David J. Kupstas, FSA, EA, MSEA Chief Actuary
Mutual funds. ETFs. Treasury notes. Stocks. Bonds. All of these are investments commonly found inside qualified retirement plans. How about real estate? Is that permitted? I am not talking about REITs or a real estate mutual fund. I mean, can a retirement plan own a single building or a piece of property? The answer is, “Yes, but...”
The first question is, why does someone want to do this? Is it because he thinks he can achieve a higher rate of return with real estate inside the plan vs. more traditional investments? If so, great. Go for it! Or is it because he’s got his eye on a beach house for his family but is short on funds and needs the plan to buy it? That would be a big no-no.
The prohibited transaction rules are often enough to cool a plan sponsor’s ardor toward real estate. These rules slap you with an excise tax if you engage in “self-dealing,” meaning transactions with a party in interest such as yourself, your spouse, certain family members, employees, fiduciaries, and others. Thus, the plan cannot buy real estate from you or sell it to you, permit you or your relatives to occupy or use the property while it is owned by the plan, or permit the property to be used on behalf of the company. Although the plan is perfectly free to leverage real estate acquisitions with a mortgage, it would be a prohibited self-dealing transaction if you, your spouse, or your company personally guaranteed that mortgage (which banks frequently require).
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Here are some other issues to watch out for:
Titling and payments: It is important that any real estate purchased should be in the name of the plan. Care should be taken that title is held in the name of the plan and not the individual. All contracts, including the offer and acceptance, should be in the name of the plan. If real estate is purchased in the name of the plan, the purchase price, and all closing costs, should be paid for from the plan. It is a common problem that a plan may not have a bank account. There is a tendency to write personal or corporate checks and have the plan reimburse the principal. This practice should be avoided. Annual real estate taxes should be paid from the plan. If the corporation pays for any plan expenses such as real estate taxes, these would be treated as contributions subject to contribution limits.
Fair market value: The fair market value of plan assets must be reported each year. For real estate, this is not easy to come by. The fair market value is usually not how much you bought the real estate for years ago or the county’s assessed value for property taxes. Generally, an independent third-party appraisal must be obtained. These appraisals represent an extra expense to the plan. You may be able to get by without getting an independent appraisal every year, but you will need it on certain occasions, notably when a plan value is needed for required minimum distribution (age 70½) calculations or when a taxable amount must be determined for an in-kind distribution.
Liquidity: Real estate is much more difficult to sell at market value (or any price) than a Dow Jones stock or a mid-cap mutual fund. What happens if the plan is loaded with real estate and needs cash to make a distribution? Some of the real estate will have to be sold. Remember, it is a prohibited transaction to sell the property to the business owner or any other party in interest. An unrelated third party buyer would need to be found. If the asset must be sold in a hurry, the plan might not get the best price it could otherwise.
Unrelated business taxable income: Qualified plans do not have to pay taxes on income and capital gains like you and I do. However, if a plan is engaged in an active real estate business, it must file a trust tax return and pay taxes on the income from that active business. Likewise, if a plan borrows money to acquire property, any resulting gain is considered “debt-financed income,” and under the Internal Revenue Code such gain is generally taxable to the plan, even though the plan would otherwise be nontaxable.
DB funding volatility: The goal of a defined benefit (DB) plan is to have certain amounts of plan assets at certain times. If a piece of real estate has the potential for extraordinarily high returns or large losses, a DB plan might not be the best place for it. The plan could become overfunded if the asset value gets too high. Conversely, additional unplanned contributions could be required of the employer if the value sinks dramatically.
These are some of the important issues involved when a qualified plan purchases real estate. There are numerous others not covered here. A plan sponsor wishing to purchase real estate inside a qualified plan would be wise to consult with competent ERISA legal counsel before embarking on such transactions.