A self-directed, or solo 401(k)—also called a self-directed 401(k) or a one-participant 401(k)—is a versatile retirement account that gives real estate investors and business owners a great way to save for retirement.
For many of my clients, the opportunity to invest in real estate is the primary reason they switch to a solo 401(k). To learn the basics about these accounts, check out “Introducing the Solo 401k: The Perfect Retirement Account for Investors.”
What Are the Advantages of a Solo 401(k)?
As a self-directed 401(k) owner, you are allowed to borrow from your account. This is one important way the solo 401(k) differs from almost all other types of retirement accounts. The IRS distinguishes between taking a loan from your self-directed 401(k) and requesting a distribution (subject to penalties and taxes).
Borrowing From Your Solo 401(k)
Unlike a bank loan, borrowing from your self-directed 401(k) does not require a credit check. You can borrow up to $50,000 or half of your balance—whichever is lower. In other words, if you have $75,000 in your account, you can borrow up to $37,500; if you have $150,000, the loan is capped at $50,000.
Just like with any other loan, you must repay it. You have 5 years to pay back your loan. After that, the remaining balance of the loan is deemed to be a taxable distribution by the IRS.
If you are on a regular pay cycle, you can choose to make blended payments that consist of the principal and interest owed, as dictated by an amortization table. If you do not receive a regular paycheck, you must make a payment every 90 days.
You can borrow up to 50% of your solo 401(k) to finance real estate investments. The smart investor can use this feature to multiply funds.
Why Use a Solo 401(k) To Invest in Real Estate?
A solo 401(k) is not the only retirement-planning vehicle you can use to invest in real estate. However, it does offer several features that make it easier and almost completely hassle-free when compared to other options.
All expenses related to your solo 401(k) real estate purchases must come from your retirement account. If you use your personal finances, the IRS will consider it an early distribution, resulting in penalties and taxes. This is easy, however, because of the checkbook control you get when you open a bank account in your solo 401(k)’s name.
Here’s a quick rundown of of the benefits of using your self-directed 401(k) to invest in real estate:
Tax-deferred profits grow your savings faster. When you use a solo 401(k) to invest in real estate, tax-deferred gains give you a larger fund pool to use for future investment opportunities.
You control your funds. If you were to use a self-directed individual retirement account (SDIRA), you would need a custodian act on your behalf when investing. When you establish a business entity in the name of your 401(k), you can open a bank account with checkbook control.
Real estate investments are not subject to Unrelated Debt Financed Income (UDFI). At 40%, the UDFI tax is hefty. If you use 20% of your SDIRA to purchase a property, combined with a mortgage that pays the remaining 80%, 80% of your gains will be subjected to the 40% UDFI tax.
You can use non-recourse business loans. Using non-recourse business loans to purchase real estate with your solo 401(k) can help to protect those assets from lawsuits, bankruptcy and more.
Investing in Real Estate With a Solo 401(k)
To start using your solo 401(k) to invest in real estate, there are six steps to take.
Solo 401(k) Investment Procedure
Step 1: Open a solo 401(k) account.
Make sure your solo 401(k) account name is the only one associated with all purchase-related documents. Using your personal name on any documents related to the purchase is prohibited by the IRS.
Step 2: Transfer funds into the account.
This may seem obvious, but it is important. Contributions can be made through roll overs, transfers from other qualified plans, or through your pre-tax deposit into the account.
Step 3: Decide how you plan to purchase property.
There are three ways you can invest in a piece of real estate with a solo 401(k).
1. A solo 401(k) cash purchase in which you use only funds from your account to invest in the property.
2. A tenants-in-common (TIC) purchase allows you to use both personal and solo 401(k) cash to invest in a property. This option allows you to partner with individuals considered “disqualified persons” with other retirement accounts. (Note: You cannot use a mortgage or debt to purchase through a TIC.)
3. A non-recourse business loan to purchase, or partially fund, your real estate investment. This option protects your other investments and funds from bankruptcy or default should one of your properties fail.
Step 4: Make an offer.
This is where step one becomes vital–your solo 401(k) is the buyer of any real estate you invest in.
Step 5: Make your deposit.
As the purchaser, your solo 401(k) must make the deposit for the property.
Step 6: Complete the closing process.
As the solo 401(k) trustee, you need to submit any required purchase documents to your escrow agent, including the check from your retirement account.
Solo 401(k) Real Estate Tips to Stay IRS Compliant
Remember, 401(k)s are funded in various ways. There are funds that have been rolled over from another retirement plan, contributions you have made, and returns on investments, for instance. When all these funds are kept as one lump sum, it becomes difficult to show compliance with certain IRS restrictions.
Segregating Funds Keeps Investors Compliant
Segregating funds helps keep your books more transparent. You need to account for all funds in your retirement account to stay in the clear with the IRS.
For example, there may be some instances in which you can hold life insurance in a 401(k). If all the funds are mixed, it becomes difficult to prove to the IRS that you are in compliance. Now you have the IRS hovering over your retirement fund with the threat of penalties and disbursement looming on the horizon.
You also want to segregate pre-tax contributions from other funds within the account because it’s easier to show the IRS where this money went when you claim it at the end of the year. Roth funds, on the other hand, must be specifically designated as such.
Segregating funds may sound like a lot of work, especially when you’re your own trustee, but it works to your benefit and protects you from a possible audit.
By Scott Smith, Bigger Pockets