Buying Real Estate with Leverage in a 401 (k) Plan – A Guide
When looking at The Internal Revenue Code (IRC) it is described in detail what a retirement plan can't invest in but there isn't any information about what it can. Sections 408 and 4975 of the Code list what Disqualified Persons are prohibited to engage in in terms of transactions. The rules are there to promote retirement accounts as a means to take care of retirement savings as well as discourage financial activity that could take advantage of tax benefits for a personal account.
With an unstable economy worldwide it is becoming increasingly common for retirees look for other options when it comes to investing such as real estate. This is seen as a more attractive proposition for retirement account holders in difficult financial environments.
It is worth noting that retirement account investors could have the opportunity to buy real estate with leverage on a 401(k) plan without becoming liable for a tax. Here's how we break it down:
For the most part making investments by use of a retirement account is exempt from federal income tax. According to IRC Sections 401 and 408 retirement accounts are exempt. Furthermore Section 512 of the Internal Revenue Codes regard most forms of investment income from an IRA as exempt from taxation. The income types that are regarded as exempt includes: dividends, the majority of rentals from real estate, gains/losses from selling real estate, loan interest and royalties. On the other of the scale the income types from retirement accounts that could attract taxation includes: income from a business or trade that is active eg restaurant, store etc, business income from an entity such as an LLC or partnership, using a non-recourse loan to buy real estate, using margin on stock purchasing. To access the rules and review them they can be found under the Internal Revenue Code Sections 511-514. These rules are more commonly known as Unrelated Business Taxable Income rules (UBTI or UBIT). If these rules were to be activated then any income that was found to be from this type of activity could be taxed at a rate of circa 40%.
These UBTI rules are applicable for IRA and 401(K) plans but a single exemption may be found under IRC 514(c)(9) and this would enable a person to buy real estate under a 401(k) plan using non-recourse leveraging and not initiate tax. Read on to find out more information on this exemption.
Further information on 401(k) plans
Using an IRA to purchase real estate and that uses mortgage finance brings about Unrelated Debt Financed Income (UDFI) which is essentially a UBTI that generates payable tax. Using a 401(k) plan however means that leverage like mortgage finance could be used without the UDFI rules and UBTI tax being applied.
The exemption which can be found under IRC 514(d)(9) gives extensive tax advantages when choosing a 401(k) plan compared to an IRA when buying real estate. To use this exemption under 514(c)(9) it must be noted that the loan should be a genuine non-recourse loan and must be used to buy real estate. Non-recourse loans are loans which are secured usually by assets such as property.
Should a person borrowing default on the loan then the loan issuer can take the property or whatever the collateral was but they cannot pursue the defaulting borrower any further regardless of whether the debt is fulfilled by the collateral or not. Personal liability for the loan does not come into play here and may be one of the only circumstances that this is the case.
There is a particular reason that non-recourse loans are the only ones that can be used when making real estate investments using retirement funds. This is that IRC 4975(c)(1) (B) does not allow a disqualified person to lend cash or any other type of credit facility with a retirement account. Being able to secure a non-recourse loan for a 401(k) plan isn't necessarily that straightforward either. Typically around 35% of equity is needed to attract an non-recourse lender to the deal.
Being able to use leverage when acquiring real estate and not being liable for tax could be an attractive prospect for retirement account holders. Using leverage is often said to be one of the most desirable parts of being involved in the purchase of real estate.
In general economic terms leverage means a way of using any technique to garner gains and losses. When used in relation to real estate being able to use leverage basically means that the gains are much higher in terms of ROI than investing in real estate without leverage.
For some however, there could be a catch which is that any 401(k) plan document much give permission for the person to buy real estate. This isn't guaranteed, particularly where a 401(k) plan has covered a great number of employees. If a person was self employed or worked for a small business with very few full time employees then a solo 401(k) plan could be the answer. A solo 401(k) plan which can also be termed an Individual 401(k) plan is IRS approved as a type of qualifying retirement plan.
For those who want to invest in real estate and bump quickly their retirement account returns then opting for a 401(k) plan or a solo 401 (k) plan may be a good choice. However, getting involved in real estate with leverage or without is never a guarantee and shouldn't be taken lightly as the risk and costs can be big.
Some things to consider are:
1) Ensure your 401(k) plan permits the buying of real estate.
2) Ensure you are using a non-recourse loan as part and parcel of the acquisition of real estate.
3) Ensure that it is real estate you are buying as the exemption under IRC 514 (c)(9) isn't relevant for buying personal property or inventory.
Be aware of the costs of the loan and other expenses as well as the amounts involved in the whole transaction in order to ensure it is viable.