Expansion of Real Estate Investments under a 401(k) Plan

[Below Ground]

Client firm is a Real Estate Broker.   The Plan is a 401(k) Plan which covers ONLY the owner and wife, who are both active in the business and the only employees of the firm.   Outside of the Plan they are involved in various real estate speculations, and do rather well with these investments; which is why they want to expand their use of real estate under the 401(k) plan.  Currently they do have two real estate investment which are solely under the Plan (no involvement of business, or commissions to the firm, with annual independent valuation).  I note that they do have other investments under the trust so it is diversified.  Anyway, they now want to use the trust's real estate assets in a "cash out refinance" of the 2 real estate investments, to obtain funds which will be used to improve the properties, and possibly buy additional properties.  To clarify, it seems that what they are intending to do is get mortgages against the 2 properties (currently owned 100% by trust fund), and use those funds to improve the 2 properties owned, and perhaps to purchase more real estate under the trust.

It is expected that this will not involve any monies outside of the trust, and that all proceeds will remain in the trust.  However, I suspect this is a prohibited transaction since they are using the two properties owned as collateral for the mortgage loans they take out against those two properties.  I also suspect that this will be a PT for other reasons, but am not sure how or why.

I greatly appreciate any and all comments and suggestions.  Thank you in advance!

[justanotheradmin]

So they are using the trust to engage in real estate business? That's what is smells like... are they reporting UBIT?
This isn't just a large pension plan that happens to hold some real property as part of a diversified portfolio. It sounds like people whose business in general includes real estate investing and they are also using the plan for that purpose. 

Beyond the myriad of possible prohibited transactions, the anti assignment wrinkle, and just burdensome issues of having real property in the plan such as making sure all the property taxes are paid by the trust - how would they ever expect to get a mortgage for those properties? A mortgage requires payments, credit, etc. The trust doesn't have a credit score, or income statements like paystubs, would they co-sign the notes? that would be terrible

I'm sure someone else with better experience will chime in with a more thoughtful answer, but my instinct would be to walk away. Even their current set-up seems ripe for issues. 

 

[ESOP Guy]

I am not an expert on UBIT but what I know is if there is leverage used in a plan you need to seek expert advice to see if UBIT will be due.  If they have to pay a type of income tax on income inside the plan my guess is this idea will be less popular.  I would add finding a CPA that knows how to file a UBIT return of a 401(a) plan is not easy.  Because of that it isn't always cheap. 

One has to really watch out for any idea that makes it look like they are trying to run a taxable business in a qualified plan and if they get clever and try to use Roth dollars so they never pay taxes on the income ever gets the IRS' upset and they can be aggressive.   

 

Too many people try to get too clever.  If it was real simple to never pay taxes on your business' income more people would be doing it.   

[justanotheradmin]

45 minutes ago, ESOP Guy said:

Too many people try to get too clever.  If it was real simple to never pay taxes on your business' income more people would be doing it.   

100% agreed.

There are just so many pitfalls, I rarely see real estate in done well in small plans. I wonder about the improvements - are they developing land? improving buildings? putting up buildings? etc. What is the real estate currently used for? is it literally just a tract of land held for investment? is it rental property etc? Are they flipping the properties?  leased farmland? etc. They should discuss those with someone who deals with real estate in plans. 

 

[Below Ground]

I really appreciate your comments.  Thanks! 

I am not a fan of using real estate under a pension trust.  This is in part due to remarks in your comments, as well as the need to have an independent valuation every year, amongst other issue.  However, there people have done very well with the investments they have so I can see why they do it.  Lets just say it is not my favorite approach.

Bottom line is that I recommended against the current cash out refinance as described, primarily due to the concern about using trust assets as collateral to borrow (potential anti-assignment wrinkle violation?).  I also suggested that they may want to talk to an ERISA Attorney, noting that I am not one (repeatedly).

Again, thanks!!!

[Peter Gulia]

And a good ERISA lawyer wouldn’t do this alone. One would insist on a team of lawyers, with expertise not only in qualified plans, I.R.C. § 4975, and the law of trusts, but also in real property practices, bank lending practices, contracts, agency, partnerships, and a wide range of tax law. And top-notch certified public accountants for accounting and for tax returns.