Investing in real estate is probably the most popular choice most people make. This type of investment can offer capital protection, appreciation and regular income. Not too many investments can offer this combination and one the best parts is you are in control. Those investors, who have the uncanny ability to time the investment well, may also generate super normal returns out of real estate investment.
If you are a participant in a traditional 401(k) plan, be aware that real estate is not normally allowed as an investment. The plan administrator will offer many choices, mainly mutual funds but not real estate. To invest in real estate, you need to have a true self-directed 401(k) plan.
There is a wide array of real estate options that you can select from. For instance, you can buy raw land, a residential property (apartment, single family homes or duplexes) or a commercial property (offices), tax liens and private mortgages.
Non-Recourse Loans – If the price of the investment property is more than the funds you have in your self-directed 401(k) account, what do you do? You have the option to borrow the balance required. This borrowing will be in the form of a non-recourse loan. With a non-recourse loan, the plan participants / investors do not have to sign a personal guarantee. If there is a default, the lender’s recourse is the property. A non-recourse loan is generally at a slightly higher interest rate than recourse loans and the investor has to put a higher down payment. Non –recourse loans can be private funds or commercial lenders.
Investing in real estate with a self directed 401(k) requires plan participants to understand and adhere to some simple but important rules.
All transactions should be at arm’s length – This means that whatever investment the plan makes, there has to be no undue influence that impacts the fairness of the deal value. For example, the investment must stand on it’s own merits and not depend upon the plan participant to make the deal go through.
There should be no self-dealing – self-dealing amounts to entering into a transaction with a disqualified individual. A disqualified individual to the self directed 401 k plan would include the plan participants, their relatives (spouse, father, mother and kids, grandparents, investment advisors and fiduciaries). Thus, you are not allowed to sell or buy a property to/from your parents or your spouse. Under self-dealing, you cannot invest in a property where you or any other disqualified person are currently living.
When rental income is generated out of any of your real estate investments, it must be reinvested in your self-directed 401(k). Expenses related to proper maintenance and upkeep of property has to be borne from the funds in the self-directed 401(k) account. An analogy we have used for many years is: think of the 401 k plan as the “mix-master”, all fund activities must originate from the plan and return to the plan.
As with all 401k planning strategies, seek an advisor who knows the lay of the land. You need to make sure you are in full tax compliance with the various IRS rules. As most know there can and most likely will be abuses in this application. To ensure minimal risk of exposure to an audit, you should limit your real estate investment activities to truly passive investment opportunities with minimal debt financing.