Feb 14, 2023
It's possible to use IRA and 401(k) money to invest in real estate. But should you? Read further to learn what factors you should consider when making that decision.
If you have been saving for retirement through a tax-advantaged vehicle such as an IRA, a Roth IRA, or a 401(k), then a sizeable portion of your net worth may be tied up in one or more retirement accounts. Investments typically found in retirement accounts include stocks, bonds, ETFs, and mutual funds that trade on public exchanges (e.g., S&P 500, Dow 30, Nasdaq).
If you have a self-directed IRA or a solo 401(k), then you may also invest in privately-held companies, small businesses, startups, real estate, limited partnership interests, LLC membership interests, convertible notes, precious metals, commodities, tax lien certificates, and other alternative investments.
What is a Self-Directed IRA?
A self-directed IRA (“SDIRA”) is a traditional IRA (funded with pre-tax dollars) or Roth IRA (funded with after-tax dollars) directly managed by the account holder, though a custodian or trustee must administer the account. Because the custodian of a SDIRA is not allowed to give financial advice (hence the term “self-directed”), traditional brokerages, banks, and investment companies usually do not offer them, but there are specialized firms that do.
SDIRAs are prohibited from investing in certain assets such as life insurance, S corporations, collectibles (antiques, artwork, wine, jewelry, etc.), and a company owned by the SDIRA holder. Also, SDIRAs may not (1) loan money to the account holder, (2) buy or sell or lease property from or to a related party, and (3) buy property that the account holder lives in or owns for personal benefits. Prohibited transactions disqualify the SDIRA as a tax-advantaged retirement vehicle.
What is a Solo 401(k)?
A solo 401(k) is an individual 401(k) designed for owners of businesses with no employees other than a spouse. It may be traditional style or Roth style With an Employer Identification Number, you can open a solo 401(k) at most online brokers.
There are some differences between the rules governing SDIRAs and those governing solo 401(k)s. For example, a solo 401(k) may loan up to $50,000 to the account holder, prohibited transactions are subject to a 15% excise tax and do not disqualify the account, and the account holder acts as trustee (no independent custodian required).
Having the ability to invest retirement funds in real estate and other private investments means having access to a wider set of investment choices and enhanced portfolio diversification. Portfolio diversification has long been understood as a way to boost returns while lowering risk.
Let’s say you are constructing a $100,000 portfolio of investments and plan to use a SDIRA or a solo 401(k) for a portion of your portfolio. You decide to allocate $75,000 to publicly-traded securities and $25,000 to a real estate syndication deal as a passive investor. Now you have to decide whether to invest in the real estate syndication through your SDIRA (or solo 401(k) as the case may be), or invest in the real estate syndication with other available funds.
Tax Advantages of Real Estate
Real estate is already a tax-advantaged investment because of deductions for depreciation and mortgage interest and the ability to defer taxable gains in a “1031” transaction. Traditional style retirement accounts defer taxable income until withdrawal after age 59 ½. So, if you use your traditional style SDIRA or solo 401(k) to purchase real estate, you will defer taxable income from the real estate investment but you will also defer the tax advantages from the real estate investment.
If you use a Roth style SDIRA or solo 401(k) to purchase real estate, your earnings from the real estate investment will be tax free, so you will lose out entirely on the unique tax advantages of the real estate investment.
Unrelated Debt-Financed Income Tax
Another important consideration is whether the SDIRA is borrowing funds to finance a portion of a real estate acquisition or investing in an entity that is using debt to finance a portion of a real estate acquisition (like the passive syndication deal in our example). It is not unusual to use debt to finance a significant portion of a real estate purchase because it allows one to acquire an asset otherwise unattainable and the leverage boosts returns.
First, the debt must be non-recourse, meaning in an event of default the lender may seize only the asset purchased with the debt. The debt must not have personal guarantees attached to it and the lender must not have the right to seize the investor’s personal assets or other retirement account assets.
Second, and this applies only to IRAs, not 401(k)s, a portion of income and gain from the asset is subject to Unrelated Debt-Financed Income (“UDFI”) Tax. This is a tax imposed on tax-advantaged accounts that use debt to finance an investment.
To calculate the tax, one needs to know the ratio of debt to equity used to purchase the property. As an example, suppose the real estate syndication purchased the property with 60% debt and 40% equity. Each year, net income from the property would be multiplied by 0.60 to get UDFI. Then certain reductions for which the retirement account may be eligible are applied. The result would then be multiplied by a UDFI tax rate that varies depending on the amount of UDFI. Likewise, gain from the sale of the property would be subject to UDFI tax.
Required Minimum Distributions
Traditional IRAs, traditional 401(k)s, and Roth 401(k)s generally require the account holder to withdraw a minimum amount of money starting at age 72. Real estate is relatively illiquid, so using these accounts to purchase real estate takes a bit more planning. Roth IRAs do not have required minimum distributions.
There is No Right or Wrong Answer
The choice to use a SDIRA or solo 401(k) to invest in real estate is personal. For some, it might make sense to load up the SDIRA with publicly-traded investments that come with little or no tax advantages and use other funds for the passive real estate syndication deal to take advantage of its tax benefits. For others, particularly those whose net worth consists mostly of retirement accounts, the SDIRA might be the only vehicle available to invest in a passive real estate syndication. The purpose of this article is not to persuade you toward a particular choice, but rather to illustrate some of the important considerations for making that decision and provide some guidance for a discussion with your financial and/or tax advisor.
If you'd like to learn more about how Volhawk can help you create passive streams of income from commercial real estate, connect with us here and one of our team members will be in touch to schedule a call.
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