does is disqualify persons from certain types of transactions. These persons are defined as Disqualified Persons.
These rules are not to limit an investor's investments.
Instead, the rules are there to stop anyone in control of a 401k from taking advantage of their power.
For example, the laws are such that a Solo 401k's disqualified persons would include:
- Someone providing services to the account
- Someone providing fiduciary services
An account cannot engage in any transaction with a disqualified person. Direct or indirect lending of any money is not allowed. A plan owner cannot use his or her own account to lend money to his or her wife, husband or fund directly from the account.
Accounts cannot receive an indirect or direct benefit from a transaction. For example, say the owner of the plan was to buy a property and fix it themselves. The 401k cannot provide money to the owner, who is fixing up the property, because there would be a direct benefit, i.e. money would be exchanged.
It's essential to read the plan and know if real estate investments are allowed.
In some circumstances, investments in real estate will not be allowed. You may need to roll the account over to another account type or form your own Solo 401k.
All expenses related to a property that's purchased must also come out of the 401k account when the property is purchased entirely with money from the account. Solo accounts can purchase an interest in a property.
Let's say that the 401k purchases a 50% stake in a property. This stake would be the amount dispersed to the 401, so if the property brings in $1,000 a month in rental income, the 401k would be entitled to $500, or 50% of the profits per month.
Some individuals will also use complex structures that allow them to bypass some of the disqualified person requirements. But when this happens, you're pushing the envelope of the law and may not want to pursue the deal.
401k Real Estate Down Payment
Investors that want to use their retirement accounts, in this case a 401k, for investments often question how to use the account for a down payment. Buying a property outright is often difficult because only $50,000 can be borrowed from the 401k at most.
In effect, there's no way to purchase a property for this amount that's really worth buying.
You may be able to purchase a fixer-upper, but there would not be any money to disperse to make repairs at this point.
But what's nice is that a 401k can be leveraged. What this means is that the transaction would be under Unrelated Business Taxable Income, or UBTI. Under the Internal Revenue Code, particularly Sections 511 – 514, the income from the investment also isn't taxed.
You will not be paying tax on the money used for the down payment nor income generated from the property.
The income is put directly into the 401k plan, so the owner of the plan never actually receives the income. When the person can retire, they'll be able to use the money that they have saved up.
Loans for the down payment will fall under what is called a nonrecourse loan. What this means is that the loan is secured by collateral. What's the collateral in a real estate transaction? The property that has been purchased.