Pension Plan Investing in Real Estate
By Diane Kennedy, CPA
There are a lot of reasons why you may consider using your pension funds to invest in real estate. It could be that your pension is the single biggest source of funds you have right now. It may even be the only source of funds you have right now. If you are going to invest, it needs to be done with your pension.
It could be that you’re looking for real estate to provide better and safer returns than traditional “wait and hope” investments.
Or it could be that you realize you could save on taxes if you use your pension plan to invest in real estate.
In this Home Study Course, we’re going to look at the benefits of using your pension plan to invest in real estate, some strategies you can use and the potential problems you need to avoid.
Three Retirement Problems Real Estate Can Solve
Chances are if you are reading this Home Study Course, you had one of three problems you wanted solved:
- You want to access your pension funds to buy real estate,
- You want to rapidly grow your pension fund, and/or
- You want to turn the pension you have into supercharged cash flow.
Let’s start with cash flow. After all, you can have a pile of cash but unless it’s a really big pile of cash it won’t help much with your retirement. You need to have a return on that pile of cash that creates cash flow.
Two Parts to Cash Flow
Want more retirement income? You have two options:
(1)Grow the pile of cash you have invested, and/or
(2)Convert the pile of cash to cash flow more efficiently.
If the income you receive from your retirement funds is high enough, you will never need to touch the capital.
I want to stress this. If your return is high enough, you don’t need a lot of money invested.
The Best Strategy of All
There are a lot of different formulas for determining how much money you need to have put away. For me, there is really only one. It’s actually an equation:
Investment Amount x Return = Income or Cash Flow
As long as that income is higher than your monthly expenditures (with an amount included for unexpected emergencies), than you will never run out of money.
Never.
You have an infinite supply of wealth. It will last forever. As long as the return stays higher than your need for it.
Recently, I talked to a friend who was investing mainly in dividend producing stocks. The return would be about 3 – 5%. In other words, if you invested $100,000, you were pretty sure you’d receive somewhere between $3,000 - $5,000 in a year.
Since that probably isn’t enough to live on, you need to have more than $100,000 invested in the dividend-producing stocks if that is your sole srategy.
At the same time, my husband and I are looking at some real estate projects in an area that has a severe rental unit shortage. We can get 12% cash on cash return with our investment. So, if we invested $100,000 we would receive a conservative $12,000 that is $1,000 per month.
That includes an amount set aside for vacancy and repairs.
It’s not just the amount you have set aside for your retirement. It’s also what your return will be on your pension.
While you’re thinking about your retirement and pension, remember to consider both parts of the equation:
The amount you have to invest, and
The return you have on your investment.
Wealth As a Measurement of Time
One of my most important ah-ha moments during the years I toured with Robert Kiyosaki (“Rich Dad Poor Dad”) speaking on stage and presenting as his CPA, had to do with the concept of wealth.
So far, throughout this book, you’ve looked at how much money you need in your pension to fund your golden years.
Let’s instead look at it as a measurement of time.
Let’s say you have to quit working right now. Period. No more earned income.
How long can you last on your investments?
If you’ve got them stuck in a money market and don’t know how to convert them to higher income producing assets, you better have a lot of cash because you are going to need it.
Let’s say you have a burn rate of $5,000 per month and you have $50,000 saved away that is not producing any income.
You’ll be out of money in 10 months. You can probably stretch that out a little longer by reducing your expenses.
On the other hand, if you had $50,000 in cash you may invest in websites that already produce income. You may still need to stay involved at some level (think “4 Hour Workweek” and its plan for outsourcing) but it’s more of a management role to keep the company running. It’s not uncommon to make $25,000 or more per year in net profit from a $50,000 website.
Knowing that, which do you need? A bigger pile of cash or a better way to turn it into cash flow?
How long can you last based on your current pension balance and the income it makes? If you eat into your principal in order to live, you will eventually run out of money.
The safest plan is to increase your income and/or decrease your expenses.
Mistake of Cash Flow
The term “cash flow” implies that cash flows to you. It could flow the other way, costing you money every month to keep a so-called investment, but that’s not a wealth plan.
If you have a real estate property right now that is costing you money every month, consider what you need to do to change that.
And, no, paying off the mortgage is not an acceptable answer. If you have to eliminate debt to make a real estate investment pencil, it’s no investment. It’s a money pit.
Watch your real estate returns and you’ll find that you can retire much faster than you expected!
Otherwise, if you fall in love with a property even though it doesn’t make financial sense, realize that you’re hanging on to it at the expense of your time freedom.
Quickly Build Up Your Pension
Do you have enough saved up in your pension? If not, you may need a plan to quickly build up the pension amount.
The slow but steady path is to live below your means and fund your pension with as much as possible.
You’ll be limited by a couple of things, though. One is the government limitation on how much you can put away in your pension per year. The other issue is that it’s a slow method. You could simply be too close to retirement to play catch up now.
If you have some money in your pension and want to invest in real estate, you may want to consider doing fix and flips or wholesale.
Normally, if you did this kind of investing with after tax money, you would be considered a real estate dealer. That means you’d be subject to self-employment tax of 15.3% plus if you tried to carry a mortgage on the sale, you’d have to pay tax on all the gain all up front. There is no way to delay the tax even though you have to wait to get paid. That all has to do with the falling into the real estate dealer status.
Your pension plan can’t be a real estate dealer, though. That’s a designation for individual investors. Your pension plan can do fix-n-flip properties without tax at least not until you take a distribution.
This can be a way to build up your pension more quickly. There are a couple of rules, though, if you decide to flip properties with your pension plan.
For the most part, assume that a property bought with your pension funds must have all rental income going to the pension fund and all rental expenses must be paid from the pension fund. Make sure you have enough cash in the fund account to pay these expenses! If you suddenly need to replace a roof, you can’t put money into the property or into the retirement account to pay for it. The pension needs to either pay for it directly or get a third party loan.
Another rule is that you can’t personally do any work on the property. If you have a fix and flip, it might be very tempting to pick up a hammer, but you simply can’t do that. You can pick up a phone to hire someone, but you can’t do the work yourself. Remember you must pay for the work from the account.
Convert Pension Money to Cash Flow
You may already have a funded pension plan, but it’s providing you a pretty low return.
For example, when I took over my elderly mother’s investments, she had plenty of money set aside, but she actually had NO guaranteed cash flow. She just depended on the market going up in value at a time when she needed to take a withdrawal. That’s a great plan for someone who is younger and building up their investments, but when you’re older and rely on regular cash flow, it’s a dangerous plan.
What’s the right investment plan for you? There is no one answer that is always right. The right strategy depends on your own circumstances and goals.
If your concern is getting a better return for the money you already have saved, then real estate can be a good, reliable way to get that cash flow.
It’s not uncommon to get a 10% cash on cash return for money you invest in real estate.
Cash on cash return is calculated as the net annual cash flow divided by the total amount of cash you have invested.
For example, let’s say you buy a $100,000 single family home with 30% down. That would be $30,000 cash invested. For purposes of this example, we’ll assume that there is no downtime until it’s rented and there are no additional expenses in order to get it ready to rent.
You rent the property for net cash flow of $250/month. That’s cash flow after you’ve paid the mortgage payment, property tax, insurance and any other expenses associated with the property.
Your annual net cash flow is $3,000. And the amount you had invested was $30,000. That means your cash on cash return (COCR) is 10% ($3,000/$30,000).
If you have $500,000 saved up, the difference between a real estate investment strategy and dividend/fixed income paper asset strategy can be the difference between a 10% and a 3% return. Would you rather have $50,000 or $15,000 per year to live on?
There are a few things to watch out for here as well. You can’t personally guarantee the loan for the property if your pension buys it. If the property needs a cash infusion, you can’t give it to the pension unless you make a legal pension contribution. You can’t make a loan to your own pension, but it could get a third party loan from an unrelated party. You can’t do fix-up work yourself. You have to get an outside party to do that work.
And, just like with the flip strategy, it’s best to operate through an IRA LLC or Solo 401(k). It just makes things easier.
Free Up Your Pension Money for Investments
There are real estate deals still all around. Some regions are showing signs of being over-heated again and some areas haven’t recovered and maybe never will.
Of course, you need to buy right so that they are sound investments. As far as using a pension plan to fund the investments. There is a right way to do that. There are actually several right ways.
Pension Plan Access Tip #1: If you have an IRA, set up an IRA LLC. The LLC will be owned solely by your pension plan. You can be a manager of the LLC and thus direct how the funds will be invested. If you have a Solo 401(k) you can act as trustee and so won’t need an LLC to work with the pension.
Pension Plan Access Tip #2: Partner in an LLC with other pension plans. Your pension can partner with other pension plans if it turns out you don’t have enough money in your own pension to make the investment you want.
Pension Plan Access Tip #3: Partner with family members. You can’t ‘self deal’ by renting to your parents or hiring your child for an investment with your pension, but you can partner with a family member through an LLC to buy and run a property.
Pension Plan Access Tip #4: Partner with yourself. There are some strict rules regarding how much ownership you can have when you partner with your own IRA. In general, figure you’re going to need to take a much smaller percentage and you must still follow the rules regarding avoiding self-dealing. You can’t rent to yourself, buy or sell to yourself or actively work on the real estate.
How NOT to Access Your Pension
We talked about some smart ways to access your pension money for real estate. Now, let’s talk about how NOT to access your pension.
Don’t take an early withdrawal.
You can use this money to invest and grow, tax-deferred. You can control the investment. You can do all that and avoid taxes and early withdrawal penalties that result from early withdrawals.
If you take an early withdrawal, you’ll have to pay tax and penalties.
If you use the strategies in this Home Study Course, you can avoid having to pay tax and penalties.
It’s that simple.
Why Real Estate?
At the end of the day it comes down to deciding whether investing in real estate is a smart choice for you.
There is nothing magic about real estate investments, other than it’s a proven way to more quickly grow wealth and more efficiently turn a pile of cash into reliable cash flow.
You can save your way to a big nest egg, provided you have enough time. You can create a reliable cash flow with dividends and fixed income strategies, provided your nest egg is big enough.
If you need a shortcut, real estate investing may be able to do that for you.
Why NOT Real Estate?
Not all real estate is created equal. There is no regulatory agency looking out for your interests and no way to insure you’ll actually get the return you hope you will. It takes a certain kind of person to take that kind of risk and be responsible for the outcome, good or bad.
It’s not the best choice for everyone.
You have to be disciplined. You have to be ready to take action. You need to make some hard decisions about tenants and property. And, above all else, you have to trust your advisors especially if you’re investing with your pension fund.
If you’re investing through a pension plan, the rules are stricter than if you’re investing with your own funds. Make sure you have the right information and your strategy is in compliance. You will need to hire an expert to help you with numerous steps. If you want to do-it-yourself, you may get yourself in trouble if you’re not careful.
Now, let’s look at the basics of pension investing.
Basics of Pension Investing
By now, you undoubtedly know about all of the benefits of investing in real estate with your pension. Before you jump in, though, there are some basics to understand.
What can you invest in? What can’t you invest in? What types of pension plans will work for this strategy?
Legal Investments in Your Pension Plan
What CAN you invest in? The answer is actually not that easy to explain.
You can invest in anything that isn’t a prohibited transaction and is not with a disqualified person.
So, the way to answer what you can do is to first answer what you cannot do.
No Transactions with Disqualified Persons
Internal Revenue Code Sections 4975 & 408 prohibit fiduciary and other disqualified persons from engaging in certain type of transactions. The definition of a disqualified person (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
Let’s break that down into plain English.
The following are, generally, considered disqualified persons:
- The IRA holder,
- The IRA holder’s spouse,
- The IRA holder’s ancestors and lineal descendants,
- Spouses of the IRA holder’s lineal descendants,
- Investment managers and advisors,
- Anyone providing services to the plan (IRA), e.g., the IRA trustee or custodian, and
- Any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest.
You can’t participate in self-dealing. That includes any kind of dealing between your parents or your children and real estate owned by your self-directed pension.