How to Rollover 401k into Real Estate

Have seen some interest on the site about this subject of rolling your 401k in real estate. So I read up and found a great article here.  Had to give it a few updates, since real estate value have declined, but real estate is a long term investment and so is your retirement planning.

Ground Your Retirement Fund with Real Estate

Warning:  Yes, you can tuck property into your retirement account. But you have to be careful. A single mistake can turn into a tax disaster. Here’s what you need to do…

By Jeff Schnepper

Over the last few years, stocks have cratered. Despite their recent rebound, millions of retired and almost-retired have been forced to extend their working years just to maintain a minimum standard of living.

But one asset has skyrocketed in value during that period — real estate. (This is no longer true November 2011) but the same still applies on how to rollover your 401k into another investment vehicle for retirement.

And while your 401(k) plan may not offer real estate in any form, the fact is, you can own real estate in your retirement plans. Retirement plans are by nature long-term investments. And, you can’t get much more long term than real estate. But you must keep in mind that you’ll be able to invest only for income and appreciation. You can’t deduct depreciation, as you can in a taxable investment.

And you have to be very careful how you do it. A single bad move can create a major tax disaster.

Know the rules

The law allows your qualified plan or IRA to own just about any kind of real estate. You can invest directly in property: single family and multi-unit homes, co-ops, condos, apartment buildings, even improved or unimproved land. You can invest indirectly in real estate investment trusts, but I’m not wild about these for retirement because their overheads are too high.

If you buy a property for your IRA, the income and appreciation normally builds up tax-free until you start to take withdrawals.

Careful now: I said normally tax-free. That’s because there’s a special tax on debt-financed income in retirement plans called the unrelated business income tax (UBIT). If the real estate is mortgaged, then you must file Form 990-T with the IRS. It allocates the income earned between debt and non-debt financing, and the tax due. So, let’s say you want to buy a $100,000 duplex for your retirement account. You put in $70,000 and borrow the remaining $30,000. On a simplified calculation with the UBIT, you’d be able to shelter only 70% of the income. The rest of the income from the property is subject to ordinary income tax rates.

That’s why an all-cash transaction is probably the easiest. If you don’t have sufficient cash, your retirement plan can purchase a partial interest in a property. That’s known as a tenant in common interest.

Or, you can borrow the money to finance the property and pay the UBIT. Depending on aggravation level, costs, tax rates and rates of return, the leverage may be worth the tax cost.

The advantages of real estate in a retirement plan are its potential high rate of return, added diversification and its lower risk over the long run.

This can be a pain to set up

Disadvantages only begin with the hoops you have to jump through. First you have to get your dollars from your retirement custodian (probably your broker) to an independent custodian that offers real estate as an investment option. Start here to learn more Equity Trust Company. There are many companies that will take care of your investment and show you the ropes.  Just know the right questions to ask.

You sign a direction letter to the custodian to purchase the property. The rents go into the retirement account and all expenses are paid from the account.

You can use a Roth individual retirement account, a traditional IRA or even a single-participant 401(k) to purchase real estate. All you need is a custodian that allows real estate investments. Check out Entrust Administration for single-participant 401(k)s and self-directed retirement plans. (You’ll find a link at left under Related Sites.)

Watch out for other traps. You can’t transfer property you already own into a retirement account. You also can’t buy a vacation house and rent it out to yourself. That’s called “self-dealing” and is a prohibited transaction. It covers your family members as well.

Perhaps the biggest drawback to investing in real estate for a retirement account is the loss of the depreciation deduction. It’s useless inside a retirement account. However, many argue that the cash flow and appreciation benefits outweigh the loss of the depreciation deduction. That does work for REIT investors.