Yes, you can hold real estate in a qualified retirement plan. But in order to do so, very strict guidelines should be followed to avoid falling into one of two traps:
- Prohibited transaction
- Unrelated business taxable income
A prohibited transaction occurs under ERISA if the fiduciary of the plan causes the plan to engage in a transaction with a party-in-interest including:
- Sale, exchange or lease of any property
- Loan or extension of credit
- Furnishing of goods, services or facilities
- Transfer or use of plan assets
- Acquisition of employer real property of employer securities in excess of the legal contribution limits
Taking these items one at a time, let’s explore the definitions of some of the terms:
Fiduciary – A person who has the ability to exercise discretionary authority over the management or disposition of the plan’s assets. A person who has responsibility for the plan’s administration. The Plan Administrator (employer) and Plan Trustees are, by definition, Fiduciaries to the plan.
- a fiduciary, counsel, or employee of the plan
- a person who provides services to the plan
- an employer whose employees are covered by the plan and any person who directly or indirectly owns 50% of more of the employer
- a relative (spouse, parent/grandparent, child/grandchild, spouse of child/grandchild) of any of the persons listed in bullets 1-3 above
- An employee organization, any of whose members are covered by the plan
- A corporation, partnership, estate, or trust of which at least 50% is owned by any person or organization described in 1-5 above
- Officers, directors, 10% or more shareholders, and employees of any person or organization described in 2,3,5 or 6
- A 10% or more partner of, or joint venture with any person or organization described in 2,3,5, or 6
So back to Real Estate in the retirement plan. The plan can purchase property to be held as a plan asset as long as the property is not purchased from a party-in-interest. Property is treated as any other investment:
- Title must be registered to the plan
- All income and expenses are run through plan accounts
- An independent valuation on the property must be determined annually for ERISA reporting purposes.
- The property is not used or enjoyed by any party-in-interest
Example of an acceptable transaction: Ajay Corp defined contribution plan buys a piece of land from an unrelated third party. They pay for the land in cash with plan assets. They pay all property taxes and expenses from the plan’s trust account. They have a valuation of the land every year by a certified real-estate appraiser. They sell the land eight years later. The proceeds of the land is deposited to the plan’s trust account.
Examples of unacceptable transactions: Assume the same fact pattern as the Ajay example except:
- The plan buys the land from a person who is a shareholder in Ajay Corp.
- Ajay Corp. uses the land to build an office in which Ajay will be a tenant
- Ajay Corp. uses the land to build a second home for one of the shareholders of Ajay Corp.
UNRELATED BUSINESS TAXABLE INCOME
Besides prohibited transactions, an investor must also be careful about Unrelated Business Taxable Income (UBTI). If the real estate in the retirement plan is operated as an active business, the income generated may be considered UBTI, and taxable on Form 990T. Generally, the income would need to exceed $1,000 in order to be considered UBTI.
The primary example of UBTI risk includes the development of the property held by the plan. The plan is not in the business of property development, so doing so with plan assets would likely be subject to UBTI.
OTHER FIDUCIARY RISKS
Mortgages and loans on the property may also be a risk. Plan assets cannot be used as collateral for a loan, so real estate in a plan cannot have a mortgage against it.
Real estate is an illiquid asset. The plan should always maintain enough liquidity to pay distributions to plan participants. Upon plan termination, the real estate would have to be sold at a time that may not be ideal.
The plan document and the plan trustees must agree with the acquisition of real estate in the plan. This option will likely not be available for a participant in the plan acting on his own.
Real estate may be held in a plan under very guarded conditions. For most employers, they would never consider holding real estate in a defined benefit plan, but perhaps in a defined contribution plan it would be suitable. Take care that, as a plan fiduciary, you do not engage in a prohibited transaction, and avoid running a business with plan assets that would result in UBTI.
Alternatives to holding real estate directly would be to invest in a limited partnership or Real Estate Investment Trust (REIT) to have the benefits of real estate without the potential pitfalls.
At Benefit Resources, we have dozens of clients who hold real estate in their defined contributions plans. We have the experience, and can help our clients navigate the challenges that come with it.
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