Investing in Real Estate Tax-Free and Tax-Deferred

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A long-standing key to wealth is the idea to “pay yourself first.”

“Pay yourself first” was first coined by George Samuel Clason in the 1920s. Clason was a successful entrepreneur who wanted to share his secrets of wealth by distributing a series of pamphlets that delivered nuggets of financial wisdom through parables set in ancient Babylon – once the richest city in the world.

These pamphlets were eventually compiled into the best selling book, “The Richest Man in Babylon.”

The idea behind “pay yourself first” is that before you spend any income, you should put some aside first for building wealth. It’s this concept that is the foundation of 401(k)s and IRAs.

Just as important as paying yourself growing your nest egg, is the idea of preserving that nest egg – specifically by reducing the taxes on the growth or that egg.

On the subject of growing your nest egg, let’s talk about real estate.

Investors have flocked to real estate investing for years to take advantage of the tax benefits as well as the above-market returns uncorrelated to Wall Street.

Unfortunately, as with other appreciated assets, when it comes time to sell, it also means it’s time to pay the tax pied piper – the IRS. However, with the right planning now, there are ways to invest in real estate tax-free and, in the alternative, tax-deferred.

The key to investing tax-free or tax-deferred is through your retirement account – whether that be a 401(k) or IRA. But you’re thinking; I thought that I could only invest in traditional equities like mutual funds through my traditional 401(k) and IRA.

You’re exactly correct on that point. So to invest in alternative investments like real estate will require you to take control of your investments through a Self-Directed IRA (SDIRA) or a Solo 401(k).

Solo 401(k)’s are only available to single-employee (you the owner). While more restrictive as to who can participate, it is an ideal platform for investing tax-free for the reasons discussed below.

So we’ve established that to invest in an alternative asset like real estate through a retirement plan, that retirement plan will need to be self-directed (i.e., a Solo 401(k) or SDIRA). And to invest in real estate tax-free – in other words, without being taxed on the gains – you will have to do it through a Roth Solo 401(k) or a Roth SDIRA.

As explained below, the Roth Solo 401(k) is by far the best platform for investing in real estate tax-free.

Here’s a brief rundown of SDIRA’s and Solo 401(k)’s:

SDIRA

A Self-Directed IRA is an IRA that gives you control over your investments. Unlike traditional IRAs held at banks, brokerage firms, and other institutions, you’re not limited to stocks, bonds, or mutual funds.

SDIRA’s were intended to encourage investors to work towards securing financial freedom by growing money tax-free in a Roth IRA or tax-deferred in a traditional IRA.

Currently, if you are under the age of 50, you can contribute up to $6,000 per year into an IRA and an additional $1,000 if you are 50 or older.

If you elect to have a Roth SDIRA, you pay taxes when you contribute money to your IRA rather than when you withdraw it with a traditional SDIRA. This means with a Roth SDIRA your cash will grow tax-free.

Solo 401(k)

A Solo 401(k) plan is an IRS approved retirement plan suitable for business owners who do not have any employees, other than themselves, and perhaps their spouse. It is a traditional 401(k) plan covering only one employee.

Like an SDIRA, a Solo 401(k) also allows you to invest in alternative assets, including real estate, private investments, limited partnerships, commodities, etc. However, unlike SDIRA’s that limit your annual contribution to $6,000, with a Solo 401(k), you can contribute up to $56,000 under age 50 and up to $62,000 age 50 and older. This is a huge advantage.

A successful entrepreneur under the age of 50 can fund a Solo 401(k) with $280,000 of investment capital as opposed to $30,000 for the holder of an SDIRA.

And if that entrepreneur takes that annual $62,000 contribution and invests it in a private real estate fund that pays a yearly return of 8%, after five years, there will be $483,925.94 in that Solo 401(k) account. And the kicker is, with a Roth Solo 401(k), all the gains are tax-free.

Why You Should be Using a Roth SDIRA or Solo 401(k)

The following example illustrates the tremendous tax advantage of the Roth retirement plans:

  • You invest in a private real estate investment fund with your Roth SDIRA or Solo 401(k) for $200,000.
  • You receive annual profit distributions of $16,000 (8%) for ten years, totaling $160,000 at the end of the ten years.
  • At the end of ten years, the fund sells the underlying commercial real estate asset, and your share of the profits is $300,000. $300,000 of profits from the sale plus $160,000 in annual profit distributions results in a total of $460,000 of return on your investment.
  • That means with a Roth Solo 401(k) or Roth SDIRA; the $460,000 you made on your $200,000 initial investment is entirely tax-free! If you conducted this same transaction in a traditional SDIRA, you would end up paying tax on the $460,000 instead of the $200,000.

If you don’t currently have a Solo 401(k) or SDIRA, but have a 401(k) through your work and are about to quit to invest full-time, the good news is you can rollover your current 401(k) into a Solo 401(k) or SDIRA without penalty provided certain requirements are met.

There are two types of rollovers – direct and indirect:

  • A direct rollover is when your money is transferred electronically from one account to another.
  • In an indirect rollover, the funds come to you to re-deposit into the new plan. You have only 60 days to deposit the funds into a new plan, or you will be subject to withholding taxes and penalties.

As you can see, there are significant tax benefits for investing in private investments such as a private real estate fund through a Solo 401(k) and SDIRA.

Ultimately, if you’re in a position to form a Solo 401(k), that will be the most advantageous vehicle for investing in alternatives since the contribution limits are much higher, and there are no income limits and the Roth version of either retirement plans will save you the most in taxes since your investment will grow tax-free.

Mike Ayala

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