Investment in rental property

[jkharvey]

Plan has purchased rental property in Hilton Head, SC. The property is in the segregated account of the HCE. The property is rented out at FMV. The HCE wants to use the property 2 weeks out of the year and pay fair rental value. It seems to me that this would still constitute a prohibited transaction? Any comments or thoughts? Also, how does the HCE get the rental property out of the plan later when he has retired and wants it entirely for his own personal/rental use? Regular distribution? Seems dangerous to me.

[KJohnson]

To the extent that the property was purchased with an "eye" toward the retirement home of a fiduciary, you may already have a PT. The participant using it, even at fair market value (assuming no QPAM) would be a PT. As far as getting it "out" of the Plan, you could seek a PTE and have the owner buy it from the Plan. You may want to look at the following for a similar situation:

Robert H. Herzog Profit Sharing Plan, Located in Santa Barbara, California; Prohibited Transaction Exemption 98-05; Application No. D-10494; Proposed 62 FR 62641 (Nov. 24, 1997); Authorized 63 FR 3773 (Jan. 26, 1998).

[IRC401]

You can get the property out of the plan by distributing it. You will need a valuation for the 1099-R, and if the recipient can't find an IRA custodian that will hold the property, he will need to find cash to pay the taxes.

If the property has a mortgage, you have UDFI issues (IRC 514). All property taxes and maintenance must be paid from the plan, not out of corporate or individual assets.

[KJohnson]

Just a note, if the individual uses the home while it is in the IRA you would have a PT for the IRA and all of the amounts in the IRA would then become taxable.

[Guest]

I agree with KJohnson, personal use of a plan asset by a fiduciary constitutes a prohibited transaction. Individual would need a PTE to use.

I do not agree that investment with the eye to personal use in the future is per se a PT. Circumstances could change and the property might be liquidated.

I had a similar investment years ago in a plan and the IRS agent on plan termination audited the use of the Real estate looking for personal use. There was none and the plan earned an outstanding return on the rental unit.

[KJohnson]

I guess its a fine line.

I think that if vacation properrty is bought because it is a great income producing investment and then, down the line, the owner wants to buy it you may be o.k. provided you get the PTE for the sale.

If, on the other hand, there is no analysis on the "numbers working" for the property and the invsttment is a means of "holding" a piece of property until an owner can retire, I don't see how you get around a 406(B)(1) violation at the time the property is bought.

For what it is worth, here is something that was posted in the Q&A's on BenefitsBoard:

Question 152: Can pension plan funds be used to buy property for rental purposes that will ultimately be my retirement home? Can pension plan funds be used by a first time buyer of a personal residence?

Answer: If a pension plan buys real estate which later is used by the participant (as a residence or otherwise), such a use constitutes a prohibited transaction under ERISA section 406 and IRC section 4975, making it both illegal and highly penalized.

If the pension plan buys the property with the intention that it will be used by the participant in the future, the purchase itself is likely a prohibited transaction (use of plan assets "for the benefit of a party in interest").

The only way to use the funds for this purpose is either (i) to first obtain an exemption from the U.S. Department of Labor, or (ii) to take a distribution (assuming the plan allows a distribution at this point), pay income tax on the distribution and use the net proceeds to purchase the real estate. If you are under age 59-1/2, there also will be a 10% penalty tax on the distribution. But up to $10,000 of a distribution from an individual retirement account may be exempt from the 10% penalty (but not regular income tax) if used for the purchase of a first home (IRC section 72(t)(8)).

These topics are covered in Chapters 9(I) and 9(IV) of The Retirement Plan Distribution Book.

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