Retirement Plan Rescue Story #4: When a Retirement Plan Bought a Dream House

The Warning 

Before the purchase, we explained some of the complications that can come with holding real estate inside a retirement plan. Many of the traditional tax advantages associated with personally-owned real estate aren’t provided inside a tax-qualified retirement plan.  The property would also need to be valued as a plan asset annually by a third party. Expenses associated with the property would have to be paid appropriately from the plan. And, most importantly, the property couldn't simply become the owner's vacation home. 

Retirement plan rules generally prohibit certain transactions between the plan and "disqualified persons," including the business owner sponsoring the plan. That meant the owner couldn't simply treat the property as his own. He couldn't buy it through the retirement plan and then use it personally whenever he wanted. 

His stated intention was to hold the property as a plan investment and rent it to unrelated third parties. With the rules explained, the purchase moved forward. 

Then the years started passing. 

An Illiquid Asset Becomes a Retirement Problem 

The expected rental income never materialized. In an effort to make it more attractive to potential renters, furniture for the property was purchased using plan assets. 

Still, the property remained an unusually large and illiquid asset inside the retirement plan. And that created a problem we had warned about from the beginning. 

Eventually, retirement plan participants reach an age when required minimum distributions may need to begin. Those distributions generally require liquidity. 

A retirement plan holding stocks, bonds, mutual funds, or cash can sell assets and make distributions as needed. On the other hand, a retirement plan whose primary asset is a multimillion-dollar house has a much more difficult problem. 

You can't easily distribute a bedroom. 

Or a kitchen. 

Or a portion of a roof. 

As the owner approached the age when required minimum distributions would become necessary, the theoretical problem we'd discussed years earlier suddenly became very real. The plan needed cash. The cash was tied up in the property. And the most logical buyer of the property was also someone who ordinarily couldn't simply purchase it from the plan: the business owner himself. 

The Rescue 

The solution required something far beyond routine retirement plan administration. 

We approached the Department of Labor seeking permission for the plan to sell the property to the owner. 

The argument was straightforward: allowing the transaction at fair market value could be in the best interests of the plan participants because it would convert an illiquid asset into cash that could be used to satisfy benefit obligations. 

The Department of Labor required substantial documentation. 

The property needed to be independently appraised; the trust accounting had to support the transaction; the terms needed to demonstrate that the plan and its participants would be protected. 

Ultimately, the Department of Labor approved the transaction through something called a prohibited transaction exemption. 

That allowed the owner to purchase the property from the retirement plan at its appraised fair market value. 

Because the property would then be personally owned rather than held inside the retirement plan, the owner could obtain conventional financing. The proceeds from the sale went back into the retirement plan, replacing the illiquid property with cash. 

The Outcome 

The transaction solved several problems at once 

• The retirement plan received fair market value for the property. 
• The plan gained the liquidity necessary to pay participant benefits and distributions. 
• The owner was able to personally own the property. And the plan could move toward an orderly conclusion without forcing participants to deal with an interest in an illiquid piece of real estate. 

What had begun decades earlier as an unusual investment opportunity ultimately required an equally unusual retirement plan solution. 

The Lesson: "Allowed" and "Advisable" Can Be Very Different Things 

One of the most important lessons in retirement plan design and administration is that the fact that something can be done doesn't necessarily mean it should be done. 

Alternative investments can create complications that aren't obvious when the investment is first made. 

How will the asset be valued? 

How will expenses be handled? 

What happens if the plan needs liquidity? 

What happens when participants retire? 

Could the investment create a prohibited transaction? 

And, perhaps most importantly, what is the exit strategy? 

Those questions are much easier to answer before an investment enters a retirement plan than 20 or 30 years later when the plan needs to get it back out. 

This particular story had a successful ending because there was a path available to correct the problem. 

Not every situation will. 

That's why proactive retirement plan administration isn't simply about determining whether a transaction is technically permissible. 

It's about looking beyond today's opportunity and asking what that decision could mean years down the road. 

Sometimes the most valuable advice a retirement plan professional can give isn't how to do something. 

It's explaining why you may not want to do it in the first place.