Double Your Real Estate Investment Return With a Tax-Efficient 401(k) Strategy

Did you know that you can use a self-directed IRA for your real estate investment? I’ve talked about this before and you can read more from our article about self-directed IRA investments.  There's no doubt that self-directed IRAs are powerful investment vehicles, but they aren't silver bullets for all investors.

That said, they do come in handy for Roth funds or when you’re planning to buy and hold onto one property for a long time. But the current IRS trends have many investors eyeballing different types of accounts.

So, what is an alternative I recommend?  I’m a big fan of the Qualified Retirement Plan (Solo 401(k) or Profit Sharing Plan) because it comes with the same benefits as a self-directed IRA and some more. Today, I’ll go over a strategy you can use to partner with your QRP to buy investment property.

House Flipping With a Solo 401(k): An Example

Fred Stark is a real estate investor who has spotted a hot property going for $200,000. He has a QRP with about $150,000 and $100,000 in the bank. Fred can easily buy the property in his own name or opt to partner with his QRP for the transaction.

How Do Investors Partner With a Retirement Plan?

To partner with his QRP, Fred is required to form an LLC. He then divides the ownership of the property in proportion to each member’s (Fred and the QRP) contribution. For example, if Fred puts in $70,000 and the QRP contributes $130,000, then ownership will be split in a 35% to 65% ratio between Fred and his QRP respectively.

How Profits Are Treated

Profits from an investment are usually distributed based on the percentage of ownership. This means that if the investment property Fred is buying generates an income of $30,000, he will receive $10,500 while $19,500 goes to his QRP. Consequently, John will have a taxable income of only $10,500. The $19,500 received via the QRP will not be taxable.

How Depreciation is Treated

Real estate depreciates over a period of between 27.5 years to 39 years. Fred can use the depreciation of the property to offset the income gains. So in fact, he can use this “paper loss” to his advantage.

What Impact Does Depreciation Have on Taxable Income?

Let’s have one more look at Fred’s $200,000 house. $175,000 is allocated to structures subject to depreciation while $25,000 is allocated to land. This means that the property will have a depreciation of $6,400 every year. Then his share of depreciation given that he owns 35% of the property is $2,240. This reduces his income to $4,760 from $7000. His QRP gets allocated $4,160. But since the QRP income is non-taxable, there is no benefit accruing from this depreciation.

But, wait: can he allocate the whole chunk of depreciation to his portion of income?

Yes. And this is where the magic happens. By using an LLC, Fred can allocate all the losses to himself, reaping the full benefit. Now his taxable income is only $600. Now his taxes are only $180 bringing his net income to a whopping $19,820 from the initial $20,000.

Set Up Your Solo 401(k) Today

If that’s not exciting, I don’t know what is.

The Solo 401(k) is a QRP that has amazing income and tax benefits that you should take advantage of. But you should proceed with caution. You may want to read our article on using a 401(k )to buy a house first. This is not a collaboration you should set up on your own.  Use a professional who has the qualifications and experience to execute it the right way.