When to form a Solo 401k: before, or after leaving a W2 job?

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When to form a Solo 401k: before, or after leaving a W2 job?

Veronica Ivy
Rental Property Investor · Charlotte, NC · Member since 2020 · 47 posts · 17 votes

Hi y'all. I'm about to leave my W2 position and basically be a full time professional real estate investor. I am super sold on the benefits of rolling over my 401k into a Solo 401k and then buying rentals with it.

My question is, the end of my work contract is May 15. I want to be able to put offers on properties asap. I know the rollover will take time. Should I set up the Solo 401k NOW before I leave my W2 employment? Or should I wait until immediately after I leave my job?

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Dmitriy Fomichenko
Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
5y

@Veronica Ivy,

Leaving your W2 position has nothing to do with your ability to establish Solo 401K plan.

To qualify for this, you must have legitimate self employment activity or business without FT employees. Do you have that in place?

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  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    5y

    @Ashish Acharya 

    The above is a "revelation" to me! Can you really report long term rental income as self-employment income? 

    0Reply
  • Veronica Ivy
    OP
    Rental Property Investor · Charlotte, NC · Member since 2020 · 47 posts · 17 votes
    5y

    My guess is Schedule C Line B code for a real estate professional reporting active rental income is 531100.

    0Reply
  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    5y

    @Veronica Ivy

    Schedule C is used to report business income. 

    Schedule E is used for rental properties:

    https://www.irs.gov/pub/irs-pd...

    Long term rental income is passive. If you have short term rentals then that income would be considered "active" and subject to self-employment taxes. Why would you want to treat your rental income as active and make it subject to SE tax??? 

    0Reply
  • Veronica Ivy
    OP
    Rental Property Investor · Charlotte, NC · Member since 2020 · 47 posts · 17 votes
    5y

    Yes, I want it subject to SE tax so I can pump it into my Solo 401k. Again, from my close reading of the IRS instructions and case law, you can elect to be taxed as a real estate professional, which means rental income is treated as taxable self-employed income and subject to SE tax BUT you can also just dump it into a Solo 401k and avoid any taxes on that income.

    When you file the election to be treated as a Real Estate Professional, you report your rental income on Schedule C NOT Schedule E, because it's active income now, not passive.

    ETA: There are lines on Schedule C for the SAME business expenses that we use for rental properties on Schedule E like mortgage payments, repairs (e.g., Line 11), depreciation, and everything!

    1Reply
  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    5y

    @Michael Plaks

    What would you say? 

    1Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    5y
    Originally posted by @Dmitriy Fomichenko:

    @Ashish Acharya 

    The above is a "revelation" to me! Can you really report long term rental income as self-employment income? 

    Never, even with real estate professional status, the income is not-self employment income. That is why it doesn’t qualify as earned income. 

    [email protected]941-914-7779
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  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    5y
    Originally posted by @Veronica Ivy:

    When you file the election to be treated as a Real Estate Professional, you report your rental income on Schedule C NOT Schedule E, because it's active income now, not passive.

    Veronica, is this your personal interpretation? Or how did you come up with this statement? Does not seem to be correct per CPA above...

    0Reply
  • Veronica Ivy
    OP
    Rental Property Investor · Charlotte, NC · Member since 2020 · 47 posts · 17 votes
    5y

    By just reading the literal IRS documents. Their instructions literally cover this. I've posted where, along with the relevant quotations. The instructions cover it!

    Originally posted by @Veronica Ivy:

    I'm sorry for getting hung up on this and not just paying a CPA, but here's the IRS website:

    https://www.irs.gov/instructio...

    Section:

    Activities That Are Not Passive Activities

    "Activities of real estate professionals. If you were a real estate professional for 2020, any rental real estate activity in which you materially participated is not a passive activity." (Bold in original.)

    The key text is:

    "A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Services you performed as an employee are not treated as performed in a real property trade or business unless you owned more than 5% of the stock (or more than 5% of the capital or profits interest) in the employer." (Bold, underline, and italics added.)

    No?

    ETA: See also explanation of the relevant tax code: https://eformrs.com/Forms10/Fe...

    Then the instructions for Schedule C are that business income includes RENTAL PROPERTY INCOME.

    https://www.irs.gov/instructio... literally says that rental property income is passive UNLESS you elect to be treated as a real estate professional.

    0Reply
  • Nathan Rutledge
    Rental Property Investor · Lakeland, FL · Member since 2020 · 16 posts · 4 votes
    5y

    @Veronica Ivy

    Hi Veronica, I would say maybe have a call with @Dmitriy Fomichenko to go over this as that is what my wife and I have done. I did not fully understand it either and with both of us being worried about issues, Dmitriy was able to answer all of our questions, and explain how it works. We will be using him and his company with this process once we finish up our taxes and contributions for 2020. I will say that it may be best to review your 401k plan and information as I left a W2 job, and also have a SEP for my personal company. The W2 I am cashing out and they are taking forever to approve it and get the money to me. We will be using the SEP in a few months to turn into the solo/SD401k for investing. I hope this helps.

    3Reply
  • Veronica Ivy
    OP
    Rental Property Investor · Charlotte, NC · Member since 2020 · 47 posts · 17 votes
    5y

    Yeah, my 401k is with TIAA-CREF and I dunno how long they'll take to rollover. I'm hopeful that it won't be fooooorever. I'm also wondering:

    I have self-employment income already, and I can set up a Solo 401k on that basis, couldn't I then contribute, say, $2000 and make an offer w/ some earnest money drawn from that account...with a closing date a few months away to make sure there's enough time for that rollover and the mortgage to close?

    0Reply
  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    5y

    @Veronica Ivy

    Once your 401k is setup and funded, technically you could make an offer and write earnest money deposit from your 401k account. Will that work practically? Will the seller agree to wait a few months? If you find a good deal and seller willing to wait - you are in good shape!

    0Reply
  • Veronica Ivy
    OP
    Rental Property Investor · Charlotte, NC · Member since 2020 · 47 posts · 17 votes
    5y

    Sweet! Thanks! I often specialize in C class (but plan to start shifting to B) properties, so I'm often dealing with very motivated sellers, and I'm careful in the deals I craft to be mutually beneficial.

    0Reply
  • Michael PlaksPro Member
    Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
    5y

    Thanks for tagging me, @Dmitriy Fomichenko.

    @Veronica Ivy, you're mixing together two unrelated tax concepts:

    A. Passive v non-passive income. It matters mostly for your ability to take LOSSES, and this is the area where the REP status comes into play.

    B. Earned income subject to self-employment tax. As both Dmitriy and @Ashish Acharya correctly stated, your rental income is never earned income, never reported on Sch C and never allows you to fund retirement plans. It has nothing to do with REP status. (Some STRs are an exception, but it's a different topic.)

    You can have a separate construction company and hire it for work on your rentals, as you're doing. You can then fund your retirement accounts based on the profits from the construction company, but not from rents on your properties.

    PS. In Veronica's defense, I do recall seeing somewhere in the IRS instructions, years ago, a suggestion that rental income for REPs should be reported on Sch C. They might still say it, as a matter of fact. However, the IRS instructions are worthless as guidance to the tax law. They are notoriously confusing and misleading, and they are often plain wrong. Suggesting to report rental income on Sch C would be an example of the IRS issuing incorrect instructions. Ignore it.

    2Reply
  • Dan Schwartz
    Real Estate Investor · Tempe, AZ · Member since 2012 · 874 posts · 648 votes
    5y

    @Veronica Ivy there are a large number of classes of "rental property" beyond "residential rental property."  When I rent equipment from a store, that equipment is "rental property" on their balance sheet and the rents I pay to use it are "rental property income" to the vendor, who will report it (and depreciate it) on a business tax return (or a Schedule C, if that is the relevant tax form).

    The subtitle of Schedule E is literally "From rental real estate...." etc.  

    1Reply
  • Veronica Ivy
    OP
    Rental Property Investor · Charlotte, NC · Member since 2020 · 47 posts · 17 votes
    5y

    Well the section in the IRS directions was that it was Real estate rentals and leasing...not equipment rentals. That's a totally different profession code for Schedule C.

    0Reply
  • Veronica Ivy
    OP
    Rental Property Investor · Charlotte, NC · Member since 2020 · 47 posts · 17 votes
    5y

    What about this?

     https://support.taxslayer.com/hc/en-us/articles/360046230792-Should-I-complete-a-Schedule-C-or-a-Schedule-E-if-I-am-a-real-estate-professional-

    0Reply
  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    5y

    @Veronica Ivy

    The comment of @Michael Plaks above addresses this issue. 

    1Reply
  • Michael PlaksPro Member
    Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
    5y
    Originally posted by @Veronica Ivy:

    What about this? https://support.taxslayer.com/hc/en-us/articles/360046230792-Should-I-complete-a-Schedule-C-or-a-Schedule-E-if-I-am-a-real-estate-professional-

    Thanks for tagging me, @Dmitriy Fomichenko.

    What you linked, Veronica, is a MISinterpretation of the rules by the technical support team of one of the software companies. They are no experts in the tax law and not an authority. Ironically, they reference the IRS Publication 527, which is also not a legal authority, however this IRS publication does NOT support their incorrect interpretation. Open the publication, search its text for "Schedule C" - and you will see that it is only mentioned in the context of "substantial services" which is the STR/AirB&B exception I mentioned in my earlier comment. The IRS does not mention Schedule C in the context of the REP status.

    I will not be commenting further on this thread, as I consider the topic closed. There is no Schedule C, no self-employment tax and no room for retirement plans in renting real property, REP or not.

    You can generate the "right" type of income via your construction company, but not via rentals per se.

    2Reply
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