Are SOLO401Ks & SDIRAs Invested in Syndications Taxed the Same?

[Daniel Dietz]

Hello All, 
I am looking ahead in my investing career and thinking about the day I might no longer want to do buy-n-hold rentals myself and instead invest in something more passive like a syndication. 

I currently own rentals in 'cash', in SDIRA and SOLO401K and am going to continue buying for probably the next 5-10 years at least. 

I realize that within the SDIRA and SOLO401K profits are taxed differently when leveraged, with essentially no taxes due within the SOLO401K. Does this also hold true when investing in a typically structured syndication which is almost all cases that I am aware of are using leverage?

If there is a difference, what might that look like on say an investment of 100K that turns into 200K in 5 years?

Thanks, Dan Dietz

[Brian Eastman]

@Daniel Dietz

IRC 514 is the go-to... if you have problems sleeping at night.

When a tax-exempt entity (IRA, 401, etc.) utilizes debt-financing, it generates taxable income in the form of Unrelated Debt-Financed Income (UDFI).

A qualified employer plan such as a Solo 401(k) has a narrow exemption to UDFI when the debt-instrument is for the purpose of acquiring real property.

A limited partnership share will pass through this real estate related exemption in most cases if the partnership is using debt to acquire real property.  

A exception can occur per IRC 514(c)(9)(E) known as the "fractions rule".  If the partnership is shifting income/expense in ways non-commensurate with each partners share, the exemption is no longer valid.  An example would be a syndicate where the general partner allocates all benefits of depreciation to limited partners not using retirement funds.  They may think they are doing a favor to those cash investors, but are actually hurting their retirement plan investors as a result.

It is not possible to give you a tax estimate based on simply amount of return an investment provides. When an IRA is exposed to UDFI the impact on operating income from rents is typically nominal. If debt-financing is still in place at the time of sale (typically the case in most syndicates), there is a capital gain tax amount applied and it can be a decent sized number. The thing to keep in mind is that the net post-tax return of a leveraged investment in an IRA will still probably be quite good. The return on the same investment opportunity can be better in a 401k. We recently wrote a blog on our site on this very topic with some math examples.