Land purchase with 401k assets

I have a client that wants to purchase land with his 401k assets and have a non-related party develop it.   It is my understanding that real estate held by a 401k plan can only be a passive investment and that this deal would not meet the requirements.  Do you agree?

Is this dumb?  Most likely.  Is it illegal?  I doubt it.   I am not a lawyer however. 

Now they might have to pay Unrelated Business Income Tax (UBIT) on the profits since it sounds like they are trying to run a tax free business.       I would look into that topic as if they have to pay taxes on their profits my guess is they will be less interested. 

You might want to search this forum using the words "real estate" for the many horror stories of how RE in a 4k plan can go bad.  

Paging @Larry Starr for his rundown on why real estate inside a qualified plan is not a wise choice, even when legally doable....

As a short-hand analysis of the UBIT issue, consider whether the real estate income, if the real estate were owned by your client as an individual, would produce capital gain or ordinary income, which may not always be crystal clear. Of course, if the property is leveraged, then you have to consider the UDFI rules and the potentially applicable 514(c)(9) exception thereto.

On 9/23/2019 at 4:26 PM, Pixie said:

I have a client that wants to purchase land with his 401k assets and have a non-related party develop it.   It is my understanding that real estate held by a 401k plan can only be a passive investment and that this deal would not meet the requirements.  Do you agree?

As usual, we have nowhere near enough information to answer thoroughly. 

The answer is not simple when dealing with a RE asset.  While it can be a permissible investment (so long as we don't have a prohibited transaction involved, which I often see is the situation), it causes its own problems.  For example, are there other employees in the plan?  Is it participant directed or pooled?  There can be BRF (benefits, rights and features) issues depending on whether all participants can buy into it or whether all participants are automatically part of it (as in a pooled trust).  Then, you have the problem of annual valuation; expect to have to spend a significant amount of money every year to get professional appraisals that would stand up to an IRS audit (that means, not what 3 real estate agents think it might be worth).  Also, if it is a really good investment, the client is turning what should be capital gain property into ordinary income property, which could be giving up a substantial tax benefit.  Because the plan is not an active developer of real estate as a business, it should still be a passive investment. But depending on the "deal" with the developer, it can lead to potential UBTI, which I always tell clients that becomes their CPAs problem (not mine) since they will have to file TAXABLE income tax returns for the plan if there is enough UBTI.

There are lots of reasons for NOT doing this; more reasons for NOT doing it than doing it.

8 hours ago, RatherBeGolfing said:

Paging @Larry Starr for his rundown on why real estate inside a qualified plan is not a wise choice, even when legally doable....

You got it! ?

As others have said

It may or may not be a good idea (My vote is bad idea)

It may or may not be legal (probably legal)

It may or may not be a prohibited transaction. (Not nearly enough information to make this determination)

It may or may not generate UBTI (based on the description I would lean more likely than not that it does)

And as others have noted real estate in qualified plans, especially small ones like this one probably is, come with a whole host of issues to consider. But I tend to agree with  Larry that even when it is possible, legal, avoids all prohibited transaction issues, and is even a good investment that the potential problems and possible downsides often far out weigh the upside.

I mean why would you want to throw away all those sweet favorable tax rules on real estate outside a qualified plans and convert it into ordinary income when it is eventually distributed from the Plan?

A lot of the issues here also apply to (k) plans, not just IRAs:  https://eforerisa.wordpress.com/2012/04/29/reality-check-on-ira-investments-in-real-estate/