ABCs of Self-Directed 401k Real Estate Investing in 2023

I often get asked the question “can I buy real estate with my 401(k)?” Yes and no.

Your current 401(k), if you called them (assuming you have an account with one of the big boys — Fidelity, Charles Schwab) and say “can I buy real estate with my 401(k)?”, the answer is, no.

They are not built for it. They make money selling you stocks, bonds, and mutual funds so if you call them, they are going to say no.

However, you can invest 401(k) in real estate. The answer is, you have to set up a self-directed 401(k). That’s obviously something we help with.

Now, there are a number of different rules relating to accessing funds in your current 401(k). There are a couple of things to be aware of.

First is the ugly question of age. If you are above the age of 59 and a half, most 401(k) plans will allow you to take out some funds to invest in real estate through a different account — your self-directed 401(k) plan.

There is also something called an in-service distribution, which, essentially, is asking your 401(k) provider “Can I take out some dollars to direct towards other investments while I still work for this company?”

The third and most common is, once you leave the job that provided you that 401(k) (let’s say you retire, you quit, you get fired), those funds become immediately available for you to do a rollover into a new self-directed retirement plan to buy real estate.

So, I have used the term “self-directed” a couple times so far. Let’s define that.

A self-directed retirement account is a retirement account that allows you to invest your existing retirement account funds into private assets, like real estate, tax free and penalty free.

So instead of taking your 401(k) funds out of the plan, paying taxes, and paying penalties, a self-directed 401(k) allows for you to use the entire balance towards purchases of physical real estate.

Now, remember if you call Fidelity and Charles Schwab, they are going to say “no — you have got to take the dollars out and pay those taxes and penalties”.

The alternative is self-directed plans. That’s what we help with. Many types of existing retirement plans will qualify for a rollover to a self-directed plan.

They allow you to own real estate in 401(k) or another retirement plan including 401(k)s, 403(b)s, TSPs, 457s, Roth IRAs, traditional IRAs, SEP IRAs, the list goes on.

Any account that is considered tax deferred would qualify to be converted to a self-directed plan.

Now, in the self-directed world, there’s a special type of account that we refer to as a Checkbook 401(k) or Checkbook IRA.

This essentially allows for you to manage your retirement investments through the control of a business checking account.

So, picture this: you have a balance in your current retirement account plan, we can essentially help you move those dollars into a business checking account with an institution of your choosing, so that you have direct access to your funds.

That way, when an investment property comes along, that you want to pounce on, you can physically write the check yourself for an earnest money deposit or send a wire online, depending on what your bank is going to allow you to do.

All of that done tax deferred, tax free, and penalty free.

There’s a couple of different sets of rules you have to be aware of when you are investing with your self-directed 401(k). They fall under an umbrella term called Prohibited Transactions.

Keep in mind, these rules are in play because when you have a self-directed 401(k), you are given so much control and so much access to your funds that the IRS has to curtail your investment options just a little bit.

This is essentially, to ensure that you don’t cheat them out of their taxes.

The first and easiest to visualize in these prohibited transaction rules is what is called Prohibited Parties.

What that essentially means is there’s a group of individuals, a list, that your retirement account, your self-directed 401k, cannot transact with.

So, I’ll give you that list. First, it’s you (the account holder), your spouse (if you’re married), any kids and grandkids you may have, and parents and grandparents (if you have them).

So, that list of individuals you cannot transact with by using your retirement plan. And there’s a number of ways that this can kind of present itself.

So, I get real estate investors calling me, for example, saying “Ted, my son is about to go off to college. I’m interested in purchasing a rental property near the campus, and I would love for my son to live on the property and have a couple of their buddies pay rent to me.”

Unfortunately, that’s going to be considered prohibited. That’s because your son or daughter, whatever the case, is a prohibited party and cannot transact with your retirement account, a-la pay rent to your retirement plan.

The next question I typically get is, “what if my son doesn’t pay rent? And there’s no transaction there. Does that circumvent that rule?”

Unfortunately, no. What that does is it actually presents the next rule, which is considered or called Improper Benefit.

And essentially, what that means is you and your retirement account cannot improperly benefit by virtue of the other. I’ll give you a different example built on the previous example.

If your son, in that example of going to college, did not pay rent to your retirement plan, you as an individual would be benefiting by virtue of perhaps not having to cover that expense for your child.

So, that thousand bucks a month that you might have had to endure, you are not having to. You are then improperly benefiting by virtue of a retirement plan investment.

Another example is “Ted, my son is a contractor. Can I hire my son to come and do the work on a property to get it ready to go so I can sell it again?”

The answer is, no. Why? Because your son, in this case, is a prohibited party.

Another example that folks will ask is “Ted, I have got a property, it’s a great property, I want to sell it to my retirement plan, my self-directed 401k, can I do that?” The answer is again no.

Why? You as an individual are a prohibited party to your retirement plan. Now, there’s a couple of other ways that these rules present themselves.

In general, if you are comfortable with the idea of Prohibited Parties and Improper Benefit, you are going to do just fine investing your retirement plan into real estate.

Last, but not least, let me show you how to buy investment property with a 401(k).

First off, we have to ensure we are observing all of the prohibited transaction rules that I just laid out.

A couple of examples again. So, we are not buying property from a prohibited party: yourself, family members, et cetera.

We are not going to buy property that we intend to work on ourselves or hire a family member to work on.

Again, that would be breaking the prohibited party rules. So, to start, we are going to observe all of those rules.

So, we are going to purchase real estate for your 401(k) from a third party. We are going to rent to a third-party individual. That’s going to ensure that you don’t run afoul with any of the prohibited transaction rules to start.

Next, I would say most important is the titling on the purchase agreement.

When you acquire a property that you are going to live in and you write John Smith, for example, on the buyer line, when you use your self-directed 401(k), you are going to use the name of that self-directed 401(k) plan.

Very important that you are using that titling. Or if you have a Checkbook model, you are going to use the name of your LLC as the buyer for any purchase contract you are going to negotiate.

That extends as well to any service providers you are going to engage, for example, property management companies.

You are going to have that contract read the name of your 401(k) plan with the name of your LLC in that checkbook model.

Same with any contractors, plumbers, landscapers, et cetera, in the name of your 401(k) is how you do business with those types of service providers.

From there, the next most important piece to be aware of is financing.

When you use a self-directed 401(k) plan to acquire real estate, and you do not have the capital available for the entirety of the purchase price, you are going to need to acquire a loan.

In this world it is called a non-recourse Loan. That essentially means the loan is not based on your creditworthiness and your credit history as an individual, like if you are buying a property to live in.

In this world, with the self-directed 401(k), the loan is based on the asset itself. So, the sales comparables, the rent comparables are going to be the most important aspects to securing that non-recourse loan.

To review, we are going to observe all of the prohibited transaction rules.

We are going to ensure that the titling on our purchase agreements and any other agreements we make are in the name of our 401(k) plan or the LLC for the Checkbook model.

And then lastly, for financing, you have to secure a non-recourse loan. Once you are comfortable with those items, really, you are home free.

Thank you for watching the video today. Again, my name is Ted Erickson. MyDirect IRA is our company. I look forward to helping you in the future.