I have a question about co-mingling funds for real estate investments. I need your professional advice. We have set up a self-directed 401k and want to co-invest in real estate.
I formed an LLC to do real estate investments of buying and rehab houses. The total investments to the LLC will be $500,000. I do the investments as the following procedure:
– incorporate a new LLC and have an new EIN for this investment
– open a new bank account for the LLC
– withdraw $100,000 from my Regular self direct 401K and directly deposit the money into the bank account: COMPLIANCE NOTE: To be in compliance, you will not technically “withdraw” funds but rather invest the self-directed 401k funds in units of the newly formed LLC (it is imperative that the LLC is newly formed and that units have not been previously issued in order to not run afoul with the solo 401k prohibited transaction rules).
– withdraw $100,000 from my Roth self direct 401K and directly deposit the money into the bank account. COMPLIANCE NOTE: Again, this is not a “Withdraw” but rather an investment by the Solo 401k Roth portion in the LLC member units.
– deposit $300,000 from my personal money into the bank account. COMPLIANCE NOTE: As mentioned above, the LLC must be newly formed and units must have never been previously issued. Simply, put the LLC must not only be newly formed, but also all investors (your personal funds, both Solo 401k fund types (Roth and Pre-tax) must purchase the LLC units simultaneously.
– after all these deposits, money will be distributed to purchase different houses and rehab
– put the rehab houses for sale and realize cash proceeds. COMPLIANE NOTE: Please take the word distribution out of the equation as it does not mix well when used in conjunction with a 401k investment. In other words, the transaction that you are explaining is not a distribution but rather an investment. Basically, the Self-directed 401k and you will be investing funds in the newly created LLC which will then invest in real estate.
– cash proceeds from sales of houses will be deposited directly back to the same bank account. COMPLIANCE NOTE: The investment gains from real estate will flow back to the LLC, right?
– purchase, rehab and sales cycle will repeat by this method
– clear accounting record will be kept for all these funds in and out of the bank account
– at the time when we decide to stop investing in this housing market, account will be closed and all investment principals + their share of profit will be sent back to the Regular 401K, Roth 401K and personal accounts respectively
– the profit sharing will be based on the invested capital ratio of 1:1:3 ($100,000:$100,000:$300,000)
– I won’t use any money from the account for any personal reason. COMPLIANCE NOTE: I’m glad to hear that you understand the importance of not using the self-directed 401k funds invested in the LLC for your personal use as it would be deemed a prohibited transaction.
As you can see, this involves cash from 3 different sources. Is this legal for me to use the self-directed 401K to invest in such manner? Will the co-mingle of these funds cause the disqualification of our self direct 401K by IRS? I am an accountant and sure to keep a good tracking of all funds so that I won’t use any money for my own benefit.
ANSWER: Based on the information that you have provided above, you are describing a transaction that has become very popular since the famous Swanson Court Case [ 106 Tax Court 76, (1196)] in which the Tax Court held in favor of a tax payer (Mr. Swanson). Basically, the court ruled that the initial and full capitalization of an entity such by retirement funds was not a prohibited transaction.
As a result of Swanson, a large number of professionals agree that any percentage ownership through an initial capitalization by a retirement plan or the retirement plan and the retirement plan owner of shares in a corporation or LLC units is not prohibited if done simultaneously. As a result, thousands of newly formed companies have been capitalized either entirely by retirement funds and any combination of disqualified persons and others.
Your professional advice will be greatly appreciated. Please let me know at your earliest convenience.
Scott C. in MA
