Investing in Real Estate with Your IRA or 401(k)
Can you invest in real estate with your IRA or 401(k)?
YES! Well…maybe.
This question turns on the word “you.” Because I can confidently tell you the answer completely depends on “you.”
Here’s what I mean. The tax code definitely allows you to make these investments. I started investing in real estate through my self-directed IRA back in 2004. But many investors, through ignorance of the tax code, don’t take advantage of this opportunity. (And many others shouldn’t, as I’ll explain in my warning below.)
And there are some investors who have an IRA or 401(k) custodian that won’t even allow these investments. Thankfully, this is easy to fix.
You have multiple options to invest in real estate through retirement plans. You just need to figure out which option fits you best.
The Threat from the Build Back Better Act
Before proceeding, I want to take a moment to celebrate. You may be aware of the ominous proposed legislation in 2021 that threatened to destroy U.S. IRA investors’ ability to participate in investments (such as real estate) designed for accredited investors.
This was hanging over our heads in the third and fourth quarter of 2021, and it looked like there may be enough votes to pass it. But Congress heard our voices en masse. After thousands of phone calls and letters from industry organizations, their members, and concerned financial advisors and investors, Section 138312 has been removed from the Build Back Better Act. Investing in real estate through your IRA and 401(k) will continue to be allowed. Now, back to the rest of this blog!
Truly Self-Directed
The key to investing in real estate with your retirement plan is to assure your custodian allows alternative investments. Traditional custodians such as Vanguard, Fidelity, and Charles Schwab do not typically allow alternative investments such as real estate.
If you have a retirement plan now with a more traditional custodian, through a current or former employer, you will have to roll it over to a self-directed custodian first. This is quite simple.
First, select a self-directed custodian and make sure you do a direct rollover, from one to another, to avoid withholding tax and potential penalties. The self-directed IRA custodian will guide you through the rollover process. So, what types of plans are available?
The Self-Directed IRA - Traditional
Most investors go with this plan. Like your 401(k) from work, the funds going into the plan upfront are not taxed, which can reduce your taxes and allow you to put more capital to work. The growth inside the IRA is not taxed either, allowing tax-free compounding over years or decades. And you’ve probably seen stats on the power of compounding capital tax-free over time.
Withdrawals from traditional IRAs can start (without penalty) as soon as 59-1/2 years of age, with mandatory withdrawals starting by 72 (recently increased from 70 ½ as a result of the SECURE ACT). Normal taxes at the current tax rate apply at that time.
The Self-Directed IRA - Roth
The Roth IRA was established by Congress in 1998. This plan allows investors to make after-tax contributions to retirement plans. This already-taxed money will then create income and appreciation in the plan tax-free. And withdrawals will never be taxed.
Some say that from a tax revenue generation point of view, the Roth IRA was one of the worst ideas ever. Meaning that it could be one of the best ideas for you.
Roth aficionados have spent a few decades coming up with creative ways to maximize income in these Roth vehicles. I personally did a small option on a piece of investment land in 2004 through my IRA that created a massive tax-free profit. I invested $100 and got a return of over $90,000. It will never be taxed. Ever. Because the $100 already was.
This type of plan can be a massive win over decades. Check out this example showing the accumulation of an investment in a tax-deferred vehicle, like an IRA, compared to paying taxes along the way.
Truly Self-Directed Solo 401(k) Plans - Traditional and Roth
Small business owners and solopreneurs can set up a self-directed solo 401(k) plan. 401(k)s have much higher contribution limits than IRAs, $58,000 for 2021 (plus $6,500 catch-up for those over 50), nearly 10X higher than IRA limits. If plan documents allow, the participant can make both traditional pre-tax contributions and after-tax Roth contributions.
Like IRAs, self-directed 401(k)s may have checkbook control (you write checks and keep records) or contributions and investments can be administered by a third party.
I’ve asked Dmitriy Fomichenko, a solo 401(k) expert and Wellings Capital investor, to comment on these vehicles.
“A Solo 401k plan is a great tax shelter. If you are in business for yourself and are doing well, you are probably paying a lot in taxes. Imagine sheltering nearly $60,000 of your income from taxes (double this number if you are in business jointly with your spouse). Dropping your taxable income between $60,000 and $120,000 will surely put you in a lower tax bracket so you’ll end up paying significantly less in taxes.” - Dmitriy Fomichenko, Founder and President of Sense Financial
There is also a retirement vehicle called an eQRP (enhanced qualified retirement plan). eQRP is just a fancy marketing name for a solo 401(k) with some bells and whistles added, but it may be right for some people.
A Few Restrictions
There are a number of understandable restrictions when investing through self-directed IRAs. For one, you can’t self-deal. You can’t buy or sell real estate from or to yourself, or immediate family members. You can’t manage or provide services to your property. And you can’t stay in it. Not even for one night.
I recall when I bought a house to flip through my self-directed IRA. I knew the restrictions, so I planned to have my teenage son do landscaping and yard work without pay (he was still young enough to want to work for free). I checked with my cautious plan administrator and was told this was off-limits. “But I’m not going to pay him at all!” It didn’t matter. I complied. I’m glad I did.
UBIT and UDFI
Though income from IRAs is tax-deferred or exempt (in the case of a Roth), income attributed to certain business as well as Unrelated Debt-Financed Income (UDFI) is subject to Unrelated Business Income Tax (UBIT). For example, if your profit is 50% higher due to leverage on the property, you may be responsible for tax on the income from the portion that is debt-financed.
There are two ways to avoid or reduce UBIT when investing in real estate through a retirement account. One is to invest using a solo 401(k). Dmitriy said: “Unlike IRA investments, leveraged income in Solo 401k is exempt from UBIT so if you are eligible for a Solo 401k, the Solo 401k becomes great vehicle to buy real estate with leverage.”
For those not eligible for a solo 401k, thankfully there’s another option. The other way to reduce the impact of UBIT is to invest using an IRA and file Form 990-T each year. By filing this IRS form annually, you can use the depreciation from the real estate investment in the early years of an investment to reduce or eliminate UBIT in later years.
We are not tax professionals, so please check with a knowledgeable CPA, tax attorney, or tax strategist if you have questions about UBIT and UDFI.
Don’t be Sloppy with Your Retirement Funds
For some reason, it seems some investors treat their retirement funds with less care than their other capital. Perhaps it is similar to how some people overspend using a credit card – a feeling that this is somehow not real money. I don’t have a solution, but I wanted to bring this to your attention and tell you that your golden years will arrive sooner than you think. You will be glad you planted and cultivated that garden well now.
Dimitry again: “I always tell my clients: If you are unsure about doing something – ask! But ask before doing it, not after! If you commit a prohibited transaction in an IRA – the entire account will be jeopardized and penalties will be severe. Don’t let that happen to you!”
A Warning
Just because you can doesn’t mean you should. Self-direction isn’t the best option for everyone, just like using debt is not for those who don’t understand responsible leverage.
Some people would be far better off keeping their retirement savings in mutual funds and/or with financial advisors. Here are four categories of folks who should consider not investing through a self-directed plan.
If you’re a Social Security system fan and like the so-called returns you’re getting on your 7.65% FICA (really 15.3%) investment every payday, then self-directed plans are probably not a fit. Self-directed plans put you at the helm of your retirement ship.
If you’re eager to invest in the latest scheme or crazy invention your neighbor is working on in his garage, self-directed plans could put you in harm’s way. But at least you’re free to lose your money as you see fit. (I don’t mean to be harsh here. Jeff Bezos started Amazon in his garage, and you could make a fortune speculating. Just be careful.)
If you are happy with the investment options in your retirement account (typically mutual or bond funds), then you don’t need the flexibility offered by the self-directed product. Honestly, many people would be far better off with this option, especially those in the second category above.
If you don’t have the time or the knowledge to acquire and manage a risk-averse investment opportunity…or perform due diligence on someone who can select and manage that opportunity (say a syndicator or fund manager), then self-directing into real estate may not turn out well for you.
But if you have the knowledge and desire to safely invest your retirement funds in commercial or residential real estate, then a self-directed retirement plan can be a wonderful option.
By investing in real estate, you are joining the world’s wealthiest investors. I’ve noticed that nearly all of them invest in commercial real estate.
Please reach out to us if you’d like to discuss this article or learn more about passively investing in private commercial real estate through your IRA or solo 401(k). Our team will be glad to assist you with any questions you have.
If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call to see if Wellings Capital’s investments are a fit for you.
Happy Investing!
As with all financial matters, please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.