Self Directed 401K Taxation of Rental Income

26 Replies

I am looking for some initial advice (prior to hearing from my CPA) concerning the use of a self directed 401k to purchase and operated a multifamily real estate unit.  My primary question is one of "business" or "commercial" rental income tax (currently Ohio State).  I know my taxes from the rental income on a personal level are deferred until retirement but is the unit subject to "business" income tax?  For some reason I believe I heard someone on BP discussing commercial taxes that were unrecognized during their analysis of a property and it significantly impacted the returns.


Thanks in advance for any advice. 

Jimmy Patrick Hall

Patrick, 

If your 401k owns multifamily real estate and receives rental income - this income will be sheltered from taxes. 401k is tax exempt entity and does not pay taxes on passive income. Some local municipalities may asses separate taxes (separate from the property tax). Your 401k would have to pay those assessments just like it would pay other expenses such as property taxes, property insurance, etc. For example, city of Phoenix, AZ charges special sales tax on all rental dwellings in the city, my property manager pays that of of the income and the rest goes into my 401k. 

Thanks Dmitriy.....appreciate the comment. 

@Patrick Hall

As @Dmitriy Fomichenko accurately stated -rental income in an Ira or 401k is exempt from federal taxation. State and local governments have been significantly increasing taxes on rental income over the last decade by adding or increasing sales tax on rental income, Forcing all real estate owners to get liscenses to be able to rent properties, increased government inspections of properties prior to new tenants moving in, increased property taxes, etc. This taxation may be what you eluded to in your post. If you are in the bigger cities it is most likely going to affect you. As an example Philadelphia about 8 years ago changed the law from exempting IRAs, 401ks, HSAs, etc to making it mandatory to pay sales tax and have a business license.  Florida imposed a new sales tax of 7.5% on commercial rental property income  while leaving residential properties income without a sales tax on income. It definitely can impact the bottom line in an analysis. The governments find where the money is and then tax it. I hope this helps. 

Thank you Carl...yes....these additional taxes are what I am referring to. So many avenues to investigate with the SD401/IRA.

Have a great fathers day.  

One thing to bear in mind is that if you obtain a mortgage on your rental properties, then you will need to file a tax return for your IRA to report UDFI (Unrelated Debt Financed Income) tax. This applies only if your rentals run at a paper profit, but with mortgage interest and depreciation, they may not. You still have to file the tax return though, even if there is no tax due.

Linda......awesome input. So many things to consider. I was planning on purchasing a 400k MF with cash but was planning on getting a line of credit on the piece in order to handle any "expected" surprises. Would I need to file if I used the LOC or if I even had the LOC available?

Thanks Again.

@Linda Weygant my understanding was that properties purchased with 401k funds cannot benefit from depreciation, because the earnings from the 401k are not taxable. Is that correct?

@Yonah Weiss ,

You are correct, the depreciation is a paper loss used to offset the income. Since 401k is "tax-exempt" vehicle there is no taxes on the income, therefore depreciation would not apply here.

@Yonah Weiss , @Dmitriy Fomichenko - The Depreciation comes into play when you're calculating your profits for purposes of UDFI Tax computation.  You get to calculate the taxable income in the same way as a Schedule E filer, then apply the UDFI Tax computation to that.

@Linda Weygant & @Yonah Weiss

UDFI does not apply when a 401(k) or other qualified employer plan uses debt-financing, if the debt is associated with the acquisition of real property. What you are referring to Linda applies to an IRA, but not to a Solo 401(k), due to the exemption 401(k)'s have.

More great info Brian....how the average joe like myself can keep up with all this is besides me.  

Respectfully, who do I follow?  

Patrick

     

More great info Brian....how the average joe like myself can keep up with all this is besides me.  

Respectfully, who do I follow?  

Also...for my edification.....UDFI stands for????

Patrick

     

@Patrick Hall @Linda Weygant @Yonah Weiss

The distinction is between (a) Individual Retirement Arrangements - IRAs and (b) Qualified Plans (e.g., 401k, profit-sharing). 

All are subject to tax on Unrelated Debt Financed Income (UDFI). However, there is a carve out that exempts Qualified Plans when the debt incurred is "real estate acquisition indebtedness." 

When UDFI is applicable, it can be offset by real estate expenses, such as mortgage interest and depreciation. 

Bernard.....great. I am a little confused or just want to clarify the responses....I am in the process of converting previously amassed 401k (developed through W-2 employment) to a solo/self directed 401k (an LLC - as I am now a consultant/1099). Planning on converting to real estate at least a portion of the account. Will I have to pay any taxes on the proceeds/rental income prior to the withdrawal period? And I am asking about income type taxes?

Income tax of any kind?

Commercial business tax?

 Thank again, all of the comments have been very enlightening and thought provoking.

Patrick

@Patrick Hall

Generally speaking you should not expect any state or federal income tax burdens.

In converting a conventional retirement to a self-directed retirement plan, there are no taxes involved.

Rental income to a plan is not generally taxed.  It is tax-deferred to the plan just like dividends in a conventional plan.

As a property owner, the plan would be responsible for property taxes as an expense of operation.

The  tax-exempt retirement plan may also be subjected to any local taxes or fees, such as some cities levy on owners of rental property.

The rental income is ONLY taxed in cases where an IRA uses outside capital in the form of a non-recourse mortgage.

Otherwise, you are not taxed until such time as you take personal distributions from the plan, just like any other retirement plan.

@Patrick Hall A little context may be helpful. A 401k Plan is a tax advantaged vehicle that is sponsored by a business. An IRA is an individual account and is not sponsored by a business.

A business, for the purpose of sponsoring a 401k, can be any type of trade or business that is carried on. An LLC is not a trade or business, but rather a legal entity that provides liability protection for owners of a trade or business. The key to sponsoring a 401k is the presence of an active trade or business, which may or may not have an LLC.

A 401k plan, according to the tax code, can invest in nearly all asset types. Most 401k plans call themselves "self-directed" because they give you the option of choosing where to invest your funds - from a menu of mutual funds. This absolves the Company and Trustee of liability for investment performance (but not from liability for providing plans that are beset with fees: https://www.reuters.com/article/usa-401k-lawsuits/...).

Solo 401k Plans come in many varieties: (a) the type that only allows mutual funds, stocks, etc., (b) the type that allows alternatives but doesn't give you direct control over your money, and (c) Checkbook 401k that gives you total control and flexibility to invest in real estate, private lending, etc. (of course, it can also be invested in mutual funds and other liquid securities).

When moving funds from your prior employer 401k, ensure that it is does as direct rollover "trustee-to-trustee," to avoid any tax issues.

Once it's in your Solo 401k Plan, you'll be able to pursue most investments with all the tax advantages that you expect from a 401k plan.

Some investments that are available in Self-Directed Solo 401k may result in taxable income to the 401k, not to you personally. In those instances, the 401k requires its own income tax return. 

Investing in a business (e.g., restaurant) would subject the 401k to the tax. Buy-and-hold real estate is not subject to the tax. Real estate development and flipping may be subject to the tax.

Hope this resolves your question!

Bernard....thanks for the schooling.  Yes....it will be a checkbook 401k.  So I am planning on figuring some type of possible commercial activity tax depending on City/County/State regs (payable by the 401k entity) and detailed on its own tax return, based on my BP education in process.    

Just recently joined  the BP and this has been invaluable.

I have been in contact with a couple individuals that setup solo 401k's.  However, if anyone can be recommended by a BP member, I would be grateful for that reference.

Patrick.

Hey, Patrick.   

I had good experience with Mark Nolan at Mysolo401k Financial, which is mysolo401k.net

Hope this helps....and good luck!

David

@Patrick Hall you are getting some good advice here from some excellent contributors here on BP. 

I have both SDIRA and SOLO401K. As stated above, the UDFI only 'is due' on the SDIRA if non-recourse loans are used (non recourse is the only kind of loan allowed in any type of retirement plan, I believe), but NOT on the SOLO401K as it is 'exempt'. 

My 'roll over' amounts were MUCH larger than my contributions since I switched over, as is often the case I think. The reason that I have BOTH kinds is that a good portion of my funds were in a ROTH IRA, which is about the only kind that you can NOT roll into a SOLO401K :-(. I believe that you CAN convert traditional funds over to ROTH AFTER they are in the SOLO401K thought.

It seems from all the research that I have done that if a person qualifies for a SOLO401K it is a superior type of plan in almost every way. 

I am just reading a book that is called "Keep It" about advanced tax planning for IRAs or any type of similar retirement plans (thanks to whoever recommend it here) that has TONS of great info and I would HIGHLY recommend it.

Dan Dietz

@Patrick Hall

There are several providers that are active on BP and are present on this forum, including myself. Have a look near the BP members' names. Those that reference IRA or 401k are the service providers that you're looking for. We're all on BP to learn from, and provide services to, - other real estate investors. (401k providers that don't allow real estate investment in their plans would not be providing meaningful services to the BP real estate community.)

Gosh...I have to say I am really enjoying (getting tuned up by) this BP forum.

My conversion will only be around 500,000.  So looking forward to escaping the mouse trap that is the standard 401k plan but am very aware that significant care must be made in order to not get slaughtered by the IRS down the road due to any prohibited transactions. 

Thanks to ALL.

@Patrick Hall I would second what @Bernard Reisz said about taking a look at the providers who are active here on BP. I called several before I chose @Dmitriy Fomichenko , who I have had great service from, and ALL of the ones here gave me more time and advice for my situation that any of the 'big firms' that I contacted. 

I think some people thing the larger firms *might* be a little cheaper (not sure) but when you are talking about an investment potential hundreds of thousands of dollars, what is a few hundred to get the best service when needed?

Dan Dietz

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