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Real Estate in Your Solo 401k
15 May 2023 - 9:55, by , in Blog, No comments

People get excited when they find out they can hold real estate in their Solo 401k.  You can combine the benefits of tax-advantaged accounts along with real estate, but you must understand the whole story before you commit.  Real estate in your Solo 401k comes with additional risks and pitfalls.  Take some time to understand the long-term implications before you start with real estate in your Solo 401k.  I personally would never advocate for real estate in your Solo 401k.  Real estate is already advantageous on its own and the risks and pitfalls inside a Solo 401k reduce those advantages substantially.  The risks and pitfalls come in two categories: strict rules and lost opportunities.

STRICT RULES

1.Non-recourse loans

Solo 401k accounts require non-recourse financing, unless you pay all cash.  You are prohibited from signing a personal guarantee or putting up any personal collateral.  This invalidates the tax advantages.  You must pay for everything in the loan process with money from your Solo 401k.  These loans cannot come from your personal money or immediate family members either.  Everything about the transaction must be “arms-length.”

2.Prohibited transactions and management

There many prohibited transactions and management that must be avoided to preserve your tax advantages.  Here is a list of what you must adhere to:

  • You cannot work on the property yourself.  You must hire non-related parties to perform the work.  Hiring a non-related property manager is a great way to demonstrate your distance from the management of the real estate.
  • All expenses and income must come from your Solo 401k.  No outside accounts may be involved.
  • The transaction must be “arms-length.”  You cannot buy property you already own or sell the property to yourself.
  • You cannot run the property as an active trade or business.  Otherwise you trigger unrelated business income tax (see UBIT below).  Flipping properties could arguably skirt the rules here.  Long-term income generating properties are safe.
  • You, your immediate family, and your business cannot occupy the property.

3.UBIT

Unrelated business income tax (UBIT) is a tax designed to prevent businesses from operating within a tax-advantaged account for the purpose of tax avoidance.  These taxes can be steeper than what you would ordinarily pay for a properly operated business.  You completely avoid this tax as long as you do not operate your real estate as a ongoing business.

LOST OPPORTUNITIES

1.Cannot permanently reduce taxes (via 1031 exchange and stepped-up basis)

If you own a property outside of a Solo 401k you can hold the property until you die and your heirs will receive a stepped-up basis.  This means that they will receive a new basis in the property and you will never have to pay any income tax related to the appreciation of the property.  They can also continue to own the property.  If you want to sell a property you can also use a 1031 exchange to defer the capital gains taxes until your death which, again, permanently vanish at that time.  Inside of a Solo 401k the property can be sold without a 1031 exchange, but ultimately your heirs receive no stepped-up basis.  They will eventually have to sell the property to satisfy the required minimum distribution rules and will ultimately pay income tax on everything.

2.No LTCG gains tax treatment

Money inside of a Solo 401k is taxed at ordinary income tax rates.  No exceptions.  If you sell a property outside of a Solo 401k after holding it longer than one year and you decline a 1031 exchange you pay long-term capital gains tax (LTCG).  This is significantly less than ordinary income tax.

3.No depreciation

You cannot use depreciation to reduce your tax liability if your real estate is inside your 401k.  If your depreciation exceeds your taxable income on the property AND you have other properties with income to offset, then you end up with a less advantageous result.  This leads to you paying more in income taxes each year than you would if you held the asset outside of your Solo 401k.

Again, because of these risks and pitfalls I do NOT advocate the use of real estate in your Solo 401k.

Sherman Asset Management does not provide tax or legal advice.  The information contained herein is provided for informational purposes only.  Do not rely solely upon this information to make tax decisions.
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