401K Investing: Is It Viable for Income Property?
There are different ways to engage in retirement account and/or 401K investing.
Before we dive in, I must say that I’m clearly not an accountant, so a detailed discussion around this is beyond the scope of this site. You absolutely, positively must consult with an accountant prior to executing any strategies involving IRA or 401K real esate investing.
With that said, we can at least discuss the concept in a general way to spur your creative juices.
BENEFITS OF 401K REAL ESTATE INVESTING
In general, the main advantages are access to “non-cash” sources of investment capital, and the ability to avoid income and
capital gains taxes
if done properly. For investors experienced at this sort of thing, the tax benefits could result in a savings of up to 25%.
The tax benefits can be substantial because you can avoid capital gains tax when you sell for a profit, and if your account receives monthly rental income from a property purchased with cash from the account, there is no income tax.
OPTION #1: TAKE OUT A LOAN AGAINST YOUR 401K
A loan against your 401K can be used to fund your down payment requirement, effectively giving you a
zero down option.
This is yet another method of minimizing your out-of-pocket acquisition costs, and is clearly preferable to simply making a withdrawal (triggers a 10% penalty, plus taxes owed on the withdrawal amount).
You’ll have to pay interest on the loan, typically 1-2% above the prime rate, and you’ll generally have 5-10 years to pay it back. You start repaying right away, in equal installments that are taken directly out of your paycheck.
I would recommend looking into this option only if you are executing a
fixer upper strategy
because you can do a post-rehab
to pay back the loan quickly. But even in this scenario, there are some downsides:
There is an opportunity cost of not earning money on what you take out.
If you lose your job or change employers, many plans require all 401K loans to be paid back within 60 days (if you can’t pay the full balance, you’ll default and will have to pay taxes on the loan balance plus a 10% penalty for early withdrawal).
You can only borrow a maximum of $50K (or less depending on the size of your nest egg).
Your tax benefits may change. For example, you may not be able to count your mortgage interest payments as
rental tax deductions.
Your employer-sponsored plan may not allow this.
Late payments may subject you to substantial penalties
Bottom line: proceed with extreme caution.
OPTION #2: COVERT TO AN IRA & BUY PROPERTY OUTRIGHT
Here, you can rollover your 401K to a “self-directed IRA” or a Roth IRA. The benefit is that you’ll dramatically expand your investment options to pretty much anything you can think of. Another benefit is that you are not limited by the $50K cap inherent in 401K real estate investing loans.
If you have a large enough balance, you could use it to purchase a property outright. In this case, your monthly
goes right into the IRA. And this monthly income, along with the profit you’ll make when you
is tax-free as long as you do not take the cash out until you are 59.5 years old.
Here are some things to keep in mind:
You may incur a penalty when doing this type of rollover
You’ll need to find an experienced account custodian if you’re considering a self-directed IRA. This is critical because you could jeopardize your tax-free status if you make errors regarding prohibited transactions, rules of self-dealing, etc.
You can’t sell your primary home to your account or use the account to buy property that you plan to live in at some point in the future.
There can be restrictions on family members’ use of your investments (for example, your child can’t rent an apartment in a building owned by your IRA).
Bottom line: proceed with extreme caution.
OPTION #3: LEVERAGE PROPERTY THROUGH YOUR IRA
In this scenario, you could use your IRA balance to fund the down payment, and then have your IRA assume the remainder of the purchase price in the form of a mortgage to complete the transaction.
As you might imagine, this option has a lot of complexity. First, you’ll need a “non-recourse” loan so that the property is the security interest, not the IRA itself. You may find it difficult to find a lender willing to do this.
Also, there may be some weird tax consequences, like unrelated business income tax or unrelated debt financing income tax. This can run as high as 35% on the income from the financed portion of the property.
Bottom line: proceed with caution when executing 401K investing.
As you can see, this strategy is not limited to just 401k real estate investing. IRAs are the more favorable option, and there can be tremendous tax benefits if this is done properly. However, you must heavily lean on your accountant to navigate around all the pitfalls.