We know real estate can be a great investment. But can you invest in real estate in a defined benefit plan? We’ll take a close look.
Although it is possible to obtain exposure to real estate by purchasing shares in a real estate investment trust (REIT), investing through a limited partnership, or buying shares in an exchange traded fund or a mutual fund that invests in real estate, an often overlooked alternative to investing in real estate is by purchasing and/or managing real estate directly. This can be done in a number of different ways, including through a tax-deferred retirement plan like a defined benefit plan.
Table of contents
- Requirements to Invest In Real Estate Through a Defined Benefit Plan
- Challenges Associated with Real Estate Investments Through a Defined Benefit Plan
- How to invest in real estate in a defined benefit plan
- Can a pension plan invest in real estate?
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This can be a great tax-efficient way to gain exposure to an important and sometimes overlooked asset class. However, investing in real estate through a defined benefit plan can be very complicated given the large number of rules and restrictions that apply to owning real property through a defined benefit plan.
Requirements to Invest In Real Estate Through a Defined Benefit Plan
Real property is treated much like any other investment that a defined benefit plan invests in on behalf of plan participants, such as mutual funds, bonds or other types of investments. The following are some of the key requirements that must be met in order for a defined benefit plan to properly invest directly in real estate.
Title, or legal ownership of the property, must be registered directly to the plan
The plan’s sponsor’s name may appear on the deed – but it would be in his or her capacity as trustee or custodian of the retirement plan on behalf of the plan.
All rental income and related expenses of the property must take place through plan accounts. You must pay for any on-going costs related to the property, such as property taxes and the like, out of plan funds – not from personal income and then use plan assets to reimburse yourself.
An independent valuation on the property must be determined annually for ERISA reporting purposes.
This normally takes the form of an appraisal in order to be able to report the property’s fair market value. The IRS is free to challenge whether the property value reported by the plan, which can leave the plan owing excise taxes and penalties for reporting an inaccurate or outdated property value.
Since defined benefit plans require actuarial calculations annually, your TPA will need to know the fair market value of the property. The fair market value of the investment should be sufficient to pay benefits, and if it falls short, you will have to make additional contributions. Finding the annual valuation of the investment is critical for compliance, so it is best to hire a third-party appraiser for the job.
Make sure that the appraiser doesn’t have any existing relationship with the fiduciaries of the plan or the plan itself. Now that you understand the process of investing in real estate using a cash balance plan, you’re ready to boost your retirement savings with this strategy. However, you have to be compliant and prepared to handle the regulatory aspect of a cash balance defined benefit plan for smooth completion.
In most of the cases, ERISA doesn’t cover 1-person plans, so you will be fine with filing only Form 5500-EZ. However, if your plan holds non-qualifying assets, you are required to submit Form 5500. Since there is no ‘one-participant plan’ election in the form, your plan will qualify as a single-employer plan, thereby triggering bonding requirements.
The property is not used or enjoyed by any party-in-interest
A plan sponsor or beneficiary cannot live in the property or stay in it for vacations – the property is for investment only if it is owned by the plan.
Fidelity Bond Coverage
If your plan has plan participants other than you and your spouse, then you must maintain a fidelity bond for at least as much as the combined value of all “non-qualifying plan assets”, which includes real property.
If you don’t maintain your fidelity bond coverage, you can lose your “small plan” exemption and may need to have an annual audit of your plan, which can subject the plan to the costly requirement that plan assets be independently audited every year.
If these requirements are all met, then real property can be an excellent choice as a potential investment through a defined benefit or other type of retirement plan.
Under ERISA rules, if the cash balance plan run by a company is subject to ERISA, the company must have a fidelity bond covering at least 10% of the net qualified plan assets. The bond requirements might vary between $1,000 and $500,000. However, in case of plans with fewer than 100 employees, the DOL waives audit requirements if: The plan derives less than 5% of its net value from “non-qualifying assets.” The plan possesses a fidelity bond that covers 100% of the value of the non-qualifying assets of the plan.
Challenges Associated with Real Estate Investments Through a Defined Benefit Plan
Perhaps the biggest challenge associated with owning real estate directly through a defined benefit plan is avoiding the rules relating to prohibited transactions.
This rule was put in place to ensure that persons who may have an interest in a plan are not utilizing plan assets in order to engage in self-dealing or transactions that would benefit that individual but may harm others who have an interest in the plan.
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Paul Sundin, CPA has written on retirement plans for Inc. and Kiplinger. He focuses on cash balance plans and defined benefit plans. Schedule a FREE 30 minute call with him:
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These rules expressly prohibit any transactions between a retirement or defined contribution plan and the plan sponsor, the plan sponsor’s business and most of the plan sponsor’s members, business partners and financial advisors. Similarly, these people cannot make use of plan-owned property either.
How to invest in real estate in a defined benefit plan
- Make sure your plan allows real estate. Many plans will not allow real estate as a defined benefit plan investment. Check your plan document.
- Ensure assets are correctly titled. Remember that the plan owns the real estate and not you. Title issues can result in tax problems.
- Don’t forget the annual valuation. The plan actuary will need a valuation of plan assets at the end of the year. This can be more complicated with real estate.
- Be careful with prohibited transactions. There should be no personal usage of the property and no prohibited transactions.
- Don’t forget a fidelity bond. Because real estate is a non-qualified asset, talk to your TPA about a fidelity bond.
Can a pension plan invest in real estate?
Pension plans, like 401(k) plans and defined benefit plans, can purchase real estate. The IRS tax code does not specifically exclude real estate from these plans even though there are some careful considerations.
Investing in real estate can be a great way to achieve diversification and exposure to an asset class that is not always correlated to the returns available through other assets like the stock market or bonds. Direct ownership of real estate can be achieved in any number of ways, including through a retirement plan like a defined benefit plan.
The devil is in the details, however, so ensuring that your investment is properly structured and that you avoid the challenges associated with investing in real property directly through a retirement or defined benefit plan is of paramount importance. Otherwise, you can lose the tax preferences and other advantages that can come through owning real estate inside a defined benefit plan.