Today, millions of Americans hold investable assets in employer sponsored and individual tax-deferred retirement accounts such as a traditional IRA, Roth IRA or 401ks. In fact, as of the end of the 2021, there were an estimated $39.3 trillion of retirement assets held by Americans in employer sponsored and individual retirement plans*. For many Americans, these tax-deferred retirement accounts represent the largest pool of investable assets in the household. Let’s take a look at how an individual investor can accumulate and then position retirement plan assets in order to take advantage of the alternative real estate investment opportunity.
Employer sponsored retirement plans that are subject to the fiduciary responsibility requirements of the Employment Retirement Income Securities Act of 1974 (ERISA) are known as qualified retirement plans. 401-k plans are the most widely used qualified retirement plan design among medium and large businesses today, while 403-b plans for non-profit organizations and SIMPLE and SEP IRA plans for small business are also widely used. As these plans have become readily available to millions of employees, they have proven offer a significant opportunity for average Americans to accumulate sizable pools of investable assets. Because of decline in the availability of traditional pension plans in the private sector over the last 40 years and because of the rise in the availability of 401-k and other plans, competitively positioned employers consider a qualified retirement plan to be a foundational piece of a well-rounded employee benefit plan. For the employee, these “defined contribution” plans offer an opportunity to systematically invest a “defined” percentage of their income. And in some cases, the employee receives an additional percentage contribution into their account from the employer, known as a matching contribution.
The opportunity to make small systematic investments that are processed by an employer through payroll reduction has empowered many Americans to save for long term needs. Many Americans have been successful at following through on regular investing and have been able to build long term assets in employer retirement accounts. In fact, many Americans who have historically had lower savings rates than savers in other parts of the world, rely on the payroll reduction process as the primary way they are able to systematically save for future needs. In addition to the systematic and convenient nature of this process for employees, there are also IRS penalties for lump sum withdrawals prior to age 59 ½. The plans themselves have restrictions as well based on plan design. These penalties and restrictions are another reason Americans have been successful in the accumulation of asset in these plans.
While 401-k and other retirement plans offer many Americans a fantastic solution for accumulating investable assets on a tax-deferred basis, the ability to diversify into alternative real estate equity in these plans is significantly limited because of plan design constraints as well. However, there is good news for plan participants seeking to access alternative real estate investments with their tax-deferred retirement accumulations. These plans give the investor control over where their assets will ultimately be held. Once assets are accumulated in employer retirement plans, those accumulated assets can be “rolled over” to self-directed Individual Retirement Accounts (IRAs) that offer significantly greater accessibility to alternative real estate investments. It is notable that a large portion of the assets held in IRAs today have come about as a result of a “rollover” by the investor from an employer sponsored plan. As long as an investor enacts a rollover within IRS guidelines, the tax deferred status of the rollover will be preserved in the self-directed IRA. To the extent that the assets in the employer plan were accumulated in a Roth 401-k account, those assets can be rolled over into a Roth IRA.
The opportunity for retirement plan participants to rollover assets into IRAs is available at the employee’s separation of service from the employer, which typically occurs as a result of retirement or resignation. There may also be other opportunities to roll funds out of some plans. An employee must work with the custodian of their employer sponsored plan or their HR department to determine when rollovers can take plane out of their employer sponsors plan. In addition to separation of service, newer qualified plans tend to have more flexibility for withdrawal while an employee is still “in service” with the employer than do plans with an older plan design.
Many of these newer plans will allow a complete or partial rollover once an employee has reached a target age such as 62 or even 55. Many leading alternative real estate investment sponsors will allow their shares or ownership positions to be held within an IRA, but the IRA must be a self-directed IRA. In addition, the sponsor must have an agreement with the IRA custodian to hold the investment assets. If allowed, investment sponsors will inform the customer of which IRA custodians can be used. An IRA custodian is a financial institution that holds an account’s investments for safekeeping and sees to it that all IRS and government regulations are adhered to timely. Since most alternative investments are valued periodically, such as once a quarter or once a year, the IRA custodians will only report a change of valuation as directed by the sponsor. Note: SEP IRA account owners can also set up self-directed SEP IRA accounts with approved custodians in order to hold alternative real estate investments.
As the reallocation with still be within a qualified account such as a traditional or Roth self-directed IRA, there is no need to use a QOZ to defer the capital gains from the sale of the stocks and bonds for reallocation. Accordingly, the sales proceeds from the sale may be reallocated into DSTs, Private REITs, or real estate funds per the private investor’s diversification plan. It is an interesting comparison that the reallocated portfolio with non-qualified funds has the same tax deferral and shelter advantages (using the QOZ) as a qualified account but without the penalties for early withdrawal, time restrictions, and distribution requirements.
In 1978 the US Department of Labor updated ERISA lifting an earlier restriction on pension funds that prevented them from investing in privately held securities and thereby allowing for alternative investments. As investors access alternative real estate investments within self-directed IRAs, they will experience the tremendous advantages of the tax-deferral on cash distributions. Dividends, capital gains distributions, as well as other cash distributions can all be accumulated within the IRA account on a tax-deferred basis. The cash will remain tax-deferred until it is withdrawn from the account. In the case of Roth IRAs, the distributions will typically be tax-free as long as IRS guidelines are followed. If desired, an investor can reinvest the cash distributions from their real estate investments into other available investments within the IRA such as mutual funds possibly using a dollar-cost-averaging strategy. Additionally, at the sale of the alternative real estate investment, the proceeds can be used to invest in other alternative real estate investments or other available investment options, all on a tax deferred basis!
Therefore, an investor will be able to continue to diversify their investment portfolio while experiencing the same tax deferred status for proceeds, cash distributions and capital gains as they would with any other investment vehicle within an IRA. Care must be taken to ensure that all cash flow payments are directly deposited by the sponsor into the investor’s IRA account and not into a non-qualified personal bank account. Distributions into a private non-qualified account would be subject to taxation and possible penalties. As is true with any traditional IRA, proceeds, dividends, capital gains as well as any other cash distributions will be taxed as ordinary income when withdrawn from the traditional IRA account. An investor may choose to withdraw only what is needed and retain the remainder of cash in the IRA free from current taxation. Any cash withdrawn from a Roth IRA would be tax-free within the IRS Roth IRA distribution regulations. Any Dividend Reinvestment Program (DRIP) that gives an investor an option to buy additional shares of the REIT with dividends with no sales charge will also be available within an IRA on a tax-deferred basis as well. Some REITs even offer an investor the option of reinvesting dividends at a discount to current share price valuation known as net asset value.
When using qualified retirement accounts to invest in alternative real estate investments, care should be taken to avoid offerings that may generate unrelated business taxable income or UBTI. UBTI is only an issue with leveraged real estate. The concept to grasp here is that the rental income generated by a piece of real estate may be partly attributable to the cash equity investment and partly attributable to the debt secured by the property. The income attributable to the cash equity investment from the qualified account would not be taxed as long as it is distributed back into the qualified account. However, the income allocated to the debt on the property does not originate from qualified money and is therefore taxable, even if it is directly deposited into the qualified bank account. However, it may be that some real estate offerings that have debt may shelter the UBTI using various deductions such as depreciation and or interest expense. Before investing into an alternative real estate offering with leverage, one should evaluate the UBTI issues with a registered representative.
Whether building a diversified portfolio of alternative real estate investments with nonqualified investment accounts or within qualified retirement accounts, the net tax advantages may be approximately equivalent. The reallocated after-tax nonqualified portfolio gains will be fully tax deferred using the QOZ, and cash flow income during the hold period may be fully sheltered due to depreciation and bonus depreciation tax deductions. On the back end, gains from QOZ investments will be fully tax-exempt leaving only gains from private REITs and real estate funds exposed to taxation. The reallocated qualified portfolio will enjoy the tax shelter provision of the plan but subject to the restrictions on distributions with respect to timing and amounts.