Should I Cash Out My 401k to Buy Rental Property?

Using retirement savings for real estate investment requires understanding the financial implications. Accessing funds from a 401(k) to acquire rental property involves navigating regulations and potential tax consequences. This decision impacts long-term financial planning and requires consideration of distribution rules, alternative investment structures, and ongoing tax obligations associated with property ownership.

Navigating 401(k) Distributions

Accessing funds from a 401(k) can occur through different methods, each with distinct rules and tax considerations. A direct withdrawal, or distribution, permanently removes money from the retirement plan. This differs from a 401(k) loan, where funds are borrowed and repaid to the account, or a rollover, which transfers funds to another qualified retirement account. Your employer’s plan dictates the availability of loans and withdrawals.

Withdrawals from a traditional 401(k) before age 59½ are considered early distributions. These amounts are subject to federal income tax at your ordinary income tax rate. An early withdrawal penalty of 10% applies to the distributed amount.

Several exceptions allow you to avoid the 10% early withdrawal penalty, though income taxes still apply. One common exception is the “Rule of 55,” which permits penalty-free withdrawals if you leave your job during or after the calendar year you turn 55. This rule applies only to the 401(k) plan of the employer from whom you separated. Public safety workers may qualify for this rule as early as age 50.

Other penalty exceptions include:
Distributions due to total and permanent disability.
A series of substantially equal periodic payments based on your life expectancy.
Qualified medical expenses exceeding 7.5% of your adjusted gross income.
Distributions related to federally declared disasters.
Birth or adoption expenses (up to $5,000 per child).
Victims of domestic abuse (up to $10,000 or 50% of the account, whichever is lower).

Hardship withdrawals are another form of distribution available for immediate financial needs, as determined by your plan administrator. While a hardship withdrawal allows access to funds, it does not exempt the distribution from the 10% early withdrawal penalty, unless it falls under a specific exception like unreimbursed medical expenses. For instance, a hardship withdrawal for college tuition might be permitted, but would still incur the 10% penalty if no other exception applies.

In contrast to withdrawals, a 401(k) loan allows you to borrow from your retirement account and repay it over time, up to five years, or longer for a primary residence purchase. The maximum amount allowed for a 401(k) loan is 50% of your vested account balance, up to $50,000 within a 12-month period. Unlike withdrawals, loan proceeds are not subject to income tax or the 10% early withdrawal penalty if repaid according to the terms.

If you leave your employment before repaying a 401(k) loan, the outstanding balance may become due immediately. If not repaid, the unpaid portion is treated as a taxable distribution, potentially incurring both income tax and the 10% early withdrawal penalty if you are under age 59½. Both loans and withdrawals reduce the amount of money remaining in your retirement account, impacting its long-term growth potential.

Direct Real Estate Investments Using Retirement Funds

Investing in real estate without taking a taxable distribution from a 401(k) is possible through specific retirement account structures. Self-directed Individual Retirement Accounts (IRAs) and Solo 401(k)s allow investment in a broader range of assets, including real estate. This approach enables the real estate investment to remain within a tax-advantaged retirement wrapper.

To utilize these options, funds from a traditional 401(k) are rolled over into a self-directed IRA or Solo 401(k). This transfer avoids immediate tax consequences or penalties, provided the rollover is completed correctly. Once funds are in a self-directed account, the property is owned by the retirement trust, not directly by the individual. All income generated by the property must flow back into the retirement account, and all property expenses must be paid from the account.

Self-directed accounts come with strict rules regarding “prohibited transactions” and “disqualified persons.” A disqualified person includes the account owner, their spouse, ancestors, descendants, and entities they control. Prohibited transactions involve any direct or indirect personal benefit to a disqualified person from the retirement account’s assets. This means you cannot live in, vacation at, or personally use property owned by your self-directed IRA or Solo 401(k).

Performing personal labor or “sweat equity” on a property held within these accounts is a prohibited transaction. For instance, if a rental property owned by your self-directed IRA needs repairs, you cannot perform the work yourself; a third-party contractor must be hired and paid from the IRA funds. Selling property you already own to your self-directed account or purchasing property from a disqualified person is also forbidden.

Another consideration for real estate investments within self-directed accounts is Unrelated Business Taxable Income (UBTI) or Unrelated Debt-Financed Income (UDFI). If a self-directed IRA uses a non-recourse loan to finance a real estate purchase, the portion of income and gains attributable to the financed debt can be subject to UBTI. This tax applies even though the investment is held within a retirement account.

Solo 401(k)s, designed for self-employed individuals with no full-time employees other than a spouse, offer a unique advantage regarding UDFI. Unlike self-directed IRAs, Solo 401(k)s are exempt from UDFI on debt-financed real estate, making them a more attractive option for leveraged real estate investments. This exemption can provide a tax benefit for those who qualify for a Solo 401(k) and plan to use financing.

Tax Implications of Rental Property Ownership

Owning rental property involves specific ongoing tax considerations beyond the initial acquisition. Rental income is treated as ordinary income by the Internal Revenue Service (IRS) and is taxed at your regular income tax rate. This income must be reported on IRS Schedule E, Supplemental Income and Loss, along with associated expenses.

A benefit for rental property owners is the ability to deduct various allowable expenses. These deductions can reduce taxable rental income. Deductible expenses include:
Mortgage interest
Property taxes
Insurance premiums
Repairs and maintenance
Utilities
Property management fees
Legal or accounting fees

Depreciation is a deduction unique to real estate ownership, allowing property owners to recover the cost of a rental property over time. The IRS considers that buildings, but not land, gradually lose value due to wear and tear or obsolescence. For residential rental properties, the cost of the building is depreciated over 27.5 years using a straight-line method. This means a portion of the building’s value can be deducted each year, even if the property is appreciating in market value.

The depreciation deduction effectively lowers your taxable income from the rental property. For example, if a building portion of a property is valued at $275,000, you could deduct $10,000 annually ($275,000 / 27.5 years) as depreciation. This deduction continues until the property is fully depreciated or sold. Form 4562, Depreciation and Amortization, reports depreciation.

Rental activities are classified as passive activities by the IRS. This classification means that losses generated from rental properties, known as passive losses, can only be used to offset passive income. If your passive losses exceed your passive income in a given year, the excess losses are suspended and carried forward to offset passive income in future years.

There are exceptions to the passive activity loss limitations. For instance, if you “actively participate” in your rental real estate activity, you may deduct up to $25,000 of passive losses against non-passive income, such as wages. This allowance begins to phase out for taxpayers with a modified adjusted gross income (MAGI) between $100,000 and $150,000, and is fully phased out above $150,000. Real estate professionals, who meet specific time and material participation tests, may deduct rental losses without these limitations.

When a rental property is sold, capital gains tax rules apply. The gain is calculated as the difference between the sale price and the adjusted cost basis of the property. If the property was held for more than one year, the gain is considered a long-term capital gain, taxed at preferential rates of 0%, 15%, or 20%, depending on your income. However, a portion of the gain, specifically the amount of depreciation previously deducted, is subject to “depreciation recapture.” This recaptured depreciation is taxed at ordinary income rates, capped at 25%.