Solo 401(k)s Now Invest In Real Estate

By: Paul Katzeff



You don't need to be Donald Trump to invest directly in real estate. Small-biz entrepreneurs are discovering that they can do it through their so-called solo 401(k) plans.



The tactic has been fueled by real estate's hot returns in recent years.



The 401(k) maneuver is similar to another hot trend, investing directly in property via an individual retirement account. Many of the same rules govern realty investments through these retirement accounts. The key is deferral of taxes on either rental income or capital gains.



Property investments through 401(k)s enjoy even more liberal tax treatment.



And different contribution formulas make it easier to put more money to work using a 401(k) than an IRA.



But if you start now, are you simply jumping onto a bandwagon that's about to roll over a cliff? Has real estate heated up to a frothy bubble, just waiting to burst?



An investor's exposure to risk varies from one local market to another, says Tom Anderson, chief executive of Pensco, a retirement plan custodian and trust company based in New Hampshire and San Francisco.



"If you invest in high-quality, high-demand areas, nothing changes," he added. "Prices won't go down significantly even in a downturn."



Jeff Desich, vice president of Equity Trust Company, a custodian based in Elyria, Ohio, says many realty investors are like value-oriented stock investors. They buy only at what they see as a beaten-down price.



Such investors among his clients hunt for property that is run down or in foreclosure. Perhaps the seller is more interested in a quick deal than in waiting for the highest possible price, such as in an estate sale.



If the real estate bubble bursts in the local market where such a buyer invests, his discount is a built-in buffer, Desich says.



"For most of my clients, a bubble breaking would be a good thing," he said. "It would open more deals for them."



Still, Desich says the less experience an investor has with real estate, the more important it is to diversify in general.



Nicknamed solo 401(k)s, the plans are actually for businesses that range in size from a single entrepreneur to a small group of partners that meet certain standards.



They proliferated on the heels of federal retirement-plan rule changes that became effective in 2002.



Suppose you're a lawyer, plumber or dentist, with a one-man business. As a wage-receiving employee of your own sole proprietorship or S corporation, for 2005 you can generally kick in up to $14,000. Your firm can put in up to 25% of your pay. That calculation can be based on up to $210,000 in pay.



If your pay is based on net earnings rather than a wage, your firm can pony up as much as 20% of your pay.



The combined contribution from both you and your firm can go as high as $42,000.



If you are 50 years of age or older, you can put in up to another $4,000, for a total of $46,000.



If your retirement plan is a SEP-IRA instead, only your firm can contribute, says IRA expert Ed Slott. And you're not allowed to make a catch-up contribution.



Big 401(k) plans typically don't permit direct investment in real estate, says David Wray, president of the Profit Sharing/401(k) Council of America. Plans must meet certain liquidity and pricing conditions.



Plan sponsors and record keepers generally see those as impossible to satisfy with direct real estate investments, Wray says.



Typically, to comply with tax rules on a solo 401(k) real estate investment, you must buy the property from an unrelated person and not use the property yourself. Compliance is easier when you buy with cash, but you can get mortgage help.



You can't buy from a so-called disqualified people. That includes yourself, your spouse, offspring or parent.



You also can't buy from a son- or daughter-in-law, or from a partnership that's at least 50% owned by disqualified people.



Also, you can't let a disqualified person use the real estate.



Solo 401(k)s have a huge edge vs. IRAs when it comes to buying with help from a lender.



Say you borrow half of the $200,000 purchase cost of a house, which you then rent to tenants.



If you invest through an IRA, half the taxable net rental income would be hit with a top levy of 35%. With a 401(k), all of the rental income is tax-deferred, Anderson says.



If you eventually sell the home at a profit, the financed portion of the capital gain would be taxed at a top long-term rate of 15%. The short-term rate would be 20%.



"Borrowing speeds your growth using someone else's money," Anderson says. "It's a no-brainer."



Smaller Tax Bite



Through a 401(k), the entire gain is tax-deferred.



Your 401(k) money would be taxed only as it is withdrawn, and then as ordinary income.



"With both types of income, it all flows back to the 401(k)," Anderson said. "You don't lose any to tax."



You can invest in property through your 401(k) alone. Or your plan can form a partnership with other investors.



Lenders prefer dealing with partnerships, Anderson says. That gives them more leeway in attacking assets in case of a default.