Want to Double Your Real Estate Investment Return? Easy! Use a Tax-Efficient 401K Strategy

You’re probably already aware you can use a self-directed IRA to invest in real estate. I’ve written quite a bit on this subject in the past, so if you haven’t read it, feel free to catch up! Those of you who’ve read these posts, however, know that in general I’m not a fan of the self-directed IRA except in the case of ROTH funds, or if you plan to buy and hold onto ONE investment property for an extended time. If you’re not in one of these two scenarios, I don’t believe current IRS trends (and interests in these transactions) make such investment methods worth the risk.

What do I prefer? I’ve always been a fan of the Qualified Retirement Plan (Profit Sharing Plan or solo 401k), since it offers many of the same benefits as a self-directed IRA, and more. Don’t worry, I’m not going to wax on about avoiding self-directed IRAs in this space; you can read more about that in previous posts, if you’re inclined to. Rather, what we’ll address here is a strategy in which you can partner with your QRP to purchase real estate.

An Example:

Enter John Q. Taxpayer, an investor who wants to buy a home for $200,000. John is well situated: he has a QRP with $150K, plus $100,000 in personal funds. Thus, John can buy the house in his own name, with financing, or he could partner with his Qualified Retirement Plan to do the transaction.

How does he do this?

First, in order to partner with the QRP for this buy, John needs to form an LLC. Then, he divides ownership of the property in proportion to what each “member” contributes. I.E., if John puts in $70,000 and his QRP contributes $130,000, he apportions 65 percent of the ownership to his QRP and 35 percent to himself as an individual.

llc

If you are conversant with LLCs and distribution, you know investment profits are also split, based once again on percentage of ownership.  So let’s say John’s investment generates $20,000; he’ll receive $7,000, while $13,000 goes to the QRP. This means that John will have taxable income of $7K; the QRP will have no taxable income from that $13K.

So Far, So Good.

Next, we consider the treatment of LOSSES, as in depreciation. Real estate is depreciated over a term of either 27.5 or 39 years, depending on how it is characterized. Further, Mr. Taxpayer can use this depreciation to offset real estate income gains. So, in actual effect, it can be a “paper loss” that works to your advantage.

So What Difference Does Depreciation Make? As It Turns Out…a Lot.

Looking once more at John’s $200K house, $175K is allocated to depreciable structures and $25K to land. With those proportions, the property generates about $6,400 per year in depreciation.  John’s share is 35 percent of that, or $2,240 of the deprecation, which reduces his income from $7,000 to $4,760. His QRP gets the remaining $4,160 in depreciation — but there’s no tax benefit to John from this, since the QRP’s portion is non-taxable.

Can John Instead Allocate Depreciation Losses for Greater Tax Benefits?

The answer is YES: he can use an Anderson Tax Efficient LLC.  An Anderson Tax Efficient LLC specifically allocates all the losses to John, enabling him to reap a full tax benefit. Here’s how such an investment vehicle works:

Without QRP

$20,000 net rental income

<$6,400> depreciation

$13,600 taxable to John

<$4,080> taxes

$9,520 net income to John

With QRP, but WITHOUT an Anderson Tax Efficient LLC

$20,000 net rental income

$7,000 allocated to John

<$2,240> depreciation

$4,760 taxable to John

<$1,428> taxes

$16,332 net income to John and his QRP

With QRP, but WITH an Anderson Tax Efficient LLC

$20,000 net rental income

$7,000 allocated to John

<$6,400> depreciation

$600 taxable to John

<$180> taxes

$19,820 net income to John and his QRP — effectively DOUBLING the original figure without any use of QRP.

Potential Profit…with Prudent Caution

In just this short example, you can see that using a QRP can produce tax benefits and income advantages in your total investment portfolio. However, this kind of collaboration isn’t something you should necessarily set up on your own. It’s best to set these plans up with the assistance of  an advisor who is qualified and experienced in the various ins and outs of taxes as they pertain to LLCs and QRPs. Call my office anytime, and we’ll be glad to explore the various options you may have available to you!

 

 

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