There can be many reasons to look for creative financing when purchasing real estate with your Solo 401k. One of the most basic times is when you are just getting started with real estate investing but an all-cash purchase is not possible. Another common example is the successful real estate investor that has most of their cash tied up in other investments but wants to acquire another property. Or it could be anyone in-between those examples who want to purchase another property with a minimum down payment.
Creative financing is a non-traditional or uncommon way of buying property. Typically, that simply means not applying for a traditional mortgage that requires institutionally predetermined down payments, terms, and conditions. The goal of creative financing is to finance a property with the investor using as little of his own money as possible. With a Solo 401k – real estate investing with little money down is possible and we’ll show you how in this article!
Real Estate Investors of all Types Use Creative Financing
Creative financing is not limited to full-time or professional investors. It’s available and used by anyone willing to make the effort to find these opportunities. Opportunities that can be relatively rare. But they are out there. The term “creative financing” is used to describe any type of financing arrangement that doesn’t involve a conventional mortgage loan. Most successful real estate investors use a combination of traditional funding sources as well as creative financing options to help them purchase properties. As a Solo 401k investor, you should be aware of these alternative financing methods.
There are many alternative financing methods. However, some do require substantial down payments such as private mortgages and hard money lenders. In this blog, we only focus on methods that offer financing without substantial down payments. The methods covered are:
- Seller Financing
- Subject to Existing Financing
- Turnkey Rentals
As a Solo 401k investor, you must always be aware of the limitations that protect your tax-advantaged status. It’s always wise to consult with a financial professional specializing in these matters. When it comes to creative financing, the most important Solo 401k boundaries that you must stay within involve non-recourse loans and disqualified persons.
Seller Financing with a Solo 401k
Seller financing is substantially different than using a bank loan to finance the purchase of a house. The biggest difference with seller financing is that the seller doesn’t give the buyer any money the way a bank loan works. Instead, seller financing allows the buyer to make installment payments directly to the seller.
The seller doesn’t receive the sales price in one lump sum. Rather, they receive monthly payments. These monthly payments could go on for 30 years as they do with a traditional home loan. However, it’s much more common with seller financing to have a balloon payment come due in 5 to 10 years.
Seller financing is a private contract between the seller and the buyer. Sellers may want a down payment but there is no requirement. It depends on what you negotiate with the seller. It could be a very small down payment or no down payment at all. You may have to give up something else in exchange for little or no money down. Possibilities include paying the high end of the property value range, a higher interest rate, or a very short-term balloon payment.
The short-term balloon payment might come in the form of a non-recourse loan in a few years. A non-recourse loan requires that you have equity in the property in the 30%-50% range. A few years of payments to the seller combined with future funding from your Solo 401k could meet the non-recourse equity requirement.
As always, the property title and seller-financed contract must be in the name of the Solo 401k. You (plan participant) cannot sign a personal guarantee for the loan. Also, the seller (financier) cannot be a disqualified person, e.g., yourself, your spouse, any businesses your own, your parents/grandparents, or children/grandchildren. The Solo 401k must pay for all closing cost obligations associated with the transaction. However, closing costs should be minimal because the seller does not have application fees, underwriters, or bank–conforming rules.
Subject to Existing Financing
A subject to existing financing deal is based on the fact that the deed to the property and the mortgage are two separate documents. The deed registers the owner of the property with the county and the lender holds the mortgage although it is secured by a note on the deed. With subject to existing financing, the seller transfers the property deed to the buyer but does not immediately pay off the outstanding loan. Instead, the buyer takes over the seller’s mortgage payments. Or they write a new contract requiring the buyer to make payments to the seller and the seller continues making the existing mortgage payments.
A subject to exiting financing deal lets you move in a tenant, and have control of the property for little more than the cost to draw up and file the closing papers. You rent for a profit, build equity, and let appreciation add to your future profit. A subject to deal can be highly profitable.
A “wrap-around mortgage” is another term for this but can include making additional payments to the seller. Essentially a second mortgage. This works when the selling price is higher than the outstanding mortgage. Separate payment is made to the seller to pay for the equity that they have acquired in the property. The buyer and seller sign a promissory note that lays out the terms of the mortgage and then the title and deed pass to the buyer. Though the seller continues to make payments on the original mortgage, they no longer own the home.
The buyer pays the seller a monthly mortgage payment (usually at a higher interest rate), while the seller continues to pay their mortgage payment to the original lender. The wrap-around mortgage takes the position of a second mortgage.
This can create risk for the buyer if the seller stops making the mortgage payments. If the existing mortgage goes into default, the original lender can foreclose on the buyer’s new property, meaning the buyer can lose the house, even if they’re current on their mortgage payments to the seller. Buyers can help prevent this by making their payments directly to the original lender. Something to be aware of is that anyone can pay anyone else’s mortgage. To take over the payments, all you need is the mortgage account number, monthly payment amount, and the lender’s mailing address. You begin making the payments and collecting rent from the property. All is good in the real estate investments world when you don’t put any money down.
You might be thinking – but what about the qualified assumptions clause in the existing mortgage? The bank requires the buyer to qualify to take over the existing loan as if it were a new loan”. There is almost always that clause in a mortgage. However, lenders don’t want to enforce it when the mortgage is kept current.
Turnkey rentals are a popular investment with Solo 401k accounts. You’re not likely to get into a turnkey for zero down but 5% down is possible. Remember, only non-recourse loans are allowed with a Solo 401k. You should expect to pay a higher than market interest rate.
A big benefit of a turnkey rental is that the investment property won’t require renovation or repairs before it’s ready for tenants. You can expect to start earning rental money immediately. These are also among the most passive real estate investments because they are professionally managed. Professional management has several upsides.
- Market knowledge about schools, crime, why one block is better than another, and much more.
- A process to find motivated sellers and proven renters.
- Management companies specializing in turnkey rentals use business facts. This takes the emotions and gut hunches out of your purchase decision.
- In-house staff takes care of minor problems like running toilets. Management companies have discount contracts for large repairs.
- They have experience dealing with renters and contractors.
Turnkey rentals have a high appeal to Solo 401k investors who want to be in the most profitable markets but don’t want the hassles of being an out-of-state landlord. Major markets for turnkey rentals include places like Seattle, San Francisco, and Florida.
In summary, it’s possible to acquire little or nothing down rental properties in your Solo 401k but it does become more complicated and can be riskier. If that seems a little more than you are ready to take on, it still doesn’t mean that you must wait until your Solo 401k has enough to make an all-cash purchase. A traditional non-recourse loan is still an option although it may take you longer to save the needed 30% to 50% down payment.
Click here to view our page on non-recourse lending resources who are familiar with writing mortgages for Solo 401k trust accounts