November 5, 2021
Real estate can be a great investment. It has the potential to provide “return” through monthly cash flow, asset appreciation, and the paydown of any outstanding loan balance. What’s more, these returns may be magnified through the use of financing and the availability of depreciation and tax deferral. Beyond that, real estate generally increases in value and may be easier for some investors to understand.
So, if real estate can be a favorable investment outside of a Defined Benefit Plan, does holding it within a Defined Benefit Plan enhance the investment opportunity?
Probably not. It is our opinion, that in most cases, holding real estate in a Defined Benefit Plan does not make sense. Simply put, the advantages obtained by holding real estate within a Defined Benefit Plan already may be obtained to some degree when the same investment is held outside the Plan. Additionally, some of the advantages of real estate investing simply are lost when properties are held within the Defined Benefit Plan. Lastly, compliance is greatly increased when a Defined Benefit Plan holds real estate. This further constrains the investment potential and increases the risk of plan disqualification, excise taxes, and penalties. We will explore each of these points in further detail.
Note that this article describes our understanding of financial and tax implications related to real estate investing. However, we are not financial advisors nor are we tax professionals. Therefore, it is not our intent to provide financial or tax advice. You should not rely on this article for making financial or tax decisions but should consult with your financial and tax advisor.
What are the tax and financial implications of holding real estate within a Defined Benefit Plan? How do these implications differ when the same investment is held outside of a Plan?
First, investment gains for assets held in a Defined Benefit Plan are deferred until distribution. However, the tax deferral applied to Plan investments already exists, to some extent, for real estate held outside of a Plan. For example, unrealized real estate gains already are tax-deferred, because unrealized gains are not taxed. An investor can even access these unrealized real estate gains to purchase new properties, without incurring any taxation, using a home equity loan. What’s more, 1031 exchanges can be used to defer even realized real estate gains.
Further, when real estate gains eventually are paid, the tax rate may be higher for real estate held within a Defined Benefit Plan than if the investment were held outside a Plan.
Other financial and tax opportunities also are lost when holding real estate in a Defined Benefit Plan. For example, offsetting other ordinary income with depreciation in excess of cash flow, with some limits, would not be available when real estate is held in a Plan. Moreover, the use of debt financing to magnify investment returns may create additional taxation when a Defined Benefit Plan owns the real estate.
Additional detail discussing each of these points is provided later in this article.
Beyond the financial and tax implications, holding real estate in a Defined Benefit Plan creates additional complexity, compliance, and risk.
For example, not all Defined Benefit Plan documents allow for alternative investments, such as real estate. Additionally, the employer has a fiduciary duty to invest the assets prudently, and it may be more difficult to justify the purchase of physical real estate using Plan assets.
There also is the need for annual, appraisals of all properties held in the Plan, so that the Defined Benefit Plan actuary can calculate the minimum and maximum contributions each year. Holding real estate in the Plan may require an audit from an outside accounting firm or more extensive bonding requirements that otherwise would not have been needed had the Plan invested solely in marketable securities.
Further, liquidity may be an issue, as physical real estate is not as easily sold as stocks, bonds, or mutual funds. This may be an issue if a distribution must be paid or the Defined Benefit Plan is terminated. There also may be logistical constraints such as finding a bank or lender that is willing to issue a loan for real estate held within a Defined Benefit Plan.
Lastly, and importantly, the risk of violating complex Prohibited Transaction rules is increased. These rules are not always intuitive, so an employer may run afoul of these regulations without realizing it. Correcting these infractions can be both time-consuming and expensive.
Later in this article, we will provide more detail regarding each of the compliance issues associated with holding real estate in a Defined Benefit Plan. However, first, we will discuss in detail the financial and tax consequences of real estate owned by a Defined Benefit Plan.
The first financial implication of holding real estate in a Defined Benefit Plan that we will explore is tax deferral.
In fact, the chief advantage of holding investments in a Defined Benefit Plan is tax deferral. This is accomplished via a tax deduction for the deposits into the Plan, as well as the deferral of taxation on investment gains until the distribution of Plan assets.
While real estate held outside a Defined Benefit Plan is purchased with after-tax money (unlike real estate held within a Plan where pre-tax dollars are used), the tax deferral aspect of Plan investment gains may be mimicked, to some extent, using real estate held outside of a Defined Benefit Plan.
For example, an investor could purchase property outside of a Plan, and as the real estate appreciates, use the equity from a home equity loan to obtain new properties. In this way, the investor is able to access the unrealized gains in the property to make new investments while still deferring taxation.
Should the investor desire to sell the property, any realized gains would be taxed and any depreciation would be recaptured. However, a 1031 exchange could be used to roll the proceeds into a new property, which would further delay taxation and the recapture of any depreciation. Admittedly, a 1031 exchange is not always possible given the timing and exchange requirements, but Section 1031 does create a reasonable opportunity for deferring taxation.
Using these methods, the investor may be able to defer taxation while retaining the advantages and flexibility inherent in holding real estate outside of a Defined Benefit Plan.
In summary, by holding real estate within a Defined Benefit Plan, the employer generally receives a tax deduction for the deposit of all contributions into the Plan, and tax deferral on any investment gains.
This favorable tax treatment only can be partially received if the real estate investment is held outside of a Plan. Specifically, no tax deduction is received for the dollars used to purchase the real estate outside the Plan, like it is when the real estate is held inside the Plan. Additionally, the tax deferral of Plan investments can be replicated to some extent, but there may be limitations when real estate is held outside a Plan.
However, these tax advantages of holding real estate in a Defined Benefit Plan come at a heavy price. For example, the eventual distribution of Plan assets likely will be taxed at a higher tax rate than if the real estate was held outside the Plan. Also, using leverage in the Plan to magnify investment gains may create additional taxes. Moreover, the ability for a taxpayer to offset other ordinary income with a non-cash depreciation expense is not available. All of these items will be explored next.
Real estate is taxed differently when it is held inside a Defined Benefit Plan.
For example, if you buy and sell real estate outside of a Defined Benefit Plan, the investment gain earned is taxed using capital gain tax rates. Capital gain rates tend to be lower than tax rates for ordinary income.
However, when Plan assets eventually are distributed, including investment gains on real estate, they are taxed at the higher ordinary income rates. (The top federal capital gain tax rate is 20%, while the top ordinary income federal tax rate is nearly double at 37%).
Thus, investing in real estate outside a Defined Benefit Plan generally has the advantage of a lower tax rate on investment gains compared to making the same investment inside a Defined Benefit Plan.
In real estate, the investment essentially consists of the underlying raw land and any structures on that land. Generally, raw land tends to appreciate in value, whereas any structures on the property wear out and depreciate.
Because structures depreciate in value, for tax purposes you generally may deduct depreciation attributable to the improved portion of the real estate. This deduction first offsets any income derived from the real estate (e.g., net rental income) but then may be able to offset other ordinary income, such as W-2 wages, subject to certain limitations. Depreciation of real estate to offset rental and wage income can be a powerful tax strategy, especially when depreciation is accelerated using cost segregation.
Although depreciation deducted eventually is recaptured (taxed) when the property is sold, deferring this taxation for a time may be advantageous. What’s more, depreciation recapture can be further delayed by rolling the proceeds of a real estate sale into a new property using a 1031 exchange.
However, when real estate is held in a Defined Benefit Plan, the deduction for depreciation is not relevant, because it is within a tax-deferred account. This means that the ability for a taxpayer to offset other ordinary income from real estate depreciation is lost.
One of the most powerful aspects of real estate investing is the investor’s ability to use leverage (e.g., debt) because investment gains are magnified.
For example, suppose an investor purchases a property for $1 million using a $200,000 down payment and financing the remaining $800,000. Further, suppose that the property appreciates by 10% in the first year (increases by $100,000). In this situation, the annual rate of return due to appreciation is 50% of the initial investment ($100,000 / $200,000 = 50%). Put another way, the rate of return is magnified by a factor of five (50% / 10% = 5.0). Rates of return attributable to cash flow similarly are magnified.
However, when real estate is financed using debt within a Defined Benefit Plan, Unrelated Business Income Tax (UBIT) may be due. The calculation of UBIT is outside the scope of this article, but the employer who holds real estate in a Defined Benefit Plan may incur additional taxes and CPA fees that are not applicable to an investor who holds real estate outside a Plan.
Now that we have discussed in detail the financial and tax consequences of holding real estate in a Defined Benefit Plan, we will explore the compliance issues related to a Defined Benefit Plan owning real estate.
The first and most basic challenge is that the Plan Document simply may not allow the Plan to purchase real estate. The Plan document essentially is the “contract” between the employer and the covered employees. It describes the Plan benefits and other rules related to the Defined Benefit Plan.
For smaller plans, the employer generally uses a Plan document that has been pre-approved by the IRS. Pre-approved Plan documents consist of boilerplate language with some ability to tailor Plan provisions. Although the flexibility of a pre-approved document generally is adequate for a small Defined Benefit Plan, restrictions on Plan investments, including the holding of real estate in the Plan, often are found in the boilerplate section of the Plan document. In that case, amending the Plan to allow for real estate investing would require assistance from an ERISA attorney. This can be done but may be expensive.
In a Defined Benefit Plan, pooled assets, invested by the employer or its advisors are used to pay participant benefits. Therefore, to ensure that Plan participant benefits will be paid, the employer, as the Plan Sponsor, has the fiduciary duty to diversify Plan assets and make prudent investments. In fact, ERISA has special rules regarding Plan investments.
And while physical real estate is not precluded as a Defined Benefit Plan investment, a large concentration in this asset class may not be considered prudent. Additionally, investment in any physical real estate may be harder to justify when compared to the investment of Plan assets in more traditional asset classes.
Of course, to some extent, these considerations do not apply to a one-owner Defined Benefit Plan with no employees, because the person acting for the employer and the sole participant are the same people.
Even if an employer is able to defend investing in physical real estate as prudent, the liquidity of this asset class may prove to be problematic.
For example, suppose a participant separates from service and requests payment of their benefit as a lump sum payment. If the benefit is large and a high proportion of Plan assets is invested in physical real estate, the immediate payment of this benefit may be difficult.
Selling the investment and receiving the funds from the sale may take several months. What’s more, it may not be an opportune time to liquidate real estate needed to pay the benefit if, for example, the real estate market is depressed at the moment but expected to recover. While this last point is true with any investment, including marketable securities, it is the combination of the need for immediate cash to pay the benefit and the longer sales cycle of real estate that makes the liquidity of real estate problematic (i.e., real estate may need to be sold below market to raise cash quickly).
The liquidity of real estate also may interfere with an employer’s ability to terminate the Plan at the time desired. For instance, an employer may need to delay Plan termination because of the illiquid nature of physical real estate. This delay may lead to additional staff benefit costs and professional fees if the termination is postponed to the next Plan year.
Defined Benefit Plans require an annual certification of the minimum contribution requirement, the maximum deductible contribution, and the Plan’s funded status (assets relative to the actuarial present value of benefits due). This certification is provided by the Plan’s actuary.
In order to complete this work, the actuary needs to know the value of the Plan assets on the measurement date. This figure is readily available for marketable securities, as these assets are typically valued daily or even minute-by-minute. However, the value of real estate is subjective and requires a licensed real estate appraiser to assess the value. This means that when an employer holds real estate in a Defined Benefit Plan, they must incur an additional annual fee to have all real estate investments appraised.
In addition to annual appraisal fees, holding physical real estate in a Defined Benefit Plan may require that the employer engage an independent qualified public accountant to audit the Plan.
These audits typically are waived for small Defined Benefit Plans (fewer than 100 participants). However, if more than 5% of the Plan assets are invested in non-qualifying assets (e.g., physical real estate), then either the Plan must be audited or the employer must increase the amount of fidelity bond coverage. Either of these alternatives adds cost to the Plan (in addition to the annual appraisal requirement when real estate is held in the Plan).
As discussed earlier, one of the main advantages of investing in real estate is the ability to use debt to leverage the return on investment. However, it may be difficult to find a lender who will provide a loan when the physical real estate is titled in the name of the Plan.
Even if a bank or financial institution is willing to provide financing, the lender may require the employer or business owner to personally guarantee the loan. While that may not seem like an issue, providing this guarantee would be a Prohibited Transaction and would subject the Plan to expensive excise taxes as well as and professional fees to correct the infraction.
Even if the employer is able to work through the financial, tax, logistical, and compliance issues discussed thus far, they may unwittingly violate the Prohibited Transaction rules. This may result in significant excise taxes, as well as legal and/or actuarial fees.
The purpose of the Prohibited Transaction rules is to protect Plan participants from conflicts of interest. Essentially, these rules prohibit the Plan from engaging in “transactions” with certain parties who may benefit from their position.
So, for example, if the Plan held real estate as a rental property, it could not lease the dwelling to a relative of the owner of the business sponsoring the Plan or even to a relative of the Plan’s actuary.
Additionally, the Plan could not hire a relative of the CEO of the employer sponsoring the Plan to fix a leaky roof in an apartment building owned by the Plan.
Often, these restrictions are common sense when they are considered in the context of the requirement to avoid any conflicts of interest with Plan investments. However, business owners often are surprised to learn that these same rules generally apply to them even when they run a one-person business and are the only participants in the Plan. For example, they could not lease property to their brother even though they are the only participant in the Defined Benefit Plan and nobody else is affected.
Moreover, the Prohibited Transaction rules are not always intuitive. As mentioned in the last section, a business owner even providing a personal loan guarantee to a bank that is lending the Plan money to purchase real estate would trigger a Prohibited Transaction.
Thus, investing in real estate increases the risk of violations, that may not easily be recognized by the employer but could result in substantial excise taxes and professional fees.
In conclusion, holding real estate inside a Defined Benefit Plan generally does not make sense.
Real estate already is a tax-advantaged investment, so the tax advantages of investing Plan assets in real estate holdings are somewhat diminished.
Additionally, magnifying real estate returns through the use of debt is better accomplished outside a Defined Benefit Plan, because UBIT does not apply, and financing is more easily obtained when the property is not titled in the name of the Plan.
Lastly, the increased compliance and cost of holding real estate in the Plan can be expensive, onerous, and increase the risk of violations, leading to excise taxes and professional fees.