Solo 401k Attached to Passive Income Entity

[Bryan O.]

Hi experts. 

I recently found out how contributions work for a solo 401k and that rental income is passive. So basically I'll never be able to contribute my solo 401k in this entity. Not the end of the world, but certainly not something I want to find out after setting up the fund. (p.s. Thanks @Brian Eastman for the great breakdown on that).

I was just told that I may not even be allowed to have the solo 401k because the entity it is attached to makes more than 25% of its income from investment. It actually makes 100% from passive because that is what I made the entity for!

I get the feeling I was steered wrong in setting up this plan, but I don't want to jump to any conclusions and I've been unable to find anything from the IRS or elsewhere regarding the requirements of the entity that the 401k attaches to. Is this 25% income threshold real?

[Brandon Hall]

@Bryan O. @Dmitriy Fomichenko not sure why I didn't reply to Bryan's questions the first time around - sorry about that.

First, while the IRS pubs are great resources to further one's understanding, it's important to note that they cannot be relied upon as authority. So when we are researching a topic, we want to get at the source code.

Sec. 1402(a) defines net earnings from self employment. Sec. 1402(a)(1) states that rental income is generally excluded (unless rents are related to agriculture) from the definition of net earning from self employment under Sec 1402(a).

Because we can only contribute earnings from self employment (or regular employment) income to retirement plans, and rental income is excluded from this definition, my stance is that rental income cannot be contributed to retirement plans. If someone has a court case that proves otherwise, I'd love to see it.

Keep in mind though, that a real estate professional may have real estate income other than rental income that can be contributed. For instance, the taxpayer may qualify as a real estate pro from their development biz and may be able to demonstrate material participation in their rentals making the income non-passive. But they still can't contribute the rental earnings, just those from their development biz.

Also, non-passive means non-passive. It does not mean "earnings from self employment." A real estate professional's non-passive rental income will not be subject to SE tax. 

The real question is: what were the congressmen drinking when they concocted all of this?