You're about to discover what most people will never know about how to invest 401k in commercial real estate. This technique doesn't involve self directed IRAs or Solo 401Ks or any other creative retirement plans. AND you can own the property yourself (rather than your retirement account being the owner). Once you understand how this is done, you'll kick yourself that you didn't do this a long time ago!
3 Conventional Options for Investing 401k Retirement Savings in Commercial Real Estate
When people consider using their 401K retirement money to invest in real estate, most only consider these 3 options:
Option 1 - Self Directed IRA or Solo 401K
These are the most flexible retirement plans because you can purchase commercial real estate within them. However, that flexibility comes with a major drawback. Since your retirement plan would be the owner of the property, all of the financial benefits of that commercial investment would stay within the plan. Therefore, you couldn't use the cash flow personally, such as to buy groceries, pay for personal expenses, write your kids' tuition check, or take vacations. Also, you wouldn't get any personal tax benefits either. The property and the financial benefits that come with it would all stay with your self directed IRA or Solo 401K plan.
Option 2 - Cash Out
Rather than going the self directed IRA or Solo 401K route, some consider simply cashing out their current retirement account and then suffer the consequences of paying ordinary income taxes as well as early distribution penalties on the amount taken out. The total costs can be 40% or more and that's why financial advisors advise against this option. Normally, people only do this in an extreme emergency.
Option 3 - Do Nothing
This is most often what people do. They do nothing towards investing their retirement money in commercial real estate. Instead, they continue investing their retirement savings in very poor investments that they have no control over and that produce meager returns. Some kid themselves by investing in a commercial real estate index fund but those perform just as bad or worse than stock index funds. If you have chosen this option in the past, how has it been working for you?
The Best Option for Using 401k Retirement Money for Commercial Real Estate Investing
Which of the above options will allow you to use your retirement money to own the property yourself so that you can enjoy the financial benefits of cash flow, tax deductions and creating wealth? The only option is Option 2 – Cash Out, right? But wouldn't that be financially reckless and irresponsible? For people who don't understand the following technique, it would be foolish to Cash Out your 401K. However, savvy commercial real estate investors understand how to strategically cash out a retirement account so that they can invest in commercial real estate with the money and avoid most of the consequences. Therefore, the only option can become the best option too.
Ordinary Income Tax Offset with Cost Segregation
How do smart commercial real estate investors make the Cash Out Option 2 financially intelligent? They offset the retirement distribution income with deductions that come from the purchase of commercial real estate. How do they do that? They use as much leverage as they can to purchase the largest multi family apartment property that they can. Why multi family and not some other asset type? The property must come with as much as accelerated depreciation as possible and apartments typically have the most accelerated depreciation. After purchasing a commercial property, we recommend you order a cost segregation study as explained in this training Cost Segregation Made Simple. Multi Family typically gets the best results from a Cost Seg study because of the number of appliances and other items that qualify for accelerated depreciation. And it's the large amount of first year depreciation that ultimately offsets the retirement cash out income. For the remainder, we will refer to this as the Retirement Cash Out Offset strategy.
10% Early Withdrawal Penalty
But, wait! What about the 10% early withdrawal penalty? Doesn't that still apply even if the savvy commercial investor is able to offset his cash out income with deductions from the purchase of the apartment property? Yes! That penalty will still apply. But, wait! Isn't 10% more than the cost of financing from a commercial bank? No! Paying a one time, upfront 10% penalty is much less than paying 8% interest on a 25 year amortized loan. This 10% early withdrawal penalty is only paid one time, in the first year. Whereas, with a bank loan, you are paying interest for many years. Therefore, the 10% early withdrawal penalty is fraction of the cost of bank loan interest and a very nominal price to pay for being able to access that money.
Retirement Cash Out Offset Strategy Example
Here's what this strategy can look like. And this example is going to assume that the individual (or spouse) is classified as a real estate professional by the IRS and is in the 25% income tax bracket for that tax year.
Step 1: 8 Unit Multi Family Apartment
An 8 unit multi family apartment building can be purchased for $640,000 or $80,000 per unit. The seller is willing to do owner financing with 10% down, or $64,000. When closing costs are included, the total out of pocket cash required to close is about $70,000. In its current state, this 8 unit could cash flow about $800 a month. However, with the right improvements and rent increases over time, it could generate $1,600 per month in positive net cash flow. Therefore, with $70,000, there is a minimum 14% cash on cash return but with the right value adds, it could be double that.
Step 2: Cash Out $80,000 of Retirement Account(401k/IRA)
In order to close, $80,000 is cashed out of the 401K and that incurs a 10% early withdrawal penalty of $8,000 and potentially a 25% federal income tax of $20,000; which totals $28,000 in potential tax liabilities. Why $80,000 and not $70,000? Remember that the 10% early withdrawal penalty applies regardless of the depreciation offset.
Step 3: Cost Segregation Study
In order to offset those potential tax liabilities, a cost segregation study is completed and those 8 units generate $80,000 in accelerated depreciation in year 1. That depreciation completely offsets the $80,000 in income created from the 401K cash out and eliminates the $20,000 federal income tax! The 10% early withdrawal penalty still applies but that's why $80,000 was taken out and not $70,000.
The above was a simplified explanation and there are some finer details that your professional tax preparer will need to advise you on but understanding the concept is the first step in being able to apply it to your personal finances. And keep in mind that the cash flow relative to the cash invested is just one facet of the financial benefits of owning commercial real estate. There is also the pay down of the debt, forced appreciation can raise the value and some depreciation can be taken year after year!
More Tax Benefits with Commercial Real Estate
As a commercial real estate investor, there are additional deduction you can take, beyond your investment property alone, such as your home office or travel expenses back and forth to your property. To learn more about the tax benefits available to commercial real estate professionals, check out How to Reduce Taxes with Commercial Real Estate.
Should You Invest Your 401k Retirement Money in Commercial Real Estate?
If you do it right, owning commercial real estate is the best retirement investment vehicle on earth. If you'd like to become a successful commercial real estate investor as well as get step by step help with structuring commercial investments using your retirement money, apply to our Protégé Program.
