Should I invest in real estate using my IRA or Solo 401k?

Someone recently made a comment to one of my articles that it would be better to purchase real estate outside the Self-directed IRA or Solo 401k because of more favorable tax treatment.  Here is my answer to that comment:

You are comparing buying real estate inside of IRA with making the same investment outside of the IRA.  But you are not comparing apples to apples.  My point is that if someone making an investment using their IRA, in most cases they are doing so because they have an existing retirement account that have been bit up by the stock market and they are considering alternative investments such as real estate.  In this case the question of capital gain tax is non-existent, because there is no such thing as capital gain taxes in IRA.  Unless you suggest they take out early distribution, pay taxes and penalties and then invested those funds in real estate.  I think you would agree with me that this is not such a good idea. 

Many of my clients are getting 15+% cash on cash returns by investing in rental properties.  And that is not including capital appreciation down the road.  This is much better than most people can get in the stock market.

I would agree with you if someone had a sum of cash outside of an IRA and was considering investing it in real estate.  If this was the case I would not recommend them taking those funds, putting them in a qualified plan and then invest in real estate.   In this case we are comparing apples to apples.  And paying capital gain tax rather than ordinary income tax would be better for most people (everyone’s tax situation is different and this would not be true for all people).

When consulting my clients I always recommend that they should own investment property outside the IRA to take advantage of the lower tax rate on the sale of the property (capital gain tax vs. ordinary income tax rate) and other tax deduction.  And if you own enough rental properties outside the IRA, the tax benefits from owning those properties can significantly lower or possibly eliminate the ordinary income tax that would be due on the income from your IRA when you start taking distributions after 59½ .

But let me take this issue even a bit further.  Suppose you are working, making decent income, paying taxes on the income you earn and then using your funds to invest in real estate outside of IRA.  Let’s assume this was a great investment and your property significantly increased in value, which will be subject to capital gain tax if you decide to sell it.  On top of that all of the income derived from the property during the years you owned it was taxes.  As an alternative to this model, you can take the income that you already paid taxes on, put it in Roth Solo 401k, but real estate with it, and enjoy tax free income for the rest of your life!  And when that property sold there will be neither capital gain taxes nor ordinary income tax!  I really like this model much better.  There is no other investment vehicle I’m aware of that provides tax free income.  That is why Solo 401k qualified plans are so popular. 

In conclusion I want to mention that everyone’s financial and tax situation is different and there is no cookie-cutter approach to investing and tax planning that would be universal for everyone.  Be sure to work with competent team and that each member of your team is the expert in their field of expertise.