Create Cashflow Using A Loan From Your 401(k) – If you have a 401(k) plan you may be able to create cashflow by borrowing against your 401(k) to create a pool of cash to invest for investing in real estate. (Check with your plan administrator and tax advisor to make sure this would work for you!) If you use the proceeds of your 401(k) loan for investing in real estate you may be able to pay interest to your 401(k) that is tax-deferred income to your 401(k) (A GOOD THING) and take a present day interest expense tax deduction on your personal tax return (A GOOD THING). Let’s say you borrowed $50,000 from your 401(k) for investing in real estate and then paid 4% interest per year to your 401(k), your 401(k) would be earning a 4% return ($2000), tax deferred, while you would have a $2000 deduction on your personal return. Let’s say you then invested the $50,000 from your 401(k) into a note and trust deed to create cashflow at 10% interest rate ($5000 profit per year). You would have $5000 of interest income less $2000 of interest expense (to your 401(k) which means $2000 of your note income would be tax deferred as earnings to your 401(k) and $3000 would be taxable to you personally in the current year. While it might be better tax planning to own the note directly in your 401(k) it might be logistically impossible to do so. For example if your 401(k) is invested in your current employer’s plan and you are unable to roll it over into a self-directed plan, most employer sponsored IRA plans will not let you self-direct your IRA into notes and real estate, but they may let you take out a loan against your own 401(k) and pay yourself interest. You would also create cashflow inside your 401(k) but depending on your personal financial situation you might prefer to have that cashflow outside of your 401(k).
Here’s a potentially better tax plan to create cashflow by investing in real estate with your 401(k) funds. Let’s say you borrowed $50,000 from your 401(k) and purchased a $250,000 rental house with 80% financing and 20% down.
Let’s say the rental house was a 6 CAP rate
($250,000 purchase price x 6 CAP rate = $15,000 Net Operating Income)
and you borrowed 80% of the money from the bank at 5%
($200,000 bank loan x 5% bank interest rate = $10,000 interest expense to bank)
and you pay back your 401(k) loan at 4% interest
($50,000 401(k) loan x 4% interest = $2,000 interest expense to 401(k))
Your gross real estate profit from rental activities would be $3,000
$15,000 NOI – $10,000 interest to bank – $2,000 interest to 401(k) = $3,000 profit
However, this $3,000 profit is before we add in the tax loss from depreciation. Assuming a $250,000 rental property is $30,000 land and $220,000 structure and we depreciate the structure over 27.5 years we get an $8,000 tax loss from depreciation.
$3,000 profit less $8,000 in depreciation results in a $5,000 tax loss
***Check with your tax advisor about all income tax related issues. Nothing on this website should be considered tax advice.***
So let’s recap this strategy to create cashflow…
EXAMPLE 1: By borrowing $50,000 from your 401(k) and purchasing a note you create cashflow and profit inside and outside of your 401(k). You would be creating tax deferral on the funds going into the 401(k) but you would have a taxable event in the current year on the profit that is in excess of the interest charged by your 401(k). Talk with your 401(k) plan administrator and tax advisor to see if you have control over the interest rate charged to yourself by your 401(k) and also confirm with your plan administrator that the interest you pay to your 401(k) accrues to your benefit rather than to the benefit of the plan administrator.
EXAMPLE 2: By borrowing $50,000 from your 401(k) and purchasing a $250,000 rental property you create cashflow outside of your 401(k) and tax deferred interest income inside of your 401(k) as well as a “phantom loss” on your personal tax return in the current year. This “phantom loss” may or may not be able to offset other income you’ve earned depending on your personal tax situation. Although the property is showing a paper loss (aka phantom loss) the property itself is profitable because you borrowed all of the money at an interest rate lower than the earning rate of the property. Investing in real estate at a CAP rate higher than the cost of borrowing is called positive arbitrage and this is a key way to create cashflow using the Hassle-Free Cashflow Investing philosophy. CAVEAT: even though the property in this example is profitable and creating a phantom loss (which are both good things) it could result in negative cashflow because the amortization on the bank loan in addition to the shorter term amortization on the loan to your 401(k). Remember, not all profitable investments create cashflow that is positive and not all negative cashflow investments are unprofitable.
If you would like help formulating your personal investment strategy or if you would like to learn about current Hassle-Free Cashflow investment opportunities please give me a call at 866-931-9149 ext 1 or schedule our phone call using this link to my calendar.
https://my.timedriver.com/WBYTQ
To your success!
David Campbell
Real Estate Investing Strategist
Office: (866) 931-9149 Ext. 1
Cell: (707) 373-9966
