In general, there is no law that prohibits investing qualified retirement plan funds in real estate, provided it’s not property that will be used by a disqualified person or a party-in-interest. It may be tempting to use retirement funds for real estate investments since the money appears to be available and real estate often has the potential for appreciation over a long time period. However, in many cases, real estate is a poor choice for qualified plan investments.
One exception: investing a small portion of plan assets, say 5% or so, in a real estate mutual fund, ETF, or REIT may provide some diversification and not have the problems listed below. But direct investments by the plan in real estate are generally a bad idea for some (or all) of the following reasons.
Liquidity: Real estate is not a liquid investment. It can take weeks, months, or years to divest the plan of real estate property, and liquid funds may be needed to pay benefits or plan expenses.
Market Value Determination: Any plan asset that does not have a readily determinable market value requires an annual independent qualified party appraisal. This is a time-consuming and potentially costly procedure.
Fiduciary Bond: Retirement plans must have a fiduciary bond equal to 10% of the plan’s assets to cover plan losses from theft of assets or fraud. However, if the plan invests more than 10% of its assets in non-qualifying assets (those that do not have a readily determinable market value), then either the bond must be increased to cover at 10% of the qualifying assets, plus 100% of the non-qualifying assets; or the plan must engage an independent accountant to conduct an audit of plan assets, which can be costly and time-consuming.
Plan Documentation: Some plans have limits on the amount or percentage of plan assets that can be invested in real estate, or they prohibit real estate investment outright. It’s possible the plan could be amended, but it’s also possible such an amendment could take the plan out of pre-approved status.
Real Estate Management: Land and buildings require maintenance. If the plan owns the property, the Trustees will need to be sure it is managed properly. The plan will be responsible for payment of property management fees, real estate taxes, repairs and maintenance, utilities, and other expenses.
Leveraged Real Estate: This refers to real estate that is debt-financed, i.e., a mortgage is taken out on the value of property. This is a particularly bad idea in a qualified plan. Since the plan is not in the real estate management business, income earned from the property (such as rental income) would be deemed to be unrelated business taxable income, or UBTI. This would require the plan to file a Trust tax return and pay Federal income taxes on the earnings from real estate and if applicable, file a state level return and pay state taxes as well.
Nondiscrimination issues: Do all participants have equal rights to invest in real estate? If not, the plan has to perform complex nondiscrimination tests referred to as the “current availability” and “effective availability” tests; if they can’t be passed, the plan could potentially be disqualified.
Distributions: Some plans allow participants to elect in-kind distributions; i.e., taking part or all of their benefits in the form of securities or other non-cash assets. In-kind distributions must be nondiscriminatory, meaning that they can’t be available only to Highly Compensated Employees. And it’s often impractical or impossible to offer distributions of a small percentage of the real estate investment as a distribution option. The plan usually must sell the real estate assets before all assets can be distributed to participants.
Fiduciary Issues: Plan fiduciaries must act in the best interests of plan participants and avoid conflicts of interest. Investments must be prudent, and they must be sufficiently diversified to minimize the risk of large losses. Fiduciaries who do not follow these principles may be personally liable to restore any losses to the plan, or to restore any profits made through improper use of plan assets. They may be personally subject to fines or other penalties.
Did we convince you not to invest plan assets in directly real estate? If you still are interested in using plan funds for real estate investments, better options would include real estate mutual funds as mentioned earlier, or applying for a plan loan or taking a partial distribution (if your plan allows these) and then investing the proceeds in real estate outside of the plan. As always, we recommend that you consult with a knowledgeable advisor before proceeding.