There are many investors who diversify their investment portfolios by investing in real estate, yet are afraid to do so with their retirement accounts, regardless of whether the account is a 401K or an IRA (individual retirement account).
Rehab Financial Group hopes to demystify this investment vehicle for you, as for many investors, it is an excellent way to generate high returns on their retirement assets.
The difference between an IRA and 401k
Briefly, most 401ks are set up for individuals through their employment. For self-employed people, the IRA is the best vehicle to create tax sheltered retirement investments. One of the biggest differences is the tax deductible amount that can be contributed each year into each type of plan. With the 401k, there is no income level phase out, but the IRA contribution has some limitations based on the individual’s income.
By investing in real estate through your IRA or 401k, your investment can grow on a tax deferred basis. Even better, if done through a Roth IRA, you can achieve some tax free growth. There are limitations and risks, however that any investor should be aware of. There are also specific rules that must be complied with in order to stay within the rules set forth by the IRS.
IRA Real Estate Investment Rules
You CANNOT purchase a property that you plan to live in, even as a vacation home with your IRA.
It must meet the strict definition of an investment property. This means that it cannot be occupied by you, or any member of your family (even if they are paying rent) and must be used as an income generating property. You also cannot purchase the property from a family member.
If the investment takes a loss in any given year, you lose some of the tax breaks and you cannot depreciate IRA owned real estate.
Lastly, if you are over 70 ½ and need to take required minimum distributions from your IRA, you need to insure that you leave enough cash in your IRA to be able to meet this requirement without having to liquidate the real estate.
Other rules related to investing in an IRA property are that you should not perform significant work at the property yourself, even if you are a skilled contractor, and reimburse yourself, as that could be considered self-dealing, which is prohibited.
Additionally, you must file a report of the fair market value of the real estate every year with the IRS. All expenses of the property must be paid from the IRA and all income must be paid into the IRA.
401k Real Estate Investment Rules
The rules in investing through a self-directed 401k are similar. Create a Solo 401k, which gives you the option to control the checkbook of the property as the Trustee of the Solo 401k without a third party custodian.
All fees, costs and income need to come out of the Solo 401k, and must not be mingled with any other funds. When making an offer to purchase an investment property, make sure that the offer is in the name of the 401k, or IRA, not your own name. The Solo 401K rules prohibit the assignment of a contract originally written in the name of a different buyer.
If you do not have enough 401k assets to purchase the property solely in the name of the 401k, you can partner with others, and the 401k would own a proportionate share of the underlying real estate.
Just be careful, you cannot invest in a property already owned by a family member (a disqualified person) but you can buy a property from an unrelated third party with a family member or friend.
Financing Through a Solo 401k
With regards to getting financing through a Solo 401K, there are certain rules that the lender must abide by. The loan must be non-recourse, meaning that the only recourse for the lender is foreclosure on the property. The lender cannot take a guaranty from you personally.
The classification of a loan as non-recourse may lead your lender to change the terms of the loan from its non-retirement account loans, so you should make sure to let the lender know that the borrower will be a retirement account, and let them explain their policies with regards to this.
At Rehab Financial Group, LP, we adjust the loan to value for these loans, but the rest of the process remains substantially the same.
If you are seriously thinking about investing in real estate through a self-directed retirement vehicle, it is worth the expense to speak with your accountant, to make sure that you are following the rules, and to discuss any potential issues you may have.
Depending on how the retirement plan is structured, you want to make sure to avoid losing the tax protections for retirement accounts and/or exposing yourself to liability for unrelated business tax income.