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401K investing

Can You Use Your 401k to Make Real Estate Investments?

The short answer is "sort of."

[Updated: Feb 04, 2021] Jan 23, 2020 by Matt Frankel, CFP
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Wouldn't it be great if you could combine the income and long-term growth potential of real estate with the tax advantages of 401k accounts?

You generally cannot invest directly in real estate through an employer's 401k plan. However, depending on your circumstances, there might be some ways for you to use the assets in your 401k accounts to make real estate investments. Here's a rundown of how 401k funds can potentially be used to buy investment real estate, what you need to know about the process, and the rules you need to follow.

Can you invest in real estate through your 401k?

If you have a 401k plan through your employer, the answer is probably no -- at least not directly. I have yet to find an employer-sponsored retirement plan that allows participants to buy investment properties or participate in crowdfunded real estate investments.

The only possibility of even putting money to work in real estate indirectly in an employer-sponsored 401k would be if there's a real estate investment fund on the plan's menu of investment options. For example, the Vanguard Real Estate Index Fund might be one of the funds offered by your plan.

If you have an old 401k, here's what you can do

So, your options for investing in real estate are rather limited if you have an active 401k, meaning that you still work for the sponsoring employer.

On the other hand, if you have an old 401k, the possibilities are much greater.

While you can't invest in real estate directly through an employer-sponsored 401k, you can choose to roll a former employer's 401k account into an individual retirement account, or IRA. And while many IRA custodians don't offer the ability to buy real estate, some offer an account type known as a self-directed IRA.

As the name implies, a self-directed IRA allows you to direct how your funds are invested, within the law. To be sure, there are some things you can't invest in. For example, the law prohibits you from investing in collectibles with IRA funds. However, there's nothing that specifically prohibits you from using a self-directed IRA to buy real estate.

  • Things you can buy with a self-directed IRA: Real estate, crowdfunded real estate investments, tax lien certificates, precious metals, cryptocurrencies, private equity investments. (Note: This is not an exhaustive list.)
  • Things you can't buy with a self-directed IRA: Collectibles, such as coins, artwork, and antiques.

A self-directed IRA can be either traditional or Roth in nature. For example, if you have a Roth 401k, you can roll the funds into a self-directed Roth IRA. While most self-directed IRAs opened for the purpose of buying real estate are done with large rolled-over accounts, you can also open a self-directed IRA to fund on an ongoing basis.

Benefits of investing in real estate through an IRA

The benefits of investing in real estate through an IRA are similar to the benefits of investing in stocks or mutual funds through an IRA. The tax advantages can help you keep more of your property's rental income and shelter you from capital gains tax if you sell a property you own.

Consider this simplified example. Let's say you buy an investment property for $200,000, and you generate $1,500 in monthly rental income after expenses. Not only would this rental income be tax-free as long as it remains in the IRA, but no matter how much you sell the property for, you wouldn't have to pay capital gains tax to the IRS. If your self-directed IRA is of the tax-deferred (traditional) variety, you won't have to pay a penny of tax until you withdraw money from the account, and if it happens to be a Roth account, your income could be tax-free -- forever.

Can you get a mortgage to buy an investment property through an IRA?

When you obtain a mortgage, the bank typically makes the loan to you personally, and therefore the loan is guaranteed by your assets. This is known as a recourse loan. If you don't pay the loan and foreclosing on the property isn't enough to recoup the bank's money, they can go after your other assets.

Well, this isn't the case with an IRA. The bank can't make the loan to you -- they have to loan money to your IRA, which is legally a separate entity. So, the bank wouldn't be able to go after any other assets you own besides the property itself. This is known as a non-recourse loan, and while they aren't common, there are companies that specialize in non-recourse mortgages to IRAs.

With that in mind, there are a few things you should know before considering a mortgage for investing in real estate through your self-directed IRA:

  • Because the bank can't go after any assets other than the property itself in the event of a default, down payment requirements are much higher than you're probably used to. Expect a non-recourse lender to want a minimum of 40% of the purchase price as a down payment.
  • For similar reasons (more risk to the lender), expect to pay a significantly higher interest rate on a non-recourse loan. It's not uncommon to find non-recourse loans with APRs several percentage points higher than the national average for purchase mortgages.
  • While IRAs are tax-advantaged accounts, the portion of your profits that results from using leverage (a mortgage) might be taxable. There's a tax known as UBIT (unrelated business income tax) that might apply, so check with a tax professional to see how it could affect you.

Rules you need to know

If you want to become a real estate investor through your IRA, there are a few rules you'll need to follow. Recall in the previous section that I mentioned that you and your IRA are considered to be two separate entities. As a result, the following rules apply:

  • Any real estate you buy with a self-directed IRA needs to be purely for investment purposes. There are some definitions of the term "investment property" that allow for a small amount of personal use, but this is not the case with the property you own through an IRA.
  • Property expenses must be paid by the IRA, not by you directly. For example, if the property needs a new roof, the check needs to come from the IRA. For this reason, it's very important to leave some funds available in the IRA to cover any unforeseen expenses.
  • You can't use any personal possessions (such as furniture you already own) in the property.
  • Any rental income needs to be paid to the IRA, not to you.
  • You can't buy a property that is currently owned by you or a relative in a self-directed IRA.

If you're self-employed, you have yet another option

Self-employed individuals have a few other types of retirement accounts at their disposal, such as SIMPLE IRAs and SEP-IRAs. One that is really worth mentioning in the context of buying real estate is a solo 401k.

Specifically, there is such a thing as a self-directed solo 401k plan, mainly offered by the same custodians that offer self-directed IRAs.

In many ways, the procedure and rules for purchasing real estate through a self-directed 401k are the same as with an IRA. There's one big difference, however. The UBTI tax that can apply to real estate profits on financed properties in an IRA does not apply to solo 401k loans. The Internal Revenue Service (IRS) provides a specific exemption for 401ks. To be clear, this can be a big tax benefit, so if you are eligible to use a self-directed 401k and plan to finance your real estate purchases, it can be the better way to go.

The Millionacres bottom line

To sum it up, you can't purchase real estate directly with funds in an employer-sponsored 401k plan if you're still an active participant in the plan. However, if you have money in a former employer's 401k plan or are self-employed, there are some good options that can allow you to put your retirement savings to work in investment properties and other types of real estate investments.

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