401k Self Directed Plan: Real Estate Investing Guide (Part Three)
“Every battle is won before it is fought.” ~ Sun Tzu
A well-devised strategy plays a crucial role in every aspect of life; let it be investments, business, or personal finance. A majority of self-employed individuals ignore retirement savings, as shown by a TD Ameritrade survey taking into account 15 million self-employed individuals in the U.S. According to the survey, 28% of these self-employed professionals have no retirement savings at all, in comparison with 10% of their counterparts in traditional jobs. This is somewhat surprising considering the level of expertise self-employed professionals and small business owners usually have. In our education series, Real estate investing with 401k self directed plan Part One and Part Two, we discussed the different options available in physical real estate and alternative real estate investments. In this part, we are going to discuss some of the best investing strategies that you can use with your Solo 401k real estate investments.
401k Self Directed Investing: Real Estate Investing Strategies
When it comes to real estate investing, several strategies can offer decent returns, provided you understand their basics and have the ability to sustain any financial emergencies.
The Classic Buy & Hold Strategy
Over the past several generations, the “buy and hold” strategy has found a decent following among realtors and property-owners. It is the most basic form of real estate investing, which involves ownership of a piece of land and the act of renting it out for money. According to the latest numbers, the average gross rent in the U.S. was $962 in 2013, with an average increase of 0.89% per year. Under the standard circumstances, you can choose to rent the property to tenants, and make regular mortgage payments with the rent, allowing you to grow your equity in the house. On the contrary, you can hold a property for appreciation purposes, and sell it in future.
The IRS allows purchasing real estate with 401k self directed retirement plans and rent it out for regular income. The key is to ensure that monthly rent payments go back to the retirement plan and any expenses involved in the maintenance of the property go through the Solo 401k account only. Buying a property with Solo 401k is a feasible option, even with a limited budget, as you can avail non-recourse financing for the property.
What Do You Need to Consider in a “Buy and Hold” Strategy?
- Choose properties carefully: If you plan to add real estate to your retirement portfolio, make sure to perform due diligence in its evaluation. It starts by understanding the market and finding the right opportunity to purchase the property. With careful study of a market, you can find discounted deals during the low times and sell them for a substantial return during the high periods.
- A careful estimate of expenses: For investors with relatively zero to some experience of real estate, it is common to underestimate expenses and deteriorate profits in the process. Before purchasing a property with your Solo 401k plan, consult a real estate expert or a trusted contractor and find out the amount that you will have to shell out of your pocket.
- Lack of experience in tenant selection: Tenant selection isn’t exactly a science, but it demands due diligence on your end. You can start with a tenant application, get consent to do a credit and background check, contact previous landlords, and if possible, get in touch with their employer. The most important factor is the income of the tenant, so make sure that he or she makes at least 2.5 to 3 timers of the rent. You can choose a brokerage to find tenants for your property, and it is likely to cost 10% to 12% of the annual rent.
- Property management: Being a self-employed professional, you might over-estimate your ability to manage a property, but it’s not as simple as it appears. Further, you cannot run out to attend a problem at a moment’s notice, and might end up hiring contractors for the same. The smart choice would be to hire a property manager, which is likely to cost anywhere between 5% and 10% of the monthly rent. It will make sure that you can focus on your job and enjoy returns from a property simultaneously.
House Flipping or Flipping Real Estate
In general, investors or active real estate professionals planning to save on income taxes often turn to 401k self directed retirement plans. If you fall into that category, there’s some good news and some bad news for you. The bad news first, certain real estate transactions such as house flipping, when processed through the Solo 401k retirement plan, are likely to fall under UBTI (Unrelated Business Taxable Income). This can trigger relevant taxes against capital gains. The good news is that, if done carefully, you can evade taxes by holding the property a bit longer.
Prohibited Real Estate Transactions
- You or any disqualified individual cannot use the property under consideration.
- You or any disqualified individual cannot provider maintenance or repair services for the property.
- You cannot purchase a property from a disqualified person or sell the property to yourself from the 401k self directed plan.
- You cannot borrow money from a disqualified person to fund the purchase.
Flip Real Estate with 401k Self Directed Account
Case I: Under the first approach, you can purchase a property with your Solo 401k plan, hire contractors to repair or upgrade the property, and sell it for profit. This case is likely to trigger UBTI rule, but you will still end up with substantial returns on your initial investment.
Case 2: Another approach is to become a bank and lend money to real estate investors, who hold an expertise in real estate flipping. The IRS will consider it as a passive investment, allowing you to pocket the interest income. Generally, these loans can be offered in the interest range of 10% to 12% depending upon the property. It is important that the interest income goes back to your 401k self directed plan only.
Case 3: In the third approach, you can buy a property with your Solo 401k account, repair it, and then rent it to a tenant. The rental income should go into the retirement plan, and once the property has appreciated, you can sell it for a profit. Renting the property for a specific period will allow you to evade UBTI. Further, you can use the rental income to repay the loan and build your equity in the property.
What Do You Need to Consider in House Flipping Strategy?
- Cheap is not always the best: When starting out in real estate flipping, novice investors often choose cheap properties, irrespective of their current condition. Buying a home that costs $110,000 is sometimes better than buying one that costs $75,000 and requires $40,000 worth of repair.
- Build a realistic budget: Create a budget that caters to every single cost that you are likely to incur in the process, and have some room for unexpected expenses, as often seen in the majority of house flips.
- Improving property beyond need: If you are processing your first house flip through 401k self directed plan, avoid indulging into over-improvement and stick to the plan. You can consult an expert and find out the minimum upgrades that you need to reach your target profits.
- Be conservative during property pricing: You are going to spend an awful amount of time fixing the property and seeing it turning into a beautiful structure. Sometimes, the whole process entices the owners to over-price the property, and as a result, the home sits on the market for an extended period. Avoid over-pricing the property and keep it competitive, while considering your maintenance charges in the process.
Final Advice
Real estate is an excellent choice for 401k self directed retirement plans, but you should be diligent enough to structure the property for receiving tax benefits. Irrespective of the benefits of real estate investing, make sure to balance your retirement portfolio and add other investments in proportion.
Note: The information provided under this series is for information purpose and should not be treated as legal advice. You must confirm the details with a legal investment advisor.
Last in Series: 401k Self Directed Plan: Real Estate Investing Guide (Part Two) Last in Series: 401k Self Directed Plan: Real Estate Investing Guide (Part One)