Things to think about when using a 401k for investing

[Anthony Simboli]

Would anyone have more information on how to use a 401k for investing? I've read in the past you could use it for downpayment with less tax implications. Is that true? In general, has anyone had experience using their 401k to invest. Any pros and cons? Tips and tricks?

Thanks!

[John Bowens]

Anthony, You hear correctly that a solo 401(k) is a preferred investment vehicle when purchasing properties with debt financing. The reason, if you were to purchase a property with debt using an IRA, your IRA will become subject to a tax called Unrelated Business Income Tax (UBIT). In the context of debt leveraged Real Estate, known as Unrelated Debt Financed Income Tax (UDFI). To make it simple, let's say you buy a property for 100k, your IRA puts 50k down and you get a non-recourse loan for 50k (Must be non recourse, you cannot personally guarantee). So your leveraged percentage is 50%. Because you are 50% leveraged, 50% of your NET income from the rental or sale of the property will be subject to UBIT tax at the estate and trust tax schedule. Let's say you flipped the house and made a 30k profit. 30k*50% = 15k would be subject to UBIT tax. The estate and trust tax schedule for income over $12,750 is 37%. 37%*15k = $5,550. There of course is some additional math involved, I'm simplifying, but this is the general construct for you to pencil out the transaction.

So now onto the solo 401(k). If you did the same deal above with a solo(k), assuming the loan is structured properly (Must standard private non-recourse or hard money non recourse loans would be) then your Solo(k) will be exempt from this UDFI tax. This is a strong benefit of a solo(k), HOWEVER, YOU MUST ENSURE YOU QUALIFY FOR A SOLO(k): 

1) You must have active earned income through the business that is sponsoring the plan (Meaning income you pay taxes on, including Payroll taxes - medicare and social security). I have heard of investors opening solok's to later find out they were not eligible. IRS states, see IRS.gov that contributions must be "recurring and substantial", if you dont have any earned income, you wont be able to meet this test. 

2) You cannot have any employees, including employees in a controlled group (Talk to your CPA about this), only exception is your spouse. 

If you don't qualify for a solok and don't plan on taking on debt, you might be better off with just an IRA, self-directed of course.

Hope this helps provide some direction.