Real Estate- Cash Flow, Appreciation and Tax Breaks Too?

Uncle SamUncle Sam wants your real estate investments to be just as successful as your investments in stocks, mutual funds, bonds, or the more traditional vehicles used to save for retirement. So, theoretically, real estate investments can enjoy the same tax deferred opportunities as securities like stocks and mutual funds.

Unfortunately, the regulations that created IRAs and 401Ks were written with stock market investors in mind, not real estate. Also very few plan managers think about real estate when they design employer-sponsored retirement plans. As a result, sheltering your real estate investments until you retire requires some planning and the help of a tax professional.

Work for Yourself? Invest for Yourself!

It’s a lot easier to invest in real estate through an IRA or 401 K if you are self-employed. Estimates of the number of self-employed vary from 10 and 42 million, according to Bloomberg. That’s a lot of potential real estate investors, yet the numbers investing in real estate are probably only a miniscule percentage of the potential.

If you are self-employed, finding a way to invest with tax- sheltered dollars is much easier. Since you are both boss and employee, you can set up accounts to fit your needs. You can set up either a SEP IRA or a Solo 401K and use the proceeds to buy an SFR. With a SEP IRA, the most popular option, you must stay passive and can’t participate in the management of property at all. With the lesser known Solo 401K, enacted in 2002, there are no requirements to be passive, contribution limits are higher and you can even flip as well as hold. If an investor uses retirement funds to purchase real estate, then there is a potential tax liability called UDFI – Unrelated Debt Financed Income. This applies when the investor purchases the property. Like most other retirement plans, the SEP IRA is subject to UDFI. The Solo 401(k), though, is not subject to UDFI, a tax on the portion of profits that can be attributed to the amount of the investment that was leveraged when a mortgage or a loan was used in conjunction with the retirement funds.

401 kJumping Through 401K Hoops

If you work for others you may have to jump through a half dozen hoops to convince your employer and plan manager to include real estate as an option in your 401K. However, you always have the option of borrowing against the money that you have accumulated in your 401K through your own tax deferred contributions, your employer’s contributions and the profits your investments have achieved. As long as you pay it back (at no interest) you would incur no tax penalties.

Another option is to take a distribution from your fund. You will have to pay taxes on the amount you take out and a penalty if you are younger than retirement age. However, if you are self-employed, you have the option of choosing between two kinds of plans that will allow you to invest in real estate, a self-directed SEP (Simplified Employee Pension) IRA and a Solo 401K.

How Do I Buy Real Estate in a SEP IRA?

Because they don’t want to put up with the regulations and additional paperwork, many financial services firms will not allow real estate purchases in IRAs. However, the IRS does not prohibit you from purchasing real estate.

A self-directed SEP is essentially the same as a regular SEP, but with a broader range of investment options, including real estate. Your real estate investment must be completely passive. That means the real estate you purchase must be an investment property exclusively, not a residence, not even a seasonal or occasional residence. All income and expenses must flow through your IRA account and no monies should be mixed with your personal funds. For example, any maintenance costs must be paid with IRA assets, and any income generated from the property, such as rental income, must be deposited in the IRA. However you can use rental income to buy another investment property, which becomes another asset and you must also treat it passively.

IRA Nest EggHire an outside property manager or property management firm. One of the restrictions involved in placing real estate in a SEP is that you cannot actively manage any property on behalf of the SEP. For example, you cannot collect rent from an investment property, nor can you physically complete any maintenance. The IRS requires that you hire an outside manager to perform these services.

Another important restriction is the IRS prohibition against using IRAs and their assets such as real estate as collateral for loans, so you are unlikely to be able to take out a mortgage for any property you purchase. Most likely, you will have to use available cash within your SEP to fund your real estate purchase.

IRA FAQWhat’s a Solo 401K?

A Solo 401K is a newer and less- well- known alternative to the SEP IRA for investing in real estate. It is designed for single owner businesses or those with part-time employees only. Business types such as sole proprietorships, closely held family businesses, partnerships and corporations can take advantage of the Solo 401k’s flexibility to invest in traditional and alternative investments tax- free or by deferring taxes. All employees must be working part-time, which is defined as fewer than 1,000 hours per year each. In 2014 you can contribute up to $52,000 in tax-deferred savings.

You may purchase many types of real estate investments to be held in your Solo 401k. For example, your Solo 401k may hold/purchase land, residential or commercial properties or tax liens. Included are foreclosures, short sales and vacation properties. Unlike a self-directed IRA, you can also combine personal funds with your Solo 401k. When purchasing property for the fund, you can use the assets of your Solo 401k to borrow from a bank or private lender to complete the purchase. Like a SEP IRA, you must pay all costs, including repair and maintenance from the 401K. You also cannot use investment real estate assets for personal use.

What if I Don’t Qualify for Either or Solo 401K or a SEP IRA?

Even if you participate in a retirement plan through your employer, you can set up at Roth IRA and used its assets to buy real estate. The same restrictions the limit the SEP IRA also are in effect for the Roth IRA Maximum annual contributions are limited by your income. The maximum in 2014 is $5,500, though. if you are 50 or older you may also contribute an additional “catch-up” contribution of $1,000. At $5500 a year, it would take a few decades to accrue enough to buy much in the way of real estate. However, if you are changing jobs from one employer to another you can rollover a traditional 401(k) into a Roth IRA without tax penalties and get a big head start on building a tax deferred real estate investment fund.

There are additional tax benefits to owning investment real estate, such as tax treatment of rental income and depreciating investment property. You might be able to realize tremendous tax savings by finding a way to use your tax deferred retirement savings to build retirement security much faster and more reliably than the typical stock market-based 401K fund. That adds up to a great start with Real Estate investing!

 

4 Comments

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Armando lopez May 26 2016 - 11:49 AM
Real estate investment learning how work whit 401k.
    Dennis Gill Jun 25 2016 - 12:27 PM
    Your 401k cannot invest in Real Estate or than in REITs and stocks that invest in real estate. However, you can convert your 401k into a personal IRA, and then convert your personal IRA into a self-directed IRA, which is the only way to invest directly into real estate. Not all IRA companies allow self-directed IRAs.
James Standart Jun 11 2016 - 11:41 AM
Why aren't you telling people about the most obvious alternative-Self Directed IRA's?
    Alisha Chocha Jun 13 2016 - 11:27 AM
    Hi James, Great suggestion! We cover SDIRAs in other blog posts/pages that you can see here: http://homeunion.com/blog/the-tax-advantages-of-owning-real-estate-using-an-llc-or-sdira/ https://www.homeunion.com/alternative-ways-to-finance-real-estate-rentals/ https://www.homeunion.com/blog/5-ways-to-finance-your-single-family-rental/ https://www.homeunion.com/self-directed-ira/ Thanks for sharing, Alisha at HomeUnion

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