The Solo 401(k) operates in essentially the same way that a 401(k) retirement plan offered by a large employer does. In fact, the official IRS designation for this type of account is a One-Participant 401(k) plan. The Solo(k) is different than a major employer plan only in that it’s strictly for companies without employees other than the owner (although spouses may be eligible). The Solo(k) has many features not offered under IRA structure and this blog will give you a better idea of the advantages and how they can dramatically benefit you and your real estate investing goals.
A Solo(k) provides you the opportunity to defer substantially more income when compared to an ordinary Traditional or Roth IRA. Becuase an account holder can make Solo 401(k) contributions simultaneously as employee and employer, they can enjoy nearly ten-fold contribution abilities over Roth or Traditional IRA holders.
One advantage to utilizing retirement account funds for real estate deals is receiving the benefit of tax-deferred growth. As plan funds are invested, they generally grow without taxes. When paying the full purchase price for real estate using IRA or 401(k) cash, there is no need to worry about depreciation or investment expenses because no taxes exist. Furthermore, when the plan sells the property at a later date, there are no concerns over capital gains or need for a 1031 exchange. The tax advantage that the plan enjoys can create a dramatic snowball effect of growth.
An IRA or Solo(k) can seek out a non-recourse mortgage and increase the purchase power of the plan assets. For those of you that don’t know, a non-recourse mortgage does not have a personal guarantee, and only the property itself is held as collateral. Lenders will usually look for down payments between 30-40% depending on who your lender is.
Normally with an IRA, profits generated from debt-leveraged financing are subject to something called unrelated business income tax (UBIT). This special tax is the IRS’s way of leveling the playing field for tax-advantaged entities utilizing leverage and investing in ongoing business activities. Let’s look at a quick math example:
Assume I purchase a property with my IRA for $100,000 and finance 50% or $50,000. For simple math purposes, also assume that I generate net income of $10,000 after depreciation in year one. If my outstanding debt ratio is 50% then half ($5,000) of my net income is derived from non-IRA dollars. Therefore, I would have to file tax form 990-T for my IRA and calculate UBIT on the net profit of that 50% that is attributed to the debt leverage. This is a simplified explanation and other details go beyond this explanation but it serves as a good example. UDFI taxes follow the IRS tax rate schedule for Trusts and Estates.
So... How does this UBIT apply to 401k real estate investing?
UBIT associated with UDFI does not apply to 401(k)s. Self-employed real estate investors that have an Solo(k) can therefore benefit from some additional tax savings under the 401k structure when leveraging retirement dollars. It’s important to note that the 401k structure is NOT exempt from UBIT when it comes to unrelated business taxable income (UBTI) derived from an operating business. Continuous fix-and-flips may constitute an operating business and may therefore be subject to UBIT as a result.
At this time, there are no IRS rulings that clarify whether a second, third or twentieth flip constitutes an operating business. It’s best that you consult an experienced ERISA attorney for advice.
Many brokerage houses offer Solo 401(k) plans for little to no cost. The pitfall of course is that your investment options are usually restricted to the offerings of the brokerage house; limiting you to traditional publicly traded securities. This means you’re unable to invest in real estate, private loans, private equity, and other allowable investments. Make sure to adopt plan documents that are written to give you the flexibility to invest in alternative assets. If you already have an Solo(k) plan, check with your provider to learn about any investment limitations. You can always perform a ‘restatement’ of plan documents, which means you’ve decided to replace your existing 401k plan documents with new documents that allow you to invest in anything allowable by law.
Unlike an IRA, the 401k structure has language that allows plan participants to borrow against plan funds. The funds must be paid back to the plan and certain timelines are associated with each loan, based on the situation. There are also limitations to the amount you can borrow from the plan. In general, participants are able to borrow up to 50% of the plan balance or $50,000, whichever is less.
This option can offer you access to fast cash if you need it for your personal finances. Be aware, these funds will be deemed taxable if they aren’t repaid within the given time frame for your loan.
Possibly the most sought after feature of the Solo(k) is the power to self-trustee your own plan. Unlike the IRA, a 401K is a do-it-yourself dream come true for those that prefer to do all their own bookkeeping and plan administration. This option is a way to gain retirement plan flexibility.
Keep in mind that with power comes responsibility, and becoming the trustee for your own Solo(k) plan is not something to take lightly. There are many rules that must be followed and special reporting requirements also exist. It can be valuable to have professional tax and legal advisors available to answer questions as they come up.
A self-employed business owner with no common-law employees can avoid having to perform regular nondiscrimination testing for the plan. Since the plan is only for an individual, the administrative burden and added cost is reduced.