Investing in real estate is offers capital protection while returns from the investments over a longer term can pleasantly surprise you. Hence investing in real estate is widely preferred. Beside capital appreciation, it can also provide regular income. 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 invested in a traditional 401(k) plan, be aware that real estate is not allowed as an investment. For investing in real estate, you need to have a self directed 401(k) plan.
Talking about real estate, there is a wide array of option 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. You can also buy your dream home where you would like to live post retirement. If the price required to buy the investment property is more than the funds you have in your self directed 401(k) account, you also 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 participant / investor does not have to give a personal guarantee. So in case of a default, the only recourse with the lender is to recover whatever they could by selling the property. A non-recourse loan is generally at a slightly higher 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 under a self directed 401(k), requires plan participants to understand and adhere to some important but simple rules,
All transactions should be at arm’s length – This implies 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 would include the plan participant, his 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 also cannot invest in a property where you or any of your family members are currently staying.
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. Expenses are paid from the plan and rents or gains come back to the plan.
At Self Directed Retirement Plan LLC, we help investors set up a self directed 401(k) account and guide them regarding real estate investment opportunities allowed by the IRS. We also warn account holders against making prohibited transactions.