Double Your Return With a Tax Efficient 401k Strategy
By Clint Coons
Most real estate investors are aware they can use their self directed IRA to invest in real estate. I have quite a few posts on this topic. If you are familiar with any of these prior posts you probably know I am not a fan of the self directed IRA unless you are dealing with ROTH funds or you plan to buy and hold one property for an extended period of time. Outside of these two situations I believe the risks of investing through a self directed IRA do not justify the risks given the IRS current interest in these transactions. My preference is, and will remain, the Qualified Retirement Plan (Profit Sharing Plan or solo 401k) which offers the same, and many more, benefits over the self directed IRA. Rest assured this is not another post on why you should avoid self directed IRA, you can read these prior posts if you are in doubt, but a strategy wherein you can partner with your QRP to buy real estate.
Consider John who would like to purchase a house for $200,000. John has a QRP with 150k and personal funds of $100,000. John could purchase the house in his own name with financing or he could partner with his QRP to buy the house. To partner with his QRP John and his QRP would need to form a LLC and divide the ownership proportional to the contributions from each member, i.e., if John contributes $70,000 and his QRP contributes $130,000 then the ownership would be divided as follows: John 35% and his QRP 65%.
If you are familiar with LLCs and their creation, then you should know profits will be split based upon ownership percentages. If John’s LLC generates $20,000 then John will receive $7,000 and $13,000 will be distributed to his QRP. From a tax standpoint, John will have taxable income of $7,000 and the QRP will not have any taxable income from its $13,000 in earnings. Straightforward right. How about the losses? If you recall, real estate is depreciated over 27.5 or 39 years depending on its characterization. Depreciation is often referred to as a paper loss because it can be used to offset your real estate income. In my example, the 200k house (175k allocated to depreciable structures and $25,000 to land) will generate approximately $6,400 per year in depreciation. John’s will receive $2,240 of the deprecation thereby reducing his income from $7,000 to $4,760 and his QRP will capture the remaining $4,160 depreciation. This of course does not benefit John because his QRP does not pay tax on its portion of the income.
Wouldn’t it be more advantageous if John could allocate all of the losses to him where then can be utilized. Of course it would and you can if you use an Anderson Tax Efficient LLC. An Anderson Tax Efficient LLC will allow John to take full advantage of all the real estate depreciation by specially allocating all the losses to John. The following table shows the tax advantage of using such a structure:
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 W/O 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 and 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
9520 x (X)=19820
Partnering with your QRP can produce some desirable tax benefits and opportunities to increase you’re your overall investment portfolio. However, this is not something you should set up without the assistance of our firm or another qualified advisor experienced in the tax aspects of LLCs and QRPs. If you would like to explore the creation of this structure, please call my office to schedule a consultation.
