Funding a Real Estate Operating Company (C-Corp) with 401K??

Question

Hi all! Thanks in advance for any input you more seasoned RE investors may have for me on this topic. As many of you have done, I'm contemplating a significant life change.  I've worked for many years, and with great success, in an particular industry, but in recent years have longed to scratch my entrepreneurial itch.  Like all of you, that has lead me to discover a passion for Real Estate investing, and flipping in particular. That said, I'm contemplating stepping away from my current career, and funding a C-Corp Real Estate Operating company with my 401(k) along with an IRA belonging to my wife.  I'm certainly aware of the risks, as I am for the potential rewards.

Is there anyone who has done this, and can walk me (and others who may be interested in this) through a typical transaction? I'm specifically interested to know how the use of these funds may impact the process by which a flip property is purchased, and how you choose to disperse the money earned upon sale of the same property once renovated.  How much you take as profit versus return to the 401k as a return on its investment, or to the C-Corp for operating costs?

Can anyone share insight into your success (or lack thereof) in funding your real estate ventures with this method?  And finally, does anyone do this using a self-directed 401K from your CURRENT employer, rather than parting ways with your job in order to use that 401k to fund a C-Corp?

Tried to boil down my questions on this -- obviously, its a complicated and nuanced topic ;-)

THANKS!

Brian Eastman · Answer

@Brian T.

The funding mechanism you are outlining is what is known as a Rollover as Business Startup (or ROBS), and is commonly used to capitalize an active business - whether that be a restaurant, insurance agency or real estate development company.

This is a very different structure than a self-directed Solo 401(k), which must be invested entirely at arms length - as noted in a post above.

In this structure, the operating business must be a C-Corp.  That corp establishes a 401(k) plan.  Any full time employee of the company (i.e. both you and your wife) can rollover existing tax deferred retirement savings into the plan, so long as that savings is available for transfer (current employer plans typically cannot be transferred until you separate from the company).  The 401(k) then purchases shares of the parent C-Corp in an employee stock option purchase (ESOP).  The structure has been around since the 1980's and we have worked with many clients using such plans to form a real estate development company.

You do need to take a reasonable salary as an employee of the C-Corp.  You have a good bit of flexibility to declare shareholder dividends (some of which will go tax-sheltered to the 401(K) owned shares) and also to make new 401(k) contributions and reduce your taxable income as a result.

It can be a very powerful wealth building tool if you work with the right advisors to create your business plan and have success in flipping houses.  A "ready, fire, aim" approach can be devastating to your retirement savings.

There are several professionals here on BP with familiarity with this program.  Get on the phone and start asking questions.  Be sure to involve your CPA.

David Faulkner · Answer

Using your wife's self directed 401k to invest in a C corp RE operating company that you run would not be an "arms length" transaction, and thus be prohibited. Even if this were permitted, you couldn't likely do it until/unless your wife quits her current employer ... then and only then could she roll the funds into a self directed vehicle, but a vast majority of 401k plans would not allow her to roll it into another self directed plan while she was employed there. In this case, that self directed vehicle would likely be an IRA LLC. If/when your wife switches jobs, cashing out her 401k to invest directly in a C corp would spur all kinds of early withdrawl penalties ... not a good move IMO. If one or both of you are self employed full time or part time and have some earned income from it, then you could look to start a Solo 401k funded through that self employed earned income and invest similarly to a IRA LLC, but again investing into an active operation that you run would be prohibited. In that case, you could use those solo 401k funds once accumulated outside of your W2 employers 401k plan without quiting with the fulltime employment company. Also, buying real estate with money from one of these vehicles and using leverage, you would need to get a non-recourse loan so that you would not be personally liable for the debt, again to ensure it is an "arms length transaction", which sounds great except for the fact that these type of loans have some stricter restrictions and generally are more expensive.

When I got laid off from a job in 2009, at the same time the Phoenix RE market got obliterated, I saw some opportunity there, so I rolled my 401k plan into a roth IRA, paid the taxes since my earned income was going to be low that year, and opened up a roth IRA LLC in AZ ... I then purchased rental properties for pennies on the dollar all cash and held for 5 years. In those 5 years I got some cash flow from them, and prices tripled by the time I sold them ... since it was a roth IRA all these profits were 100% tax free. I've also heard of some investors funding hard money loans for flippers and/or investing in RE notes from their self directed retirement plans. These need to be passive type investments and not made to relatives or spouses or business entities that they actively run. Also, since it is retirement funds, you can't touch it without early withdrawl penalty until you are of retirement age, though you may be able to touch the principal (but not interest) of Roth funds prior to retirement without penalty.

So, it can be a good move, but there are lots of expenses and restrictions involved that you will need to research. There are many specialists out there, some of them on BP (@Dmitriy Fomichenko), that can help guide you through the ins and outs of such strategies.

George Blower · Answer

@Brian T.

Here are some of the items to consider when investing a ROBS 401k in a real estate operating company.

1) The corporation that you invest your retirement funds through the ROBS 401k in may invest in real estate that satisfies the following requirements:

a. At least 50 percent of the assets of the business, valued at cost, must be invested in real estate which is managed or developed and with respect to which such entity has the right to substantially participate directly in the management or development activities.

b. Such entity in the ordinary course of its business must be engaged directly in real estate management or development activities.

2) Expenses related to the real estate will be paid by the corporation.

3) The real estate will not be used for personal use.

4) There may be periods of time when the 50% test described in 1(a) above is not satisfied. This confirms that it would be acceptable as long as the 50% test is satisfied on the following dates: (i) the "initial valuation date" or the first date on which the corporation makes an investment that is not a short-term investment of funds pending long-term commitment; and (ii) at least one day during each annual valuation period. An “annual valuation period” is an annually recurring period of not more than 90 days that begins no later than the anniversary of an entity’s initial valuation date. For example, if the corporation’s first long-term investment is made on October 3, 2016, that date is its initial valuation date. The first annual valuation period can commence as late as October 3, 2017. An annual valuation period that commences on October 3, 2017 would end on December 31, 2017 and recur each October 3 through December 31 thereafter. Once an annual valuation period is established it may not be changed except for good cause.

Jeff Greenberg · Answer

I am not a CPA or tax expert.  With that said, you would not be able to take any disbursements or put in sweat equity unless we are talking about a loan from your 401k.  Any dispersements would be taxable and possible penalties.

Hyoung Choi · Answer

Maybe an update on how the ROBS plan worked out for you?  Just recently started the process as well.

Todd Morgan · Answer

@Brian Eastman Great - thanks for the info!

Brian Eastman · Answer

@Todd Morgan

That makes sense then.  Yes, short term rentals are considered providing a service, just like operating a hotel.

Most ROBS providers will have connections with financing sources including SBA lenders.  You should be able to get corporate financing.  A local resource here in Colorado that does commercial/non-recourse loans is FirstBank.

Todd Morgan · Answer

@Brian Eastman Thanks Brian. I should have mentioned we are looking at short term rentals to satisfy the active investment requirements.

Brian Eastman · Answer

@Todd Morgan

I recommend you consult with your ROBS provider about this situation.  I am primarily concerned that you are using the corporation for passive rental holdings, which is not generally a compliant use of the structure.  It is possible, I suppose, to configure passive rental holdings under the auspices of providing property management services, but that would be anything but a tax-efficient way to accomplish the goal.

You are correct that any debt instrument should be corporate debt and non-recourse to you.  Find a different lender that offers such programs.

Todd Morgan · Answer

We recently did this exact thing (formed a C corp under the ROBS program) and are now looking for our first rental property. We ran into a hiccup when getting pre-qualified that I wonder if anyone has any advice on. The lender wants to put my name on the title, they said "We are not allowed to close a loan with a business name on title. That would be considered a business or commercial loan and we only offer residential loans."Since we are using corporate funds for the down payment, our thought it the home should be titled by the company, not me. We are a business wanting to buy residential property, so wouldn't we still be looking for a residential loan?

Funding a Real Estate Operating Company (C-Corp) with 401K??

Most Popular Reply