Unrelated business income tax

[Guest RCox]

I have a 1 man plan who wants to purchase as part of plan assets real estate that's subject to a mortgage. What are the issues involved (prohibited trans, unrelated business income tax, etc)-how do you handle it?

Thanks

[Kirk Maldonado]

Hire a competent ERISA attorney.

[mming]

Advise against it - a trust cannot be considered qualified if it allows a transaction that would impose a lien on the plan (unless its done by the IRS).

[Blinky the 3-eyed Fish]

Wouldn't the lien be on the property, not the plan?

[mbozek]

mming- what is the basis for your statement tht a plan cannot put a lien on assets? The UBIT rules impose income taxation at the rate for trusts on gains from plan assets which are pledged as collateral for a loan but does not affect the qualfied status of the plan.

[mwyatt]

I think I could infer that since this is a 1-man plan, the projected life expectancy of this plan is pretty short. I'd pose the question to your client "what do you do with this asset when you terminate the plan in the near future, given that you can't roll it over to an IRA or sell it to a Party in Interest?" If that doesn't get his attention, may want to think about comparing capital gains rates v. ordinary income to talk him out of this proposed investment.

He may also want to consider the fact (especially since you're talking mortgage here) that what makes real estate work for most of us, either residential or for investment, is the ability to deduct interest costs and if an investment, expenses. How do you deduct these costs in a tax-exempt vehicle? Answer is you can't; therefore he may want to reanalyze this investment before proceeding. He may very well find out that he'd be ahead of the game using after-tax money for this investment.

[E as in ERISA]

From whom is he planning on buying the real estate from? Is he buying it because it's a good retirement plan asset, or because he is helping someone out? Remember that the plan must satisfy the "exclusive benefit" rule that requires that the decision to buy the real estate must be exclusively for the purpose of providing retirement benefits. The fact that you are saying that the real estate is "subject to a mortgage" raises these questions. It sounds like the current owner has a mortgage. But that doesn't mean that the plan has to assume that mortgage (or that the mortgagor will legally allow it to assume that mortgage). If the plan has sufficient assets, it can pay the full purchase price in cash and extinguish the mortgage. If it doesn't want to do that, then is there a question of whether this investment is as good or better than the alternatives? Or is the debt a good idea for the plan? (Debt must also pass the exclusive benefit rule).

[mbozek]

There is no advantage for a plan to own real estate because the plan gives up all the tax advantages available to an individual, e.g., deduction of interest, taxes and depreciation, loss of capital gains taxation and UBIT tax on borrowed assets at 35% rate. In addition there are significant legal expenses and other charges for RE ownership that must be paid from plan assets (e.g. taxes and insurance). Finally the trustee for the plan is personally liable for negligence and environmental violations which occur on the RE.

[Guest RSNOW]

I agree with above comments about the wisdom and some ancillary issues regarding the real estate purchase, but focusing on the initial question (or at least the topic) of UBIT for the stubborn client who insists on doing this, the UBIT rules do contain an exception to the UBIT debt-financed rules for real estate purchases held for investment. If you follow the specific parameters a plan can obtain property (but avoid purchasing from disqualifed individual/party) and borrow money to help finance the purchase and still avoid the UBIT. However, the parameters include; purchasing property for a fixed price, debt or timing of payment cannot depend in revenue of property, it cannot be leased back to seller, or leased back to a person related to the plan (e.g., owner), no seller related to owner can provide financing, and it cannot be held in a partnership in which other non- tax-exempt partners exist where the primary purposes to avoid tax to tax exempt partners.

However, I do believe that if any revenue is derived from the property (e.g, an office building lease) then the combination of debt-financing AND income to the trust still would trigger the UBIT.

I think the example I can think of that may avoid the UBIT from kicking in is probably buying a raw piece of land with the plan getting a mortgage and following all the above parameters and holding for investment with no improvement on the property that would generate income. Sure there are other ancillary issues duely noted above to consider as well, but let's not say you can't do it, just rather is it worth it.

[mbozek]

Purchasing raw land on speculation that it will increase in value is the riskest type of investment because the owner is gambling that the property will increase because of attactiveness to a developer in the future, eg., if the population in the area grows. In the meantime the plan must pay for the cost of maintaining the property,e.g., property tax, ins. from other plan assets which could be invested in income producing assets. It would be better for the plan to invest in several REITS (assuming ther are no UBIT issues) which would have a yield of 7-8%. Also I dont think the plan could get a commercial loan for raw land.

[Guest RSNOW]

No doubt about the risk involved and limited loan opportunities. There probably are better examples that could be given, however, I mainly wanted to clarify the point that there are certain limited real estate investments that can be debt-financed that may pass muster with UBIT rules, but other issues mentioned in this discussion may not make it a wise or very practical approach. I wouldn't advocate it either.