Buying rental within Solo 401k vs. taking loan from Solo 401k

21 Replies

I have been going over this in my head for weeks and I just need some feedback.

Which option is better, buying a rental property directly within my Solo 401k (with the intention of refinancing non-recourse down the road) OR take a loan from the Solo 401k to buy the property (with the intention of refinancing conventional)?

I am not thrilled with the non-recourse loans (poor LTV and higher cost and interest rates), BUT there are so many pros and cons for each choice. Can I hear some of your thoughts on what you would do?

@Sheryl Gurvey

This is a no-brainer.  Buy the property with the 401k.  A 401k loan sounds appealing, but carries two hidden costs.  

Firstly, when you borrow from the plan, you will repay the interest to the plan at a rate of about 5%.  You are giving up any potential returns > 5% over the life of the loan.  This is an opportunity cost.

More importantly, you are not just paying 5% interest to the plan.  The real cost is much higher.  When you put money into the plan, it was done on a pre-tax basis.  When you repay the loan, you are repaying with after tax dollars.  That means you likely need to earn about $70K or more pre-tax to replace the original $50K that was tax-sheltered within the plan.

Owing income producing property in a Solo 401k is a great way to diversify your retirement savings into an asset class that is solid and produces good results. You will want to retire some day, and taking advantage of the tax-sheltering benefits of a 401k or IRA to build a large nest egg is one of many strategies you should pursue.

Sure, non-recourse loans are a bit more expensive than a loan you can put a personal guarantee on, but it is still cheap money. You are able to leverage your retirement plan capital and receive a higher cash-on-cash return as a result. When was the last time you were able to do that on Wall St? (Not that I would ever trade on margin anyway, even if you could in an IRA).

One more potential problem with a 401k loan- it's my understanding that should your employment end unexpectedly, for any reason, the loan becomes due and payable in full.

We are self employed and have used a 401k to help pay for real estate investments. That route works better for us. We manage our own properties and do a lot of our own work to improve them.  That is not allowed with a self directed 401k. Because our rentals are long term investments, we can take advantage of capital gains treatment on our profits.

So it just depends on your goals and circumstances.

I would NOT put any real estate into a retirement plan. Why? You lose most of your tax advantages. When you hold RE outside of your retirement plan, you can write off taxes, insurance, maintenance, capital improvements, and depreciation. Having these write offs will offset most of your gross rental income. You may have a tax liability on the difference, but this is usually minimal. On residential property, that depreciation is roughly 3.6% per year for 27.5 years. You get to write off 100% of the cost of the asset excluding land. That is HUGE in the long run. It goes on and on and on and on...for 27.5 years. Beautiful! That helps shield your income for a long time. Furthermore, if you want to sell and defer taxes, you can 1031 out of the property. If you put RE into your retirement account, you lose these tax advantages. Sure, you don't have to claim the rental income...but look at what you are giving up! You are giving up all the yearly write-offs .....taxes, insurance, maintenance, depreciation! You don't give these up just one year. You give these up EVERY year of ownership within your retirement account. You give up the ability to write off 100% of your investment (excluding land costs). You lose the ability to 1031 out off the asset. Talk to a good accountant before you make a decision. When I fully understood the pros and cons, I felt it was a no-brainer: hold RE outside of your retirement account. I do have a SOLO 401K and do use it to invest in RE but in a different manner. I do HML. I get excellent returns and don't forfeit any tax advantages. My two most recent HML netted over 20%. I was pleased with the return and didn't lose one dime in tax advantages as holding RE would have done! BTW, if you have a SOLO 401K, you may be able to borrow money from it tax free for up to 5 years. Get advice from a good accountant and ask for the pros and cons and then make your decision. If you put RE into your retirement account and THEN change your mind, I believe taking it out would constitute a distribution (taxable).

John Thedford, Real Estate Agent in FL (#BK3098153)

@John Thedford

While I cannot argue with your logic - there are tax advantages for investing in real estate outside of a 401k or IRA - you are answering a different question in my opinion... or comparing apples and oranges.

When one invests within an IRA or 401k, the tax implications are what they are, and they are different than investing with after tax funds.

In that sense, comparing investments in a particular asset class, between qualified and non-qualified funds -  whether stocks or real estate or whatever - is not a true comparison.

What one should compare is how will my retirement plan perform investing in real estate vs investing my plan in other assets.  If one has comfort in real estate investing, whether in rental property or note lending as you suggest, they will likely get a higher net return on investment for their plan than if they invested their plan in stocks and funds.  

Whether you "leave some write-offs" on the table is a moot point.  What you generate in terms of security / risk / reward with your 401k investments is what matters.

Notes are nice, but they do not appreciate and you typically cannot use leverage within a Solo 401k to acquire notes.  You can use leverage to acquire property, thus potentially generating a higher return than through lending.

There is no one solution to any of these questions...

If you do plan to take a solo 401k loan, try to take it from the Roth solo 401k bucket as qualified distributions from a a Roth 401k are not subject to taxes; therefore, while the loan payments are made with after tax money, the qualified Roth solo 401k distributions will be tax free. 

For those who can afford to invest both solo 401k funds and personal funds in real-estate, this option is best as you can have the best of both worlds. That is, you end up owning real estate under a tax shelter vehicle as well as in a capital gains vehicle.

@Brian Eastman Just want to reengage on this thread.  Are you sure you can leverage to purchase real estate with a solo 401k?  I think I've heard otherwise but am not sure.  For instance, if I have $50,000 in my solo 401k and want to purchase a property worth $200,000, can my solo 401k get a mortgage to purchase the property?

@Daniel Chun

You can obtain a loan with the Solo 401k plan for the purchase of investment property. The loan must be non-recourse. Here is a list of major lenders offering such loans:

Many small private lenders will do non-recourse loans as well.

In your example you probably will not be able to go up to $200K in the purchase price, typically lender will require at least 30% down plus 10-15% of the purchase price in reserves, so you need to have about 40% of the purchase price available in cash in your retirement account. Therefore with $50K you can probably buy a property in $120-130K price range (depends on the lender, property condition and location). Check with some of the lenders on the list above to get more specific info relative to your situation. 

Dmitriy Fomichenko, Broker
(949) 228-9393

@Daniel Chun

I am absolutely positive that a Solo 401k (or a self-directed IRA) can borrow with a mortgage.

As Dmitriy notes, any loan with a retirement plan must be non-recourse, meaning no personal guarantee from you.  For you to pledge your assets as security for the plan's loan would be a violation of the self-dealing restrictions for such plans.

Non-recourse lenders typically want to see about 30-40% down and 10-15% cash reserves in the IRA or 401k, though, so 25% down as in your example is not likely.

I agree with Brian. In addition, I would never let tax deductions determine whether to invest in real estate or not. I remember as an investment advisor what happened the last time they changed the rules on real estate by the IRS. Lots of money and properties lost.

Why would anyone not want forever tax free gains and cash flow with the Roth portion of their Solo 401k?And then to supercharge the growth by using leverage. What's not to like about a Solo 401k with a checkbook?

I believe--but correct me if I am wrong--that there is one potentially huge advantage of holding real estate in a tax deferred retirement account (SDIRA or solo 401k):

The elimination of immediate capital gains taxes and the opportunity for market-timing arbitrage. 

So here goes.

If I own real estate in my name and sell it, I must pay capital gains taxes unless I use 1031 exchange to buy more real estate.  The window for this is 180 days.   If I think that prices are maxed out, and are likely to drop in the future, I can't sell the property and wait without paying capital gains taxes.  180 days is not enough for a meaningful shift in prices.   If I sell now and buy now, I am essentially paying the same price level.

If I own real estate in a tax deferred account--SDIRA, solo 401k (these are not identical, obviously).  I can sell the property today and pay no taxes, as it is in a tax deferred account.  I could invest in some other asset, or sit on cash for a long period of time--until the forced-withdrawal rules of retirement accounts require that I start pulling money out.    If property values drop, I can buy again.  I believe the downside is that ultimately, I must pay a (hopefully) tax rate of income taxes on withdrawals, versus paying 15% capital gains tax.  And of course, there is no guarantee that the market will behave the way I want to

Originally posted by @Erik Kubec :

... If I own real estate in my name and sell it, I must pay capital gains taxes unless I use 1031 exchange to buy more real estate.  The window for this is 180 days.   If I think that prices are maxed out, and are likely to drop in the future, I can't sell the property and wait without paying capital gains taxes.  180 days is not enough for a meaningful shift in prices.   If I sell now and buy now, I am essentially paying the same price level...

Eric, it is my understanding that in your assumption you considering exchanging one property into another in the same market. So for example if you own appreciated property (SFR) in Denver, CO and would exchange that for another SFR in Denver, CO you would be essentially paying similar price level. However many investors who use 1031 exchange strategy don't do that. There are number of other possibilities to consider. You could sell in Denver and exchange into Columbus OH which is very different market than Denver (remember that there is no national real estate market, all markets are localized). Or you could consider investing in multi-family in your local market which could be in a different market cycle than single family...

The point that I'm trying to make is that 1031 strategy work. And if you have some personal assets or own some property in your own name (outside of a tax-deferred account) - you can't simply transfer that into an IRA or 401k and eliminate capital gain taxes. So comparing buying real estate inside a tax-deferred account vs. personally is like comparing apples and oranges (I like both fruits btw :-), but there are number of other factors you must consider when you making investment plans and determinations. And no two situations are alike, your strategy might be very different than mine... you must take individual approach and not generalize.

Dmitriy Fomichenko, Broker
(949) 228-9393

@Mark Nolan , thank you.  It seems that this would not be considered a 'flipping business' because:

  • The same property has been held in the 401k for 5 years--there has been no 'flipping' business activity
  • If I were to sit on cash  after selling (or something non-real estate) for 2 years, this would give more evidence to this not being a 'flipping' business
  • If I were to buy another property in 2 years, again, not much of a flipping business.

@Dmitriy Fomichenko , thank you. The property in question is held in a solo 401k. Yes, it wouldn't make sense to sell an SFR in Denver and then buy another SFR in Denver with in 30 days. The property is a townhome. Let's say my crystal ball tells me that, over the next 2 years:

  • all the apartment building will depress rents for attached dwellings (like the one in my solo 401k).  
  • Interest rates go up a point, depressing purchase prices
  • Colorado figures out the construction defects challenges, and either condos are built again, or those apartment are converted to condos, flooding the market with supply, and depressing prices.
  • China, in a trade war with the US, goes beyond the new, light capital controls and implements something with real teeth:  Let's say they give their citizens a 'tax holiday' for a year or two if their citizens sell their real estate held else where and repatriate the funds.  If they don't, after the window, they will be subject to jail and penalties.  

All of the above things would cause the value of the townhome to drop.  If I were certain of the accuracy of my crystal ball, I should sell now, not pay any capital gains, and sit on cash.  After the market has dropped a bunch, I could buy back in at lower prices.  No capital gains taxes.  

Of course, all real estate is local.  But all debt is national.  There absolutely is a national market for real estate.  Somebody in Columbus is looking at the same interest rates as I am, and possibly also competing with the same buyers (Chinese, Blackstone, Waypoint) as I am.  Currently, multiple cities are setting records for apartment building.    I think the way to look at it if I were to sell 'Denver / buy Columbus' (or another city) is to understand how much 'decoupling' from national trends there is.  Waypoint, Chinese nationals, Blackstone may not be in Columbus, but interest rates will be similar to what I pay in Denver

Folks, as I understand it, regarding leveraged property inside your SD-IRA, the leveraged portion will be hit upon sale with UBIT as the IRS does not want you having a tax-free opportunity on the leveraged portion of the asset. That rate is at the current 35% Corporate tax rate so not a small deal here. However, a Solo 401K, there is no UBIT issue. Can you confirm?

@David Thompson

It is best to take something this off topic and start a new forum.

In an IRA, debt-financed income is subject to UDFI taxation (a subset of UBIT). The tax is paid by the IRA at trust tax rates which scale from 15% to a max of 39.6%. Because of the deductions one will have, most investors dealing in a rental home or two will not generate enough net taxable income to get into a higher tax bracket, but even if they do, it is a high tax on a small percentage of the overall income generated by the property. The use of leverage in an IRA will almost always result in a higher cash-on-cash return to the IRA relative to an all cash purchase.