Purchasing Real Estate in Cash Balance/Combo Plans

[SwimmingInBowelsOfERISA]

I am a FA and I was referred to clients of a CPA. These individuals own multiple business entities, primarily in real estate. The only EEs of all companies are the owners (parents, 60's) and their two children (30's), also owners. Ignoring control group/affiliate service for the purpose of this thread, they are interested in starting a CB or Combo plan for the purpose of defraying taxes and purchasing Real Estate. They have no interest in investing in "traditional" securities or any other assets other than RE.

Aside from the the usual issues related to owning RE in a retirment plan (PTs related to income/expense flow, management, can't "contribute" RE assets, etc etc) I have a few concerns because I have never had a client with an interest in investing solely in RE in a QRP. First, I am concerned that it would, at a minimum, violate ERISA's "duty to diversify". Second, I am concerned that the IRS will view this unfavorably by default. Third, I believe that legal issues, valuation issues and related expenses may outweigh the benefits. Fourth, I am not aware of any trustees and/or custodians, apart from SD-IRA's and some uni-k's, that work with this.

Has anyone else had or heard of a situation like this? Is there something else that I should also be concerned with? I will undoubtedly be reaching out this week to local TPAs and ERISA attorneys I have worked with in the past, but I am interested in some feedback from the community.

Thank in advance for your responses.

[mbozek]

Just looking at the basics what will be your role in this plan? As a FA you are registered rep which means you can buy/sell securities. RE is not a security. Are you going to be the named or de facto fiduciary. Will your compliance dept approve such a role?

If this going to be a cash balance plan the plan sponsor must hire an enrolled actuary who will design the plan benefit formula and determine what the funding requirements will be. In a Cash balance employer must make annual contributions necessary to meet the minimum funding requirements under the tax law. I have no knowledge of what would be the funding requirements but I think the first step is to hire an enrolled actuary assuming you can find one who would accept an assignment to represent a plan funded solely in RE.

If the plan is invested only in RE where will it get the cash needed to pay expenses, distributions, etc? RE is not a diversified investment like an index fund so there will be limitations on what % of plan assets can be invested in RE.

Another question is what is the exit strategy for the owners? Are they intending to fund the plan for a short period with RE, say 5-10 years, retire, terminate the plan and distribute the benefits. If the FMV of the RE is not sufficient to pay benefits and costs of termination will they contribute more funds?

I am going to stop here because I think establishing a retirement plan solely invested in RE is a really bad idea that I would not want to be associated with.

[SwimmingInBowelsOfERISA]

Thank you for your response!

To answer your questions:

First, I am an FA but I am not a Registered Rep. I am an independent Investment Advisor Rep (IAR-RIA) with no B/D affiliation, very distinct from a RR, and thus only Frost model compensation here (no rev share/commissions).

Second, typically I act as a 3(21)(A)(ii) IA fiduciary and as an SEC (but not ERISA) fiduciary to plans for the purpose of many services outside the scope of investment advise or management. And in a few cases our firm acts as a 3(38) IM. So I don't have any issues with my compliance dept per se because I have ample experience in the same capacity. For this plan, I have no interest in advising in the capacity of an erisa fiduciary on the real estate investments, not because I can't but because it's outside the scope of my expertise. My services to the clients will include business and estate planning (on a personal level), but services related to the plan will be limited to a scope of services similar to other contracts with existing plan clients (vendor and professional aggregation/search and monitoring assistance, oversight, compliance assistance, etc), but nothing that would otherwise qualify me as an erisa fiduciary with respect to administration, management or control of assets, or investment advice or management.

With respect to hiring the actuary, that is part of the conversations I am having this week with other local colleagues. And your questions about cash required to pay expenses, distributions, etc. are all valid, which I am very much aware of and are part of my reasoning why I am unsure whether this is a good idea to begin with. It will certainly require an individually designed plan, and since the IRS has changed the determination letter rules it makes the consideration of an individually designed plan and the subsequent IRS view on tax qualification all the more important.

Your question about the "end game" I found insightful because I need to investigate that more fully. I know the "older" owners want to fund it for about ten years before retiring, but I'm sure they don't fully realize how the income will be generated, and as a matter of fact I had not even begun to consider that, but an excellent point in any event.

Thank you for your advice!

[david rigby]

Agree with mbozek's comments.

You will be able to find an actuary willing to accept this assignment, but not one who thinks that investing in RE is a good idea. If it were I, the fee would be a bit higher than usual.

I'm skeptical that they understand the cash contribution issue(s). If I were a cynic, I might consider the possibility of some "nefarious" scheme to seek some tax-favored treatment of current RE investments. BTW, do the principals assume a distribution (i.e., at retirement) would be made in-kind? To an IRA custodian that will accept RE?

Also very skeptical that the principals care about IRS audit/scrutiny, probably assuming no one will ever look at it. It would shock me if such an individually designed plan were ever submitted for a D-letter.

[SwimmingInBowelsOfERISA]

Good points David.

I've only met with them once, and likewise I am also somewhat skeptical of what they think they can accomplish. They have been a client of the CPA for over twenty years, and the CPA at least is solid and ethical but not a retirement plan expert by any means. And his clients do care about taxes and audits; it's my understanding that the CPA's first engagement with them was dealing with an audit because they were going through a tax "preparer", and I definitely got the impression that they wanted to make sure it is done right or not at all.

I fully plan on doing some serious prying for more information about what their goals and expectations are before I entertain moving forward. Needless to say it sure wasn't a run of the mill conversation with a potential plan sponsor. Thanks for the response!

[ESOP Guy]

To echo others:

I have seen a few people try and run their taxable business through a qualified plan thinking it is a clever way to not pay taxes currently. It tended to end badly.

Other possible issues you will want to look into is will what they are doing going to trigger any kind of Unrelated Business Income tax (UBIT) within the trust. For example if they used debt to buy the RE it will most likely cause the trust to owe taxes on the leveraged portion of the investment.

You don't see UBIT very often so it can sneak up on people.

[SwimmingInBowelsOfERISA]

Good point ESOP guy.

The fact that these individuals already have RE businesses makes me think that part of their motivation is to use the plan to defray taxes on ordinary business activities. But at the same time they are averse to the markets (which seems to be very common based on my experience with people of the same ethnic background as them), so I don't want to jump to conclusions. However, looking from the outside in I could see how a regulator could view this arrangement dubiously.

And if we move forward, we will certainly be paying attention to IRC 512.

Thanks!