Can You Use a 401(k) to Invest in Real Estate?

Investing in real estate offers portfolio diversification and potential growth. While leveraging retirement funds for real estate ventures is possible, it is not as straightforward as traditional real estate purchases or common 401(k) investments. This strategy requires a detailed understanding of specific Internal Revenue Service (IRS) regulations and plan structures to maintain the tax-advantaged status of retirement savings and avoid penalties.

Qualifying 401(k) Plans for Real Estate Investments

Not all 401(k) plans allow direct real estate investments. Most employer-sponsored 401(k) plans limit investment options to mutual funds, stocks, and bonds, lacking the self-direction features needed for direct real estate acquisitions. While some employer plans offer indirect exposure through Real Estate Investment Trusts (REITs), direct property ownership is typically not an option.

Self-directed 401(k) plans, particularly Solo 401(k)s, are the primary vehicle for direct real estate investment using retirement funds. A Solo 401(k) is designed for self-employed individuals or small business owners with no full-time employees other than themselves or their spouse. Eligibility requires self-employment income and no common-law employees working over 1,000 hours per year, excluding a spouse.

Funds from other retirement accounts, such as traditional IRAs or old employer-sponsored 401(k)s, can be rolled over into a Solo 401(k) to consolidate assets for real estate investment. This rollover must be executed carefully to avoid triggering taxes or early withdrawal penalties. Solo 401(k)s often feature “checkbook control,” allowing the plan participant, as trustee, to manage funds directly through a dedicated bank account. This streamlines real estate transactions without requiring third-party custodian approval.

Allowable Real Estate Investment Structures

A qualifying 401(k) plan permits various real estate investments, but they must adhere to IRS rules ensuring the property is for investment purposes only. Direct property ownership, such as residential rental homes, commercial buildings, raw land, or duplexes, is generally allowed. The property can also include real estate notes, tax liens, or investments in real estate syndications. These investments must be titled in the name of the 401(k) plan, not the individual.

The property must be held solely for investment and cannot provide any personal benefit to the plan holder or certain related individuals. This means it cannot be used as a primary residence, vacation home, or for any personal use, even if fair market rent is paid. The property also cannot be used by a business owned or controlled by the plan holder or disqualified persons. All income and expenses, such as rental income, property taxes, and maintenance costs, must flow entirely through the 401(k) account.

Certain assets are prohibited from being held within any 401(k) plan, including collectibles like artwork, rugs, antiques, and alcoholic beverages. Life insurance contracts are also generally prohibited. Any violation of the personal use rule can lead to severe tax consequences for the retirement plan. The investment’s benefit must remain with the retirement account, not the individual.

IRS Prohibited Transactions

The IRS enforces rules to prevent conflicts of interest and self-dealing when retirement funds are used for real estate investments. These regulations ensure the retirement plan, not the individual, benefits from transactions. A “prohibited transaction” involves any direct or indirect dealing between the 401(k) plan and a “disqualified person.”

Disqualified persons include the plan holder, their spouse, and lineal ascendants (parents, grandparents) and descendants (children, grandchildren) and their spouses. This also extends to any entity (like a corporation, partnership, or trust) in which the plan holder or other disqualified persons own 50% or more.

Examples of prohibited transactions include the 401(k) plan buying, selling, or leasing property to a disqualified person. Lending or borrowing money from a disqualified person is also prohibited. Providing or receiving services from a disqualified person related to the property, such as the plan holder managing the property for compensation, or using the property for personal benefit, are forbidden. Even indirect benefits, like a disqualified person earning a commission on a property purchased by the 401(k), are not allowed.

Engaging in a prohibited transaction carries severe penalties. The disqualified person must pay an initial excise tax of 15% of the amount involved for each year. If the transaction is not corrected, an additional tax of 100% of the amount involved can be imposed. In serious cases, the entire 401(k) plan can be disqualified, making all assets immediately taxable to the plan holder and potentially incurring an additional 10% early withdrawal penalty if under age 59½.

Tax Implications of 401(k) Real Estate Investments

Investing in real estate through a 401(k) plan offers tax advantages, as income generated from the property grows tax-deferred within the account. Rental income and capital gains are not taxed until distributions are taken in retirement. For Roth 401(k)s, qualified withdrawals in retirement are entirely tax-free, assuming the account has been held for at least five years and the owner is over age 59½.

A consideration for real estate within a 401(k) is Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI). UBTI applies to income from an active trade or business regularly carried on by the retirement plan, which is not typical for passive real estate rentals. UDFI can arise when a 401(k) uses borrowed money, such as a non-recourse loan, to acquire or improve real estate. A portion of the income from such debt-financed property may be subject to UBTI.

Solo 401(k) plans are exempt from UDFI on leveraged real estate investments under Internal Revenue Code Section 514. This means if a Solo 401(k) uses a non-recourse loan to purchase investment property, the income generated is typically not subject to UBIT, unlike with a self-directed IRA. All property expenses, including property taxes, insurance, and maintenance, must be paid directly from the 401(k) funds. These expenses are not personally deductible on the individual’s tax return because the property is held within a tax-advantaged retirement account.

When distributions are taken from the 401(k) in retirement, they are taxed according to the plan’s structure. Pre-tax contributions and their earnings are taxed as ordinary income. Qualified distributions from a Roth 401(k) remain tax-free. The absence of traditional real estate deductions, like depreciation, on the individual’s personal tax return is a trade-off for the tax-deferred or tax-free growth within the retirement account.