Given the volatility of the stock market over the last 12 to 18 months, many of our clients have asked about the possibility of investing retirement plan assets and IRAs in real property. While every sector of our economy has seemingly been impacted by the current downturn, nontraditional investments (such as real property) can often provide favorable long-term returns and can also help plan trustees satisfy the diversification requirements imposed by the Employee Retirement Income Security Act (ERISA). Notwithstanding these advantages, plan fiduciaries and IRA owners should consider the following rules before investing these assets in real estate:
Generally, both ERISA and the Internal Revenue Code (IRC) prohibit a plan fiduciary from engaging in transactions that constitute direct or indirect dealing between the plan and a “party in interest” (or a “disqualified party” under the IRC). “Transactions” are defined broadly, and include sales, leases, loans, and the furnishing of goods or services. The definition of a “party in interest” is also broad, and includes plan fiduciaries, entities (and their owners) who sponsor the plan, and family members of both groups. In general, these rules prevent a plan fiduciary from receiving any “collateral” benefit from the investment. Violations result in automatic penalties under the IRC, as well as the potential for both civil and criminal fines under ERISA. If a violation is not corrected, the applicable penalties automatically increase. In the case of an IRA, this may result in immediate taxation of the entire account.
The IRC defines unrelated business taxable income (UBTI) as gross income of a tax exempt organization (including retirement plans and IRAs) from any unrelated trade or business regularly carried on by the organization. While interest, dividends, and “straight rent” from real property are specifically excluded from the definition of UBTI, unrelated debt financed income (UDFI) is specifically included in UBTI calculations. “UDFI” includes gain on the sale of property based on the average indebtedness prior to the sale, and also includes the net income derived from property. While qualified plans may avoid UDFI as long as no prohibited transaction is involved, IRAs are not as lucky.
Plans that are subject to Title 1 of ERISA must file an annual report (Form 5500) with the Department of Labor. Within this form, the plan sponsor represents the value of plan assets, contributions, distributions, and expenses each year. While representing the value of plan assets which are invested in regularly valued, publicly traded investments (stocks, bonds, mutual funds) poses no problem, real property is neither regularly valued nor publicly traded. As a result, in order to establish and support the value attributed to real property, the plan sponsor may need to have the property appraised periodically.
An accurate valuation of real property is also important for allocation purposes. In a plan which incorporates a “pooled” investment approach (as opposed to participant directed investing), gain or loss on plan assets is allocated among all plan participants each year. As gain or loss is based directly on the value of plan assets, an accurate and supportable valuation that can withstand questions by plan participants is critical in maintaining the credibility of plan fiduciaries, as well as in establishing fair values for participant accounts.
Finally, plan sponsors should note that for bonding purposes, ERISA characterizes real property as a “non-qualified asset.” If the value of the plan’s “non-qualifying assets” measured as of the beginning of the plan year exceeds 5% of the value of all plan assets, the bonding requirements imposed by ERISA will increase.
Historically, finding an IRA custodian willing to hold (and possibly manage) real property inside of an IRA has been difficult. Most investment managers lacked the expertise required by these investments and were concerned about the potential of environmental liability. While these difficulties remain, several companies have begun offering custodial services directly targeted toward investments in real property. The custodial services offered by these companies include management functions such as paying taxes, collecting rents, and coordinating general repairs and maintenance. As these companies may attempt to push liability for prohibited transaction penalties and UBTI back to the account holder, care should be taken in reviewing the IRA agreement offered by the custodian.
As may be apparent from the comments above, the rules that govern the investment of retirement funds and IRAs in real property are complicated. That said, with careful planning and proper advice the rules should not prevent retirement plan trustees or individuals from considering real estate investments as part of their overall investment portfolio and strategy.