Is an employee able to invest his or her 401(k) in a real estate investment?
Rev. 12/20/07, E-mail Alert 2007-17

It depends. First, the plan document would have to permit this type of investment.

If the plan permits this, the next concern is that the prohibited transaction rules have to be carefully followed. Construction or development on the property would be permitted by an outside developer, but not necessarily by the participant. The account would have to pay for the work that increases in the value of the property. If the participant makes the improvements, any payment to the participant would become a transaction between the plan and a party in interest.

May the employee construct a house and then move into it? No, that is also a prohibited transaction.

Can property be rented? Yes, but this may result in unrelated business taxable interest or UBTI. This may cause the plan’s otherwise tax-exempt trust to be subject to taxation.

If taxes are owed, the individual would have to have enough cash in their account to cover these expenses. In addition, the participant will need to have sufficient assets to pay the usual and customary expenses for the property, including real estate taxes. If taxes are paid by the individual rather than the plan such payments would be a contribution to the plan. In addition, there would have to be enough cash to pay any required minimum distributions that are due to be paid. If there is insufficient cash, then the property would have to be sold to make the RMD payment, or the entire property could be distributed if the plan permits in-kind distributions.

Violating the prohibited transaction rules is a costly lesson to learn the hard way. Legal advice is recommended before investing your retirement plan assets in real estate.