Q: When does a 401k file a tax return?

Here is the actual question in full: This year, I used my Solo 401K and invested in a syndication as a LP. The anticipated loss on year one for LP is 10K. In my Solo 401K, I also anticipate to receive rental income from a buy and hold property - $12K with a non recourse loan as of 12/31 ( currently third party managed) . Since the income is more than $1K, do I anticipate to file my return for my 401K ? If so, will the reported income is netted between my loss from syndication and my rental income? My current CPA is not too sure when I asked him this questions.

(I got this question off of Facebook)

A: Let’s unpack this.  #1 – I recommend getting a new CPA, asap.  Not knowing how 401k plans work is pretty much a cardinal sin.

First – does a 401k have to file a tax return? You might be tempted to say no, since you are thinking 401ks don’t pay tax. But it’s more complicated than that.

Form 5500 – Your 401k is going to have to file a form 5500 once its net assets are greater than $250,000.  It’s not the most intuitive form, so find a professional to file it for you. I can't tell from the question what the size of the 401k is, but this is the first question I would ask.

That said – real estate can be one of the WORST investments to make in a self-directed retirement plan.  There are two reasons (1) unrelated business income tax and (2) rules against self-dealing.

Form 990-T – this form must be filed with the IRS if you have Unrelated Business Income Tax (UBIT).  Leveraged real estate can cause UBTI.  Again, this isn’t DIY level stuff, get a professional involved.  And I am not going into detail here.

The second issue is self-dealing.  Doing any amount of work on the property may be considered self-dealing.  You really can’t even fix a clogged toilet.  I would be careful to not even pick out the new drapes.  You risk having the whole thing treated as a distribution, which would result in tax, penalties, and likely interest.

Direct real estate investments can have great tax benefits so why own them in a non-taxable account?  Things like depreciation and tax-free distributions of debt, can greatly enhance your tax situation – why would you trade them in for problems like UBTI and Self-Dealing?

Owning REIT stock, on the other hand, is just the kind of investment you want to hold in a tax-deferred account.