Many investors know about the tax benefits of investing in real estate, including the long-term capital gains benefits as well as the various regular and depreciation deductions available for commercial properties.
While most investors are familiar with the capital gains deferral benefits of 1031 exchanges, many are unaware of the tax deferral and even the tax elimination benefits of investing through a Solo 401 (k) or a Self-Directed IRA (SDIRA).
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.
A Self-Directed IRA is an IRA that gives you control over your investments. Unlike other IRAs held at banks, brokerage firms, and other institutions, you’re not limited to stocks, bonds, or mutual funds.
Both the Solo 401(k) and the SDIRA allow you to invest in alternative assets, including real estate, private investments, limited partnerships, commodities, etc. This is what distinguishes Solo 401(k) ‘s and SDIRAs from 1031 exchanges, which are limited to direct real estate investments.
Solo 401(k) ‘s and SDIRA’s both offer traditional (tax-deferred) and Roth (tax-free) options. Whereas the traditional options are funded with pre-tax dollars, the Roth options are funded with after-tax dollars. The main advantage of the Roth option is that the gains are tax-free.
The following table compares the Solo 401(k) ‘s with SDIRA’s:
Let’s compare the tax ramifications of investing $100,000 in private investment through a Solo 401(k), SDIRA, and direct investment for five years.
Since a direct investment is made with after-tax dollars and because the Roth option provides the most advantageous tax benefits for a long-term investment, we will use the Roth Solo 401(k) and SDIRA for purposes of this exercise.
For simplicity’s sake, we will ignore the contribution limits and the early withdrawal penalties. We will also assume a rate of 25% for both the income tax rate as well as the capital gains rate.
The investment will pay 10% annually, which will be distributed annually to the direct investor but retained by both the Solo 401(k) and SDIRA investors. There will be a 20% appreciation at the end of the five-year term.
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.
Kyle Jones is a co-founder and Key Principal of TruePoint Capital, LLC. Kyle is responsible for the company’s strategic planning, investment decisions, asset management, and overseeing all aspects of the company’s financial activities, operations, and investor relations.
Kyle obtained a Bachelor of Science degree from Texas State University – San Marcos, where he also played Division 1 Baseball.