Real estate investors often come to us desiring to put money into a retirement plan. But the problem is that rental real estate does not generate “earned” income. It generates passive income. In order to qualify to put money into a retirement account, you need to have active or earned income just like you would have if you worked a day job or had a normal operating business.
One of the main goals of many real estate investors is that they want to put money into a retirement account where they can self-direct the investments and put more money into real estate. Essentially, they want to take a tax deduction today and have the ability to invest in real estate assets that will grow tax-deferred. So herein lies the dilemma.
But we first must realize that the problem with generating earned income is that it is subject to employment taxes at a rate of 15.3%. So real estate investors need to understand that they will be subject to some employment taxes in exchange for the tax deferral opportunities associated with a retirement plan.
There are a few structures that we could consider under this scenario. Let’s take a look at one such structure that has worked well for many real estate investors.
First of all let’s assume this investor has 50 rental properties and they are generating $10,000 a month in taxable income. Let’s also assume that the properties are held within an LLC that is taxed either as a disregarded entity or as a partnership with flow-through taxation.
The investor will then establish a separate management entity using a C-Corporation structure. This management entity would manage the 50 rentals and be paid a management fee for doing so. This management fee would be a deduction for the investor LLC, but taxable income to the C-Corporation. The C-Corporation would be able to deduct it’s expenses relating to its management activities, such as telephone, mileage reimbursement, supplies, etc.
Since the C-Corporation now has operating income it would pay you a reasonable wage for the work that is being performed. The company would then establish a retirement plan that meets the goals of your retirement strategy.
Specifically, the company could establish a solo 401k plan that allows for employee deferrals and a profit-sharing component that will allow an employer match. Depending on your age and compensation, this would allow a contribution of up to $60,000 into the plan for a given year. The company would be able to take a full tax deduction for this amount and it would grow tax-deferred.
The employee can then be the trustee of the plan and invest the money in other rental real estate, if desired. There are certainly pros and cons of this scenario. But if the ultimate goal is to get money into a tax-deferred retirement account this is a great option.
Real estate investors need to consider saving for their own retirement. Often they believe that their rental properties are their retirement. And this makes sense. However, it is advantageous to consider establishing a tax-deferred account to allow your real estate assets to grow tax-deferred or even tax free in the case of a Roth contribution. It is never too late to start planning for your retirement.
