Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How to Use a Self-Directed Solo 401k for Real Estate
Transcript
- Lucas: So you've got a Solo 401k, you're self-employed, and you want to put some of that retirement money into real estate — a rental duplex, maybe a private mortgage note, even raw land. Luna: Which feels like a natural move if you're in the FIRE space. Real estate is a huge part of how a lot of early retirees generate cash flow. Lucas: Right, but the moment you try to do it inside a retirement account, the IRS throws up a bunch of rules that can trip you up. Today I want to walk through how a self-directed Solo 401k actually works for real estate — the setup, the traps, and why it's arguably the best vehicle for this if you're self-employed. Luna: Define 'self-directed' here, because a lot of people hear that and think they can just buy a house in their regular 401k. That's not how it works. Lucas: No. A standard 401k from an employer — or even a standard Solo 401k at a big broker like Vanguard or Fidelity — only lets you invest in the stuff they offer: mutual funds, ETFs, maybe a brokerage window. Lucas: A self-directed Solo 401k uses a custodian that allows alternative assets. Typically you set up a limited liability company, or LLC, inside the plan. That LLC has a checking account, and you — as the plan's trustee — have checkbook control. You can write checks from that LLC to buy real estate directly. Luna: So the LLC is owned by the 401k trust. You're not buying the property personally, the retirement plan is. Lucas: Exactly. And that distinction matters for liability and tax treatment. The property is an asset of the plan. Any rental income flows back into the LLC, then into the 401k, and it grows tax-deferred. Luna: What about using leverage? Can you get a mortgage inside a Solo 401k? Lucas: You can, but it's complicated. If the plan borrows money to buy real estate, that portion of the income is subject to something called unrelated business income tax, or UBIT. Lucas: Specifically, the debt-financed portion of the rental income is taxed at trust rates, which can be high. So if you put 25 percent down on a 200-thousand-dollar property, about 75 percent of the net rental income might be subject to UBIT. That can eat into returns. Luna: Is there a workaround? Or is it just better to buy cash? Lucas: Cash is cleaner. But if you want leverage, you could look at partnering with another investor outside the plan, or using a non-recourse loan from a specialty lender. There are lenders who do 'Solo 401k loans' — they lend to the plan, not to you personally. But the UBIT still applies. Luna: So the ideal scenario is: you have enough in the Solo 401k to buy a property outright, or you use it to fund a larger down payment and keep the debt small enough that UBIT is minimal. Lucas: Right. Or you avoid real estate that produces income and instead invest in raw land or a property you intend to flip — though flipping inside a retirement account has its own issues with dealer status and UBIT on short-term gains. Luna: Let's talk about the big no-no: prohibited transactions. I think that's where people get into trouble. Lucas: Huge trap. The IRS says you cannot use the property personally. That means you can't live in it, can't vacation in it, can't let your parents live in it, can't let your kids live in it. If you do, the entire account can be deemed distributed — meaning you owe taxes and penalties on the whole balance. Luna: And that includes using it for your business, right? Like if you're self-employed and you buy a commercial property and run your business out of it. Lucas: Exactly. That's a prohibited transaction. The plan can only benefit you as a retirement saver, not as a current business owner. So you can't lease the property to your own company, or to any disqualified person — spouse, children, parents, even siblings in some cases. Luna: What about hiring a property manager? If you personally hire and fire a property manager, is that a problem? Lucas: The LLC inside the plan can hire a property manager. The key is that you, as the individual, are not doing the work. The LLC is the owner, and it can contract with a third-party manager. But if you personally mow the lawn or fix a toilet, that's considered self-dealing — prohibited. Luna: So you basically have to treat the property like a completely arm's-length investment. You can't add sweat equity. Lucas: Correct. And that's a dealbreaker for a lot of early retirees who want to be hands-on. If you want to swing a hammer, do it outside the retirement account. Lucas: But there are ways to play that are less hands-on. One popular approach is to use the Solo 401k to lend money — act as a private mortgage lender. You can issue a note secured by real estate to a third party, and the interest payments go back into the plan tax-deferred. Luna: That's interesting. So instead of buying a property, you're the bank. And the borrower makes payments to your Solo 401k. Lucas: Exactly. And you avoid UBIT because there's no debt — the loan is an asset of the plan. The interest is regular investment income. You just need a proper promissory note, a recorded deed of trust, and you have to make sure the borrower is not a disqualified person. Luna: Let's back up a step. How does someone actually set up a Solo 401k that allows this? Because most people don't know where to start. Lucas: First, you need to be self-employed with no full-time employees — other than a spouse, who can also be included. Then you find a custodian that offers self-directed Solo 401k plans. There are several: Rocket Dollar, Quest IRA, Broad Financial, Equity Trust. Lucas: You open the plan, then you create an LLC under the plan. The LLC gets its own EIN from the IRS, and you open a checking account in the LLC's name. The custodian holds the plan assets, but you have checkbook control over the LLC account. Luna: And the costs? I think there are setup fees and annual fees that are higher than a standard Solo 401k. Lucas: Yes. Setup can be three to five hundred dollars, and annual fees maybe one to two hundred. Plus the state LLC costs. But compared to what you'd pay in taxes on a rental property in a taxable account, it can be worth it. Luna: We've talked a lot about the mechanics, but I want to ask about the philosophy. You're sheltering rental income from current taxes, but when you withdraw in retirement, it's taxed as ordinary income. If you're doing a Roth Solo 401k, it's tax-free on withdrawal. Lucas: Great point. If you have a Roth Solo 401k, the real estate income grows tax-free. But you can only contribute to the Roth side with after-tax money, and the contribution limit is the same — for 2026, it's 23 thousand dollars plus catch-up if you're over fifty. And the employer profit-sharing contribution has to go to the pre-tax side unless you have a designated Roth account. Luna: So for someone who wants to maximize tax-free growth, the Roth side is ideal, but the contribution room is limited. Lucas: Right. And you can't convert the pre-tax side to Roth inside the plan — that's not allowed. So you have to think about which properties go where. Lucas: One more practical point: you need to file Form 5500-EZ once the plan hits 250 thousand dollars in assets. And if the real estate is owned by the LLC, you might need to file a separate tax return for the LLC if it generates more than a de minimis amount of UBIT. Luna: That's a lot of compliance. But for someone who's serious about real estate and already maxing out their retirement contributions, it's a way to compound tax-deferred or tax-free. Lucas: Exactly. And that's really the idea behind these kinds of episodes — not that this is for everyone, but if it fits your situation, it's a powerful tool. Luna: And speaking of tools that help people make better financial decisions, this show is one of those. We've always kept it ad-free because we think the information should stand on its own. Lucas: Yeah, we don't run ads on these episodes. No sponsors, no product pitches. If you find the content useful and want to support that approach, a simple way is to go to buy me a coffee dot com slash fexingo. No pressure, just a way for listeners who value it to keep it going. Luna: Right. And we appreciate everyone who listens, whether you contribute or not. Now, back to real estate — let's say you do set up a Solo 401k and buy a rental. What's the first thing you do as a trustee? Lucas: Document everything. Keep a paper trail showing that the property was bought with LLC funds, that all income goes into the LLC account, and that you personally never touch it. If the IRS audits, you need to show that it's a plan asset, not a personal asset. Lucas: Also, make sure the title is in the name of the LLC, not in your name. And the LLC's name should include something like 'FBO Solo 401k' — FBO meaning 'for benefit of.' Luna: Any other traps? Like, what about using a real estate agent who is a disqualified person? Lucas: That's a grey area. If the agent is your spouse or your child, that's a prohibited transaction. If it's an unrelated third party, it's fine. But if they're a business partner, it could be an issue. Best to stay conservative. Luna: So the rule of thumb: treat the plan like a completely separate entity that you manage as a fiduciary, not as an owner. Lucas: Exactly. And if you do that, a self-directed Solo 401k can be one of the best ways to get real estate into your retirement portfolio. It gives you control, diversification, and tax benefits that you just can't get with a standard IRA or 401k. Luna: It's a lot to set up, but for the right person, it's a game changer. Lucas: Absolutely. And like anything in the FIRE space, the key is to run the numbers for your specific situation. Talk to a CPA who understands self-directed plans. Because when it works, it works beautifully.