Self-Directed Solo 401k for Real Estate Investors – Q&A

330 Replies

Over the years I’ve seen many questions here on BiggerPockets forum related to various aspects of using self-directed Solo 401k real estate investing. But the challenge is that those questions are spread out across probably hundreds of different threads and some had incorrect or misleading answers.

The purpose of this thread is to consolidate the questions and provide investors utilizing this vehicle with the useful guide for the years to come. Please do not post questions related to Checkbook IRA, investing in cryptocurrency, precious metals or other alternative assets not related to real estate in this thread, there are other forum topics addressing those issues, simply search the forum or post your question in a new thread.

Let me begin with the question that comes up quite often:

“Can I partner with my self-directed Solo 401k plan to make a joint investment?”

Answer:

You are considered to be “disqualified person” to your Solo 401k. IRS rules prohibited any direct or indirect benefit for such person from his/her retirement account, and as such you are not allowed to furnish any service, goods or facilities to your 401k:

https://www.irs.gov/retirement-plans/plan-particip...

While in some instances it might be possible to get into an investment together with a disqualified person you must be very careful! In my experience dealing with thousands of clients and reviewing many potential transactions involving disqualified person the end result was a prohibited transaction. You also must remember that while in the beginning transaction might be structured in compliance with the rules there is always likelihood of it leading to prohibited transaction in the future because of disqualified person's involvement.

Once you have your personal funds and 401k funds in the same deal you are now opening a “can of worms” and the burden falls on you as the tax payer to proof that there are no personal benefits from your use of the 401k funds, and 401k did not benefit from the use of your personal funds. In most cases that is exactly why the 401k account holder wanted to partner. Don’t do it!

Updated over 1 year ago

For those readers who are not familiar with the self-directed Solo 401k you can read this article to learn more: https://www.biggerpockets.com/blogs/2810/21298-solo-401k-advantages

Hey  Dmitriy, thanks for setting up this post! There is a lot of disinformation out there about self-directed Solo-K's and having a real pro overlook a post is helpful. I have a question about UBIT. Since the new tax plan reduces the corporate rate from 35% to 21% does this also mean a decreased UBIT rate down to 21%?

@Chris Weiler , thanks for your question, this is a good one!

Corporate tax rate and UBIT for non-profit/charities are not the same. To my knowledge UBIT tax rates were not affected by the new tax reform. Perhaps one of the tax experts can chime in to confirm...

Can I use my solo401k to become a private lender to other real estate investors?

Yes, @Dennis Canon , this is very common, I've seen many Solo 401k investors on both side of the isle, as borrowers and as lenders to other investors and to those buying real estate using their retirement accounts, as long as the other party is not "disqualified person". You can't use your Solo 401k to lend funds on your personal deal (or to an entity that you own). 

Originally posted by @Chris Weiler :

Hey  Dmitriy, thanks for setting up this post! There is a lot of disinformation out there about self-directed Solo-K's and having a real pro overlook a post is helpful. I have a question about UBIT. Since the new tax plan reduces the corporate rate from 35% to 21% does this also mean a decreased UBIT rate down to 21%?

I'm not really an expert in SDIRAs, but I believe UBIT tax rates remained unchanged, as trust rates. Waiting for a confirmation from someone who knows more than I do.

  

Hello @Dmitriy Fomichenko . First I would like to put in a recommendation for you, I have had nothing but great service with my SOLO that you helped set up. 

I have a potential partner who is interested in rolling some of his IRA funds into a Self Directed Plan, either SOLO or SDIRA. His concern is what happens at the time when he retires and no longer has Self Employment income. Would he still be able to keep his SOLO once he is no longer self employed?

Thanks, Dan Dietz

@Daniel Dietz , I appreciate the compliment, it is a pleasure to serve you!

A Solo 401k plan is an employer-sponsored plan, therefore in order to maintain Qualified Retirement Plan, he must maintain a small business or some sort of self-employment activity in some legitimate form. If he shuts down his current activity but continues with another type of self-employment activity and make earnings then the plan can continue to exist.

If, let's say, he quits all of his self-employment activity and only receives income from passive sources (interest, rental, pension, social security, etc), then the Qualified Plan must be terminated. He will then have the option of rolling over his 401k into an IRA.

Yes it is possible to partner with your solo 401k when investing in real estate. This can be done under a TIC transaction or by pooling the funds in an LLC. This type of transaction has to be performed under certain conditions so it is best to consult with a retirement accounts attorney/CPA.

@Chris Weiler

A strategy that I am starting to see as a result of the Tax Cuts and of Jobs Act of 2017 (P.L. 115-97) to combat UBIT is investing a solo 401k or an IRA in a C-corporation. In the coming weeks I will post a detailed post on my Bigger Pockets Blog post surrounding this strategy.

@Dennis Canon

Yes a solo 401k may invest in promissory notes, both secured and unsecured notes. A common security for a promissory note is real estate. This means that if the borrower defaults on making the note payments, the solo 401k can end up owning the property if certain legal steps are taken. 

Promissory notes are a popular investment for bot IRA as solo 401k participants who want to take a back seat approach to real estate investing because they don't have to manage real estate.

@Dmitriy Fomichenko I noticed that throughout this post you refer to this technique as a Solo 401k, does this strategy only apply to 401ks or can I use it with an IRA/ Roth IRA? How can I tell if I can use/ switch my 401k into a Solo 401k?

@Nathan McQueen

Yes the 401k rules allow for the transfer of former employer 401k plans to an IRA or a solo 401k. However, in order to transfer the former employer 401k to a solo 401k, you first have to qualify for a solo 401k plan.

Generally, to qualify for a solo 401k you need to be self-employed at minimum on a part-time basis and not have any full-time W-2 employees. 1099 contractors can generally be excluded from participating in the plan as well. A good government resource regarding retirement plans for the self-employed is IRS Publication 560.

Originally posted by @George Blower :

Yes it is possible to partner with your solo 401k when investing in real estate. This can be done under a TIC transaction or by pooling the funds in an LLC. This type of transaction has to be performed under certain conditions so it is best to consult with a retirement accounts attorney/CPA.

Here is the issue with combining personal funds and 401k funds to make a joint investment:

The IRS could easily claim that such transaction violates the IRS conflict-of-interest and self-dealing prohibited transactions in accordance to the IRC 4975(c)(1(D),(E) and (F). Most of the times the reason someone is considering pulling personal funds together with their retirement funds is because there is not enough funds individually to make such investment. Therefore making the investment personally benefited the 401k account holder, since without pulling the retirement funds, the real estate investment could not have been made. This is very easy case for the IRS to declare such joint investment to be a "prohibited transaction".

So glad we have experts on this topic!  Thanks!!

I have $60K in a two separate traditional employer sponsored 401k's.  I want to roll them both into the solo401k since I lost my job and now generate only income from AirBNB on some rental properties I have.  This is self-employment income.

I want to use the Solo401k to eventually purchase a short-term rental property.  So questions:

1) Since these rentals should be high cash flow, I want to convert them to Roth once in the Solo 401k.  Am I correct in thinking that any future income generated from these Airbnb rentals will be fully tax exempt?   Does the UBIT come into play here at all?

2) if I make this transfer in early 2018, at what tax rate will my traditional 401k money be taxed at when converted into Roth?  Will it be my highest marginal tax rate as of 2017?  Or my current tax rate in 2018?  Since I dont have a job, the only income I have is from the airbnb.  I would like to time the conversion so I pay the least taxes possible.   Thanks everyone!

@Noah Mencia

In order to qualify for a Solo 401k plan you need to have legitimate self-employment activity or small business with earned income and no full time employees other than business owner(s) and his/her spouse. Rental income is not considered self-employment income, it is passive income. Here is a link to the IRS resource where you can learn more about self-employment:

https://www.irs.gov/businesses/small-businesses-se...

if you scale your AirBNB activity perhaps it will be possible to use some of the income as "active" but you must work with experienced CPA to provide you with the expert guidance, you don't want to ran afoul with the IRS.

If you establish legitimate business or self-employment activity and become eligible for a Solo 401k you will be able to buy short term rentals in your 401k. Any passive income in your Roth 401k will be tax-free. The UBIT would come into play if your 401k generate unrelated business income, i.e. you run an active trade or business in your 401k such as flipping business, purchase franchise, etc.

If you decide to rollover your old 401k into Solo 401k, and then convert those funds into Roth - you will pay ordinary income tax rate on the amount of conversion. You'd want to convert the cash and then use Roth 401k to purchase the property, not the other way around.

@Noah Mencia

Good question. 

While the UBIT rules are complex and depend on the facts and circumstances, short term rental income earned from real estate owned by a Solo 401k will generally be subject to UBIT if such income constitutes business income.

While income earned from leasing real estate is typically considered non-business rental income, the IRS has identified certain scenarios where real estate rental income is treated as business income.

  • The average period of customer use is 7 days or less.
  • The average period of customer use is 30 days or less and significant personal services are provided with the rental.

See Treas. Reg. § 1.469- 1T(e)(3)(ii)

As such, if Solo 401k real estate is rented via Airbnb on a short-term basis as described in one of the above scenarios, the income would generally be subject to UBIT.

@Dmitriy Fomichenko Thanks-- but as far as I know, the airbnb income is not considered passive, but active.   I believe it goes on the Schedule C (or E? I always get those two confused).  In this case, would it not be treated as self-employment income?

When you say "scale", this seems like a relative term.  I have 6 units and that's how I generate all of my income currently.  Seems like this would constitute self-employment income as its my only source.  Thoughts?

On the 2nd point: when you say "ordinary income tax rate", what rate would this be?  So if it's the beginning of the year and I haven't made any $ yet, it would be the lowest tax bracket then?  And would any income I earn this year start getting taxed at the tax brackets above and beyond what I convert?  i.e.  if I roll 60k over, and made $100k this year, would the 100K get taxed at brackets from 60-160k?  

Also not sure I grasp the last point of 'converting cash then using roth 401k to purchase, and not other way around' -- whats the distinction here?  Dont really grasp this last point.  Thanks for clarification and hope I can get some $ into the Solo with you Dmitriy!

@George Blower   Thanks for these points.


So basically have to set a minimum 7 day rental period and provide very little services.  Good to know but not necessarily practical.  I suppose one could game the  system in slow months and book it oneself or thorough a family member for the 2 slow months and work it so the overall average works to over 7 days.   May be worth it depending on the tax burden.  

Found this online:

A Solo 401(k) Plan subject to UBTI is taxed at the trust tax rate because an IRA is considered a trust. For 2018, a Solo 401(k) Plan subject to UBTI is taxed at the following rates:

  • $0 - $2,500 = 15% of taxable income
  • $2,501 - $5,900 = $375 + 25% of the amount over $2500
  • $5,901 - $9,050 = $1,225 + 28% of the amount over $5,900
  • $9,051 - $12,300 = $2,107 + 33% of the amount over $9,050
  • $12,300 + = $3,179.50 + 39.6% of the amount over $12,300

So these Im assuming would be the profits generated.   Ramps up REALLY fast-  39.6% of any profits over $12,300.  In this case, I think it would def. make sense to play the loopholes game to avoid this tax at all cost.  Knew it seemed too good to be true! lol

@Noah Mencia

Taxes is not my expertise so please confirm with our CPA. The bottom line is this: if you have earned self-employment income - you can legitimately establish Solo 401k plan. Your self-employment activity must be ongoing in order to maintain your Solo 401k plan. In other words if you have some self-employment income this year but don't expect any next year - this would not be appropriate vehicle to use (I'm not saying this is your case, just using that as an example).

When you do Roth conversion you will get a 1099-R for the year in which the conversion was made, that would be considered your income for that year and you would have to report it on your tax return with all of your other income sources. You will pay taxes on your total income, consult with your CPA for details. It is very possible (depending on the amount of conversion) that this event will bump you up to the next tax bracket (again, the reason why you need to have your CPA on board). 

Here is my comment on the last point: if your intention is to invest in property using Roth 401k, use the cash in your 401k as soon as it is funded to convert to Roth. This makes it simple. If you buy the property using pre-tax funds and then decide to convert the asset into Roth, you would have to have independent 3rd party appraisal to determine the value of the property, which is possible but makes it more complex. 

@Noah Mencia

Correct that Schedule C is used to report earned income which could qualify as self-employment income.

Originally posted by @Noah Mencia

So basically have to set a minimum 7 day rental period and provide very little services. Good to know but not necessarily practical. I suppose one could game the system in slow months and book it oneself or thorough a family member for the 2 slow months and work it so the overall average works to over 7 days. May be worth it depending on the tax burden. 

Noah, your proposed "gaming the system" is a prohibited transaction, don't do it! 

This is a good post - I started off on BP answering a lot of questions related to this matter and it was shocking to see all the bad information coming from investors who had already consummated transactions.  Just because someone is doing it and hasn't been caught doesn't mean that they are doing it correct.

At the end of the day it comes down to this - if you are planning to use a retirement account to invest with the goal of creating more retirement income, this avenue may work.  If your goal is to use your retirement account to help leverage your own money or to create income for you personally it will not work.

For those of you who have 401(k) plans - if the plan allows you could take out a participant loan.  This would allow you to borrow from the account and pay yourself interest.  This doesn't carry half the red tape and regulation that investing with your account would create.

If you are serious about investing with a retirement account you better talk to an expert.  The tax liability and penalties can be substantial, especially considering your funds would be sitting in a piece of property!

Quick question,

I'm 20 years old and have recently just now started my full-time job out of college. My 6 months of employment with the company is approaching where I will qualify to open a company sponsored 401k. 

If my main focus was to absolutely make real estate my future goal in terms of retirement and investing, is there any reason I should go over my employer's matching contributions? Also to tag along, will the Roth or Traditional IRA be more beneficial to accommodate my goal of REI? I already am currently taking advantage of pretax deductions through benefits and a Health Savings Account.

Thank you very much!

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