I am the 100% owner of my company, and we have a 401(k) plan that allows all our employees to direct the investment of their own accounts from a menu of mutual fund options via our recordkeeper’s website. The plan has been in place for a while. Not only have total plan assets grown quite a bit, but I have personally accumulated a significant plan account for myself. I am considering using a portion of my plan account to invest in real estate. Most likely, I will purchase a rental condo.
Am I allowed to invest my plan account in real estate? Are there any special considerations or impacts on the plan? Does the answer change if the person who will rent the condo is my son who is starting college?
We receive variations on this question several times each year, and it can be a pretty challenging one to answer. The reason is that regardless of what anyone thinks about how good of an investment real estate might be, there are a number of additional requirements that apply when the real estate will be held inside a retirement plan. Complying with those extra requirements can get expensive, which can eat away at the returns and make things somewhat less attractive.
Here is a quick rundown:
- Nondiscrimination: Plan investment options must be made available on a nondiscriminatory basis. That means if you invest in real estate, that same option must be extended to the rest of the plan participants. Given the complexity of real estate investing in general, this raises fiduciary concerns about whether it is prudent to give participants with no prior real estate experience (other than maybe buying their residence) the option to invest their accounts this way.
- Valuation: Plans are required to report assets on the 5500 each year at current fair market value. That’s pretty easy to do when just dealing with publicly-traded mutual funds. With real estate not being publicly-traded, the only way to obtain a current, fair-market value is to engage a professional to appraise it. It is not sufficient to ask a buddy who is a real estate agent what he or she thinks the property might be worth or whether anyone thinks values changed much since last year.
- Prohibited Transaction: There is a set of rules that prohibits a plan from entering into transactions with related parties such as participants, fiduciaries of the plan, and/or certain family members. The intent of those rules is to prevent anyone using plan assets for personal gain or to benefit someone other than a participant. In this context, it means that every element of the transaction must be independent and at arm’s length. That includes the initial purchase, the annual appraisals, and the ongoing usage. If you were to either stay in the condo or rent it to your son, it would violate these rules and be a prohibited transaction, subject to potentially significant penalties.
- Maintenance: If the plan holds the real estate, the plan must also pay for its upkeep. That includes not only repairs and maintenance but also things like property taxes or condo HOA fees. That means your account would have to maintain sufficient liquid assets to cover all of those ongoing costs.
- Custodian: If you’ve addressed all the above and are still interested in using your plan account to buy real estate, you will need to find a custodian that can hold it in the name of the trust. There are not many of them, and the ones that do exist tend to charge a premium for the service.
Given all these requirements and the associated costs of compliance, it might make more sense to make the real estate investment outside of the plan where there is much more flexibility.