I often receive a surprised look when I mention to people that they can use their retirement account to invest in real estate. A follow up question often then raised (with some skepticism) is – why is that not so widely talked about or promoted? For one simple reason, traditional employer 401Ks and traditional retirement account providers (IRA, Roth IRA, Rollover IRA) are provided by traditional brokerage firms who mostly benefit from managing stocks, bonds, and mutual fund investments and do not get compensated for investing in real estate, commodities, crypto, mortgage notes or other types of investments.

It was only after I started building my real estate portfolio that I learned about self-directed retirement accounts. The two more popular options today include self-directed Solo 401K and SDIRA (self-directed IRA).

A self-directed retirement plan is exactly that – a retirement account that allows you to self-direct or choose what type of investment you want in addition to stocks, bonds, and mutual funds.

How do I establish a self-directed retirement plan? The account would typically be established by a self-directed retirement account custodian (we can provide a list of a couple of providers you can look into to start your search with). In addition, if you are switching jobs or leaving your job, you would be eligible to roll over your employer sponsored 401K plan proceeds into a self-directed retirement account. There are some procedural steps you must follow in order to avoid triggering a tax event but with the guidance of the retirement account provider, it can be easily accomplished. This rollover process could take up to two weeks depending on the incumbent provider.

The key differences between the Self Directed Solo 401K and the SDIRA pertain to checkbook control, amount of maximum contribution allowed, and other tax and debt related advantages noted below, detailed below.

Checkbook control: In a Solo 401K you or your company (if you are self-employed) may serve as the trustee and as such you have 100% checkbook control of the plan. In a SDIRA you must work through a custodian who will administer the account on your behalf.

Amount of maximum allowed contribution: That amount varies from year to year. For 2022 it is $61,000 or $67,500 if 50 years or older for a Solo 401K (this includes elective and profit sharing contributions combined) and $6,000 for SDIRA.

Other tax advantages of a Solo 401K vs IRA : What many people do not know is that certain income streams may be taxed while in a SDIRA. The two most common ones are UBIT (unrelated business income tax) and UDFI (unrelated debt financed income, a type of UBIT). UBIT would apply if you are actively (vs. passively) involved in managing the real estate investment. That tax rate could be 35% or more. As such, you may want to apply SDIRA proceeds towards passive investments like syndications for example. UDFI is incurred when the property purchased is financed and such tax is based on the highest amount of leverage carried within the last 12 months. For example if you bought a property in Year 1 for $100K and financed it at a 50% LTV with non-recourse debt and you sell the property for $200K in Year 5, then 50% of the profit or $50K would be subject to UBIT. That taxable income is before any adjustments for depreciation recapture, etc. There may be certain exceptions to that, if the debt is paid off early. As such, you should always consult with your real estate savvy CPA to assess the tax impact based on your specific situation and specific investment and how best to approach it or time the sale.

The Solo401K is exempt from UDFI but may not be exempt from UBIT, if you are actively involved in the investment.

Other features: In case of emergency you are able to take a loan against your Solo401K in the amount of the lesser of $50K or 50% of the vested balance. The loan should generally be repaid within five years and must charge a reasonable interest rate. The SDIRA does not offer that benefit.

The above information just scratches the surface of the self-directed options and how they can be utilized. We definitely recommend that you connect with one of the self-directed account providers and your CPA, if you choose to dive deeper into this.

Above all, we hope today’s snippet illuminated one more way on how to get started with passive real estate investing and added another tool to your tool chest.

Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.

Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.