How to fund a solo 401k with rental properties
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Accountant · Atlanta, GA · Member since 2015 · 1k+ posts · 1k+ votes
5yThere's a lot of noise in this thread, hopefully this will help clarify...
First, when we're talking about contributions to a Solo 401(k), we need earned income. Earned income is W-2 compensation to an employee or income that is subject to self-employment taxes. We're not talking about passive or non-passive income. That doesn't come into the picture when we deal with retirement contributions or eligibility and using those terms just muddies the waters.
Second, how this can be structured depends on how the rentals are held. If the rentals are wholly-owned and held directly, or held through a disregarded entity ("DRE"), or held as a fractional direct interest as a TIC, they're probably reported on your Schedule E. In this situation you can't just form a sole prop or DRE property management company with the goal of reporting the management fees extracted from the rentals on Schedule C. This is you are the reporting taxpayer on both ends of the transactions. What happens here is that transactions between the "businesses" are disregarded for federal income tax purposes. We cannot recategorize income.
Management fees between a Sch E and a Sch C are not going to work. The risk is high that they will be recategorized by the IRS upon audit or examination, which means that you've overcontributed to a retirement plan. That is not a good spot to be in.
Third, we have to make sure the juice is worth the squeeze. An arms-length management fee is around 10% of gross rents. If you are just starting out and/or have less than $100k of gross rents, this strategy shouldn't even be considered IMO. It's good to bring up, but a good CPA is going to concisely explain why, after the additional costs...administrative overhead, additional filing fees, employment or SE taxes, etc you'll most likely find the cost-benefit is negative. It does have its place, but that is more geared toward a discussion with a tax professional.
9 Replies
- Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes5y
David, rental income is passive income.
Placing your rentals into an S-Corp usually doesn’t make sense from tax standpoint because you will be exposing all of the income to SE tax.
If you have a portfolio of rental properties that you do manage yourself - you could set up a property management company and charge PM fees, this income will now be considered “earned” and eligible to contribute to a retirement account. But there are implications to that strategy so be sure to discuss your specific situation with qualified tax expert as this is not a tax advice and I’m not a tax expert.
- 5yAshish AcharyaBusiness MemberCPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
Originally posted by @David C.:
I have been watching several of Mark Kohler's videos on Youtube regarding tax strategies and planning, and came across something that made me scratch my head. In his diagrams, he considered all rental properties as passive income, and had noted that profits (if any) from this passive income are not able to be utilized to fund a solo 401k or a self directed IRA.
That being said, if you are the property manager, couldn't you consider yourself a real estate professional and run these profits through a separate S-Corp (or an LLC taxed as an S-Corp) and then draw off a W-2 / and a K1 and then shuttle these proceeds over to a solo 401k ?
Thanks in advance,
Dave
I love Mark Kholer. You dont need (dont want to) S-corp to do that. You can simply convert passive income to non-passive via Sch C via management fees and use Sch C to fund the 401k. You have to remember, this is not going to offset your entire management fees becuase not everything can be funneled into the 401k, only a portion of it. This is why management fees will be not subject to SE taxes.
You also mentioned the real estate professional. Being a real estate professional has no value on what we are discussing here.
INVESTOR FRIENDLY CPA®5241 Reviews - 5yBasit SiddiqiBusiness MemberAccountant · New York, NY · Member since 2015 · 8k+ posts · 3k+ votes
@David C.
You may be able to do that.
However, you have to consider the drawbacks of your stategy.
You are converting a potential scenario where you have passive losses with no active income to passive losses with active income. You will likely have taxable income and an increased tax bill in scenario 2.
There is a cost of creating an S-corp, annual S-corp tax returns, payroll tax returns. Therefore, the benefits has to be greater than the costs for it to make sense.
Basit Siddiqi CPA4.979 Reviews - 5yDavid C.Investor · Member since 2021 · 131 posts · 100 votesOP
@Ashish Acharya and @Dmitriy Fomichenko thanks for the responses.
Currently, we are using the schedule C plan to fund the solo 401k, however, income on Schedule C gets taxed as ordinary income, which is a huge hit.
Follow my thought process here for a moment:
I form a separate LLC taxed as an S-Corp, lets call it XYZ. XYZ accepts profits from the child LLCs for the year. From this S-Corp she will draw a small salary as a W2, and the remainder will not be subject to S.E. tax, FICA or Obamacare and can be placed directly into her solo 401k or a Back Door Mega Roth.
I am definitely going to speak with my CPA, but wanted to see if anyone else had any insight if this was feasible.
- 5yAshish AcharyaBusiness MemberCPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
Originally posted by @David C.:
@Ashish Acharya and @Dmitriy Fomichenko thanks for the responses.
Currently, we are using the schedule C plan to fund the solo 401k, however, income on Schedule C gets taxed as ordinary income, which is a huge hit.
Follow my thought process here for a moment:
I form a separate LLC taxed as an S-Corp, lets call it XYZ. XYZ accepts profits from the child LLCs for the year. From this S-Corp she will draw a small salary as a W2, and the remainder will not be subject to S.E. tax, FICA or Obamacare and can be placed directly into her solo 401k or a Back Door Mega Roth.
I am definitely going to speak with my CPA, but wanted to see if anyone else had any insight if this was feasible.
The retirement contribution amount is dependent on our W-2 amount (can't go too low). Also, your Corp contribution as profit sharing is also dependent on your W-2 (25%). S-Corp is not the same as Sch C. This gets complicated and we have to optimize the FICA/SE tax-saving vs income tax saving via retirement contribution. Yes, absolutely talk to the CPA.
INVESTOR FRIENDLY CPA®5241 Reviews - Accountant · Atlanta, GA · Member since 2015 · 1k+ posts · 1k+ votes5y
There's a lot of noise in this thread, hopefully this will help clarify...
First, when we're talking about contributions to a Solo 401(k), we need earned income. Earned income is W-2 compensation to an employee or income that is subject to self-employment taxes. We're not talking about passive or non-passive income. That doesn't come into the picture when we deal with retirement contributions or eligibility and using those terms just muddies the waters.
Second, how this can be structured depends on how the rentals are held. If the rentals are wholly-owned and held directly, or held through a disregarded entity ("DRE"), or held as a fractional direct interest as a TIC, they're probably reported on your Schedule E. In this situation you can't just form a sole prop or DRE property management company with the goal of reporting the management fees extracted from the rentals on Schedule C. This is you are the reporting taxpayer on both ends of the transactions. What happens here is that transactions between the "businesses" are disregarded for federal income tax purposes. We cannot recategorize income.
Management fees between a Sch E and a Sch C are not going to work. The risk is high that they will be recategorized by the IRS upon audit or examination, which means that you've overcontributed to a retirement plan. That is not a good spot to be in.
Third, we have to make sure the juice is worth the squeeze. An arms-length management fee is around 10% of gross rents. If you are just starting out and/or have less than $100k of gross rents, this strategy shouldn't even be considered IMO. It's good to bring up, but a good CPA is going to concisely explain why, after the additional costs...administrative overhead, additional filing fees, employment or SE taxes, etc you'll most likely find the cost-benefit is negative. It does have its place, but that is more geared toward a discussion with a tax professional.
- Investor · Broward County, FL · Member since 2018 · 1k+ posts · 938 votes5y
I like the concept of having a management corporation. In my case I prefer a C Corp. While you can take a w2 salary from the Corp, it is not the initial goal as converting passive income to active income is usually not tax wise. However, in my case the goal of my C Corp is to have just enough income to cover all the Corp expenses including all the fringe benefit that I can get from the c Corp that I couldn't get otherwise. Also there are much more business expenses that I can justify for the Corp than if I was only doing a disregarded rental LLC.
Sometimes however taking a salary out of the C Corp may be justified, even if it costs more in taxes initially. If you need a W2 income for lending underwriting purpose for instance. Or to justify the creation of a solo 401k where you can rollover other retirement plans that you have.
These situations need to be modeled carefully to determine their cost benefit ratio.
- Member since 2023 · 3 posts · 0 votes2y
Quote from @Ashish Acharya:
Originally posted by @David C.:
I have been watching several of Mark Kohler's videos on Youtube regarding tax strategies and planning, and came across something that made me scratch my head. In his diagrams, he considered all rental properties as passive income, and had noted that profits (if any) from this passive income are not able to be utilized to fund a solo 401k or a self directed IRA.
That being said, if you are the property manager, couldn't you consider yourself a real estate professional and run these profits through a separate S-Corp (or an LLC taxed as an S-Corp) and then draw off a W-2 / and a K1 and then shuttle these proceeds over to a solo 401k ?
Thanks in advance,
Dave
I love Mark Kholer. You dont need (dont want to) S-corp to do that. You can simply convert passive income to non-passive via Sch C via management fees and use Sch C to fund the 401k. You have to remember, this is not going to offset your entire management fees becuase not everything can be funneled into the 401k, only a portion of it. This is why management fees will be not subject to SE taxes.
You also mentioned the real estate professional. Being a real estate professional has no value on what we are discussing here.
I don't believe Mark said you would have to do the mgmt company with a Scorp status. A solo 401k, with a LLC mult husband and wife is fine. And because the LLC profits flow onto the 1040 after all expenses. You really have complete control on how much profit.
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