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 buying 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.
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.
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.
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.
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, 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.
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.
This content was originally published here.