In Part 1 of this post, I discussed some of the DOL rules that can make real estate not all it’s cracked up to be as a 401(k) investment. Here in Part 2, we will take look at some IRS wrenches that get thrown into the works.
More often than not, real estate holdings in a qualified plan are limited to one or several of the highly compensated employees. There might be any number of seemingly valid reasons for this limitation.
Nonetheless, the option to invest in a particular type of asset is generally considered to be a benefit, right or feature subject to nondiscrimination testing. That means if HCEs invest in real estate, the plan must offer the opportunity to a sufficient percentage of NHCEs. It is not enough to simply say, "Well, I would have let them if they expressed an interest." Offering the opportunity means communicating it to them.
Unrelated Business Taxable Income
A qualified plan is normally exempt from income tax. However, if a plan derives income from carrying on a trade or business, that income is unrelated to the primary purpose of the plan. So-called Unrelated Business Taxable Income or UBTI may be subject to tax even though the plan is otherwise tax-exempt.
Certain forms of income, e.g. rental income, are generally exempt from the UBTI rules, but other forms are not. If the plan is in the business of buying and selling real estate, the proceeds of the sales may trigger taxation. If a limited partnership is involved, the plan may be required to look through to the activities of that partnership to determine the applicability of UBTI.
These rules can become extremely complex, so it is often necessary to seek the advice of an accountant or tax attorney specializing in this area.
Distributions on Plan Termination
This really crosses both agencies in that it raises qualification and fiduciary issues. While maybe not as big of a problem in fully participant-directed plans, real estate in a plan with pooled accounts can create significant challenges in a plan termination. Basically, the property must be liquidated to cash so that distributions can be paid; however, it is not always possible to find a buyer.
One solution that is frequently proposed is to liquidate all other assets to cover distributions to employees, leaving the owner(s) with the real estate. Although that may sound plausible, the problem is that every participant in the pooled account “owns” a piece of each investment. That means that no participant, including the owner, can claim the real estate as belonging only to him or herself no matter how noble their intentions may be.
Another option that is sometimes suggested is for the owner to use outside assets to purchase the real estate from the plan. Since transactions between the plan and an interested party are generally prohibited, this solution might not work either. In limited circumstances, plan fiduciaries can use the DOL’s Voluntary Fiduciary Correction Program to request permission for the owner to purchase illiquid real estate, but the fees associated with going through this process can easily reach five figures.
One of the only remaining options is to have the plan distribute the real estate to a liquidating trust, established so that the plan termination process can be completed. Each participant receives a proportionate share of the trust. Of course, someone must recordkeep the trust accounts until such time as the real estate can ultimately be liquidated and the cash proceeds paid.
The esteemed Mr. Trump may be wise to love real estate, and it may be an extremely profitable investment...outside of a qualified plan. However, when a plan is doing the investing, the cost of complying (and probably correcting) the issues raised by both DOL and IRS may make any excess investment returns as elusive as Mr. Vonnegut’s elves and pixies.