Real Estate Investments
While it is entirely possible to own real estate in the confines of a qualified employee benefit plan, there are certain pitfalls which must be recognized and avoided.
As a preliminary matter, one must consider operational compliance with the plan and trust agreement. Failure to comply with the terms of the plan may lead to disqualification of the plan, the forfeiture of the company’s income tax deduction for contributions to the plan, and the taxation of the corpus to the participants on a current basis. While these possibilities are remote, the severe consequences which might ensue suggest careful consideration of this matter.
Another issue to consider is the possibility of a prohibited transaction. Section 4975 of the Internal Revenue Code imposes
(non-deductible) excise taxes on a prohibited transaction of up to 100% of the amount involved. The Department of Labor can impose sanctions as well, for violation of ERISA section 406 (29 USC 1106) (consisting of nearly identical definitions of prohibited transactions). Sanctions can include civil and criminal penalties, as well as a civil action for injunctive relief (e.g., removing the trustees from their positions).
Essentially, any dealing between the plan and a party in interest (ERISA; called a disqualified person in the Internal Revenue
Code) is a prohibited transaction, unless granted an exemption. See 29 USC 1108, ERISA section 408 for a list of exemptions; the Department of Labor grants additional exemptions (either "class exemptions," applicable to the world at large, or private exemptions, applicable only to the party seeking relief). With this in mind, it is important to avoid a transaction which may appear to fall under this rubric. Some common examples which come to mind include the plan:
a) purchasing real estate from a party in interest;
b) purchasing real estate from an unrelated third party, with commissions or other fees to inure to a party in interest;
c) paying a party in interest to manage the plan's investments;
d) purchasing real estate as a joint venture with a party in interest.
While a precise definition of party in interest may prove elusive, it may safely be assumed that the company and the owners (as well as their spouses and children and in-laws) qualify.
Note also that even if the acquisition, holding and operation of real estate does not constitute a prohibited transaction, nonetheless it may considered a breach of fiduciary duties under ERISA section 404, 29 USC 1104 if judged to be imprudent. A imprudent transaction can be costly to the trustees, who may be surcharged; civil injunctive relief is available to the Department of Labor against any "fiduciary" (a term of art) of the plan.
Some of the considerations that may go into the determination of the prudence of a particular investment are: overall business considerations; the liquidity of the investment and of the remaining plan assets; whether the participants whose monies are invested had investment choices or not; and so on. While investment results are not a factor in this mix (an investment which turns out badly is not necessarily a bad investment ...) invariably investments which turn out badly are subject to stricter scrutiny than those which turn out well.
A way to avoid (or lessen the impact of) the issue of prudence would be to establish directed accounts, if not already done, and to 'assign' the real estate to one or more of these accounts. This will insure that all of the gain will inure to that account(s) and not to any other; if the accountholder(s) are principals in the company, this minimizes the chances that contention will occur over the prudence of the investment. Further, this course of action will avoid having the real estate deemed a non-qualifying asset; see further discussion below. However, such directed accounts are not allowed in defined benefit plans.
There is a reciprocal risk in this course, however: under IRC section 401(a)(4) a pension / profit sharing plan may not discriminate in favor of highly compensated employees. (Generally, a highly compensated employee is a 5% or greater owner of the plan sponsor, or someone who made more than a specified amount in income from the plan sponsor in the prior year. See IRC section 414(q)). The regulations under this statute elaborate by providing that the plan may not discriminate in provision on any particular "benefit, right or feature." See Treas. Reg. 1.401(a)(4)-4. The right to invest in a directed account, the right to invest in real estate in one's directed account, and - possibly - the right to invest in this particular item (in order of decreasing likelihood) may be deemed to be a "benefit, right or feature," the failure to provide that right to a specified percentage of the non-highly compensated employees (there is a mathematical test) would be deemed to be discriminatory under the Internal Revenue Code, the consequences of which could be sanctions (up to and including plan disqualification, as mentioned above). Under these circumstances, it would be prudent to allow rank and file employees the right (at least) to have directed accounts. Note that the plan document must be amended to allow for this, or risk IRS sanction, as mentioned above.
Another issue in real estate is valuation. For assets, such as real estate, which do not have a readily established market value, the IRS insists upon an independent valuation annually by an independent appraiser, which will involve additional time and expense. While this is always an issue in the valuation of the plan, it is particularly important when participants are paid out their benefits, as an incorrect valuation can lead to an incorrect payout.
Further, one must consider additional expenses in fidelity bonding. Traditionally, the U.S. Department of Labor (“DOL”) has waived, for plans covering less than 100 participants, ERISA’s requirement to have the plan administrator engage an independent accountant to audit the plan’s assets; these audits are prohibitive in cost, running into four figures. In 2000, DOL required, for the first time, an audit of these plans meeting certain requirements. Specifically, if 5% or more of the plan assets are what DOL regulations call “non-qualifying,” then the plan administrator has two unpleasant options:
a) engage a CPA to prepare the audit report, or
b) purchase a special fidelity bond,
and make certain disclosures to plan participants. Although plan administrators are accustomed to paying nominal fees to secure a fidelity bond, these bonds are much more expensive. In addition, the required disclosures may be uncomfortable to all concerned. Thus, a plan is effectively discouraged from holding non-qualifying assets.
Qualifying plan assets are defined in DOL regulations (29 CFR 2520.104-46(b)(1)(ii) as, in general, assets held for the plan banks, brokers and the like, or assets held in a participant’s segregated account. So, unless the real estate were held in a segregated account for a particular participant (and, by definition, a defined benefit plan cannot have segregated accounts, as it is not an individual account plan, as defined by ERISA), they would not be deemed qualifying plan assets, and they might well trigger the (expensive) fidelity bond or the (more expensive) CPA audit.
In general, neither the plan sponsor nor any trustee may benefit from a plan investment. Some examples would be commingling plan assets with the plan sponsors assets in a joint venture, or charging the plan for services such as real estate commissions on the sale of plan property.
Further, the use of plan assets in business activities similar to those of the plan sponsor, or requiring substantial expertise, will create taxable income to the plan, thus defeating the tax deferred advantages of a qualified plan. An example of this type activity would be acquisition and development of real estate or ‘flipping’ real property. This results in ‘unrelated business taxable income’ or UBTI. The tax rates on UBTI mirror those of trusts, and rise to the maximum rate at about $15,000 of net income. The plan investment should be “passive” in nature. That is, plan beneficiaries may not contribute the success of the investment using their own labor which would otherwise generate taxable income. An example of this would be a plan beneficiary or related party making repairs to a rental property owned by the plan.
Also worthwhile of consideration is the client’s exit strategy. Most participants in small qualified pension and profit sharing plans eventually take a lump sum distribution, which is then rolled over into their personal IRA. While real estate can be held in an IRA, finding a willing custodian (by law, all IRA assets must be held by a custodian) may prove challenging. The participant may be forced to either take them in kind as taxable income (and ordinary income – see below), possibly generating a large tax bill, or have the plan administrator must sell them off.
A final issue to ponder in this regard is taxation. (Almost) any income from a pension or profit sharing plan is taxed as ordinary income, while gains from real estate held by a taxpayer usually qualify for more favorable capital gains treatment. This unfavorable differential must be balanced against the (additional net) deferral enjoyed by pension assets. Note that the realization requirement for income taxation implies that there will be substantial deferral in any event; only the net deferral of the plan should be reckoned.
In summary, while real estate can be a viable investment in a qualified plan, there are many considerations to be weighed and reckoned with. If you wish to go ahead with this investment, the first step would be to amend/restate your plan and trust agreement as mentioned above.