Real Estate as a Retirement Plan Investment: Likely a Bad Idea - July 2023 Newsletter

In general, there is no law that prohibits investing qualified retirement plan funds in real estate, provided it’s not property that will be used by a disqualified person or a party-in-interest. It may be tempting to use retirement funds for real estate investments since the money appears to be available and real estate often has the potential for appreciation over a long time period. However, in many cases, real estate is a poor choice for qualified plan investments.

One exception: investing a small portion of plan assets, say 5% or so, in a real estate mutual fund, ETF, or REIT may provide some diversification and not have the problems listed below. But direct investments by the plan in real estate are generally a bad idea for some (or all) of the following reasons.

Liquidity: Real estate is not a liquid investment. It can take weeks, months, or years to divest the plan of real estate property, and liquid funds may be needed to pay benefits or plan expenses.

Market Value Determination: Any plan asset that does not have a readily determinable market value requires an annual independent qualified party appraisal. This is a time-consuming and potentially costly procedure.

Fiduciary Bond: Retirement plans must have a fiduciary bond equal to 10% of the plan’s assets to cover plan losses from theft of assets or fraud. However, if the plan invests more than 10% of its assets in non-qualifying assets (those that do not have a readily determinable market value), then either the bond must be increased to cover at 10% of the qualifying assets, plus 100% of the non-qualifying assets; or the plan must engage an independent accountant to conduct an audit of plan assets, which can be costly and time-consuming.

Plan Documentation: Some plans have limits on the amount or percentage of plan assets that can be invested in real estate, or they prohibit real estate investment outright. It’s possible the plan could be amended, but it’s also possible such an amendment could take the plan out of pre-approved status.

Real Estate Management: Land and buildings require maintenance. If the plan owns the property, the Trustees will need to be sure it is managed properly. The plan will be responsible for payment of property management fees, real estate taxes, repairs and maintenance, utilities, and other expenses.

Leveraged Real Estate: This refers to real estate that is debt-financed, i.e., a mortgage is taken out on the value of property. This is a particularly bad idea in a qualified plan. Since the plan is not in the real estate management business, income earned from the property (such as rental income) would be deemed to be unrelated business taxable income, or UBTI. This would require the plan to file a Trust tax return and pay Federal income taxes on the earnings from real estate and if applicable, file a state level return and pay state taxes as well.

Nondiscrimination issues: Do all participants have equal rights to invest in real estate? If not, the plan has to perform complex nondiscrimination tests referred to as the “current availability” and “effective availability” tests; if they can’t be passed, the plan could potentially be disqualified.

Distributions: Some plans allow participants to elect in-kind distributions; i.e., taking part or all of their benefits in the form of securities or other non-cash assets. In-kind distributions must be nondiscriminatory, meaning that they can’t be available only to Highly Compensated Employees. And it’s often impractical or impossible to offer distributions of a small percentage of the real estate investment as a distribution option. The plan usually must sell the real estate assets before all assets can be distributed to participants.

Fiduciary Issues: Plan fiduciaries must act in the best interests of plan participants and avoid conflicts of interest. Investments must be prudent, and they must be sufficiently diversified to minimize the risk of large losses. Fiduciaries who do not follow these principles may be personally liable to restore any losses to the plan, or to restore any profits made through improper use of plan assets. They may be personally subject to fines or other penalties.

Did we convince you not to invest plan assets in directly real estate? If you still are interested in using plan funds for real estate investments, better options would include real estate mutual funds as mentioned earlier, or applying for a plan loan or taking a partial distribution (if your plan allows these) and then investing the proceeds in real estate outside of the plan. As always, we recommend that you consult with a knowledgeable advisor before proceeding.

Don’t Tip-Toe Around Crypto: Run the Other Way! - May 2023 Newsletter

If you’re thinking of adding cryptocurrency (or “crypto”) to your qualified retirement plan or IRA, this article will give you a bunch of reasons why you should seriously reconsider your thinking.

Technically, cryptocurrencies, like Bitcoin, Ethereum, or many others, are not specified as a prohibited investment in retirement plans. But this article is an opinion piece; and with that in mind, here are 7 reasons why crypto is a terrible option as an investment inside a qualified retirement plan or IRA.

Department of Labor (DOL) Compliance Assistance Release 2022-01

This release makes it clear that the DOL has serious concerns about exposing a 401(k) plan’s participants to investments in crypto, or products whose value is tied to crypto. The Employee Benefits and Security Administration (a division of the DOL) expects to conduct an investigative program (i.e., audits) aimed at plans that offer investment in crypto and related products, and “take action” to protect the interests of plan participants. DOL audits are often rigorous and can result in large financial penalties to plan fiduciaries.

Crypto is a volatile and speculative investment

The SEC has cautioned that crypto is highly speculative. Crypto has been subject to extreme price fluctuations. These fluctuations may be as a result of difficulties in valuing crypto, fictitious trade reports, or theft and fraud. Extreme volatility can have a devastating effect on plan participants, especially those close to retirement. Participants unhappy with investment results may decide to take legal action against plan fiduciaries.

Plan participants need to make informed investment decisions

Crypto is very different from typical 401(k) plan investments, which typically include mutual funds and/or ETFs investing in stocks, bonds, and cash. Participants are much less likely to have sufficient knowledge, or have the technical expertise to make informed decisions, about crypto. By including crypto as an investment option, plan fiduciaries are effectively telling participants that they have approved it as a prudent option.

Custodial and recordkeeping concerns

Crypto is not held like traditional plan assets in a trust or custodial account. With some crypto, simply forgetting a password can result in loss of the asset forever. Some methods of holding crypto can be vulnerable to theft and hackers.

Valuation concerns

There are concerns about the reliability and accuracy of crypto valuations, which have been described by experts as “complex and challenging.” Crypto market intermediaries may not adopt consistent accounting treatment and may not be subject to the same reporting and data integrity requirements that apply to more traditional investments.

The regulatory environment is evolving

Plan fiduciaries will need to decide whether crypto meets regulatory requirements that apply to plan securities. For example, the sale of some crypto could constitute the unlawful sale of unregistered securities. The Financial Industry Regulatory Authority (FINRA) has cautioned that some crypto has been used in “illegal activity, including drug dealing, money laundering, and other forms of illegal commerce.” This could result in problems for investors, for example, authorities could shut down or restrict the ability to use or trade that investment.

Executive Order regarding crypto

On March 9, 2022, President Biden signed an Executive Order that directed numerous Federal agencies to crack down on digital assets, including popular crypto, and to study the potential development of a Central Bank Digital Currency (CBDC). Since the Order was issued, much work has been done in this area, which could dramatically affect current crypto markets.

Of course, there are benefits to society that can arise when many of the current problems are straightened out. And some investors have had very large returns on their crypto investments. However, the above concerns should give pause to any fiduciary who is considering allowing crypto as an investment in a qualified retirement plan.