“Real estate doesn't interest me. It's no doubt a great flaw in my personality, but I can't think in terms of boundaries. Those imaginary lines are as unreal to me as elves and pixies.” -- Kurt Vonnegut, Jr.
When it comes to real estate in 401(k) plans, unfortunately, not everyone shares Mr. Vonnegut’s disinterest. Rather, some subscribe to the Donald’s statement, “It’s tangible; it’s solid; it’s beautiful. It’s artistic, from my standpoint, and I just love real estate.”
Regardless of one’s beliefs about the prudence of real estate investment, when the location, location, location is inside a qualified plan, life gets very complicated very quickly. ERISA’s fiduciary rules and the requirements that plan assets be presented at fair market value do not always play well with real estate. The IRS also has a few rules that create unintended consequences as well. My experience has been that those who advocate using plan assets to purchase real estate are very much unaware of these complications.
We’ll take a look at some of DOL’s concerns in this post and then address some IRS issues in Part 2.
The financial schedules to the Form 5500 require assets to be reflected at fair market value as of the reporting date. For publicly traded instruments such as mutual funds, this is no big deal. Not so much with real estate. The plan must engage an independent appraiser to establish the fair market value, and the DOL is serious when it comes to the qualification and independence of the appraiser. That means a letter from the trustee’s real estate buddy won’t cut it. The reason might best be explained by a quote from Will Rogers, “In a real estate man's eye, the most expensive part of the city is where he has a house to sell.” According to this letter from the DOL, failure to properly obtain and report fair market value of plan-held real estate constitutes a fiduciary breach.
Real estate held through limited partnerships doesn’t make things any easier. As explained in another DOL letter (see bottom of page 3), “A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”
Plans with more than 100 participants on the first day of a plan year are required to be audited by an independent CPA. Smaller plans are exempt from the audit requirement unless more than 5% of total assets are so-called non-qualifying assets. You guessed it…real estate (including LPs) is a non-qualifying asset. The fact that it’s held in someone’s individually directed account doesn’t change things. A plan can avoid the audit by securing an increased fidelity bond covering 100% of the value of the non-qualifying assets and by providing additional disclosure in the Summary Annual Report for the year. However, in many cases, the real estate holdings are not “discovered” by someone who understands these requirements until it’s too late. I have been involved in examinations in which the DOL has required the employer to obtain CPA audits for historical years, so this is not one of those “no harm, no foul” issues. With audits easily running into five figures per year for a qualified CPA, the cost can be significant.
Real estate is not always the most liquid of assets, and there can challenges in acquiring and disposing of it. Sometimes, it seems to make sense for a participant to use his or her plan account to purchase property s/he owns outside the plan. The problem is that it lands in prohibited transaction territory. Generally speaking, transactions between the plan and parties related to the plan, including participants, are not permitted. This can be particularly problematic if, upon realization of the audit requirement, a sponsor wants to get the real estate out of the plan but doesn't want to sell it to an unrelated third party. In limited circumstances the DOL’s Voluntary Fiduciary Correction Program does permit a plan to sell the real estate to a related party but only if the proposed transaction if submitted to DOL for review and approval.
In the next installment, we will take a look some IRS requirements that might make Mr. Vonnegut's personality look less flawed.