I have been getting a lot of questions about investing IRAs and qualified plans in real estate. The stock market has tanked over the past three years, and interest rates are so low bonds are unattractive. The best opportunity, therefore, is real estate, or so the story goes.

I don’t know if real estate is, in fact, the new frontier of huge profits, but I do know that investing IRA and qualified plan money in real estate presents special issues and traps.

Howard Hughes, the eccentric billionaire, warned against investing in anything that needs fixing or eats. Real estate falls into the first category, and there is special wisdom in his admonition when applied to IRAs and qualified plans.

Background There are two ways to invest directly in real estate. First, the investor can actually own the property for the rental income or appreciation or both. Second, the investor can hold mortgages on real estate for the interest income. I don’t like the direct investment approach, but I really like the mortgages. There is a third, but indirect, way to invest in real estate, and that is through real estate investment trusts (REITs). REITs are publicly traded companies that hold and manage real estate. Shares in REITs are sold like any other stock and mutual fund. They are attractive for plans and IRAs that want to invest in real estate without the direct ownership hassles discussed here.

The federal pension law, ERISA, is a thicket of rules for investments. With respect to real estate, the prohibited transaction and unrelated business taxable income rules present special problems. Of course, overlaying those technical rules are ERISA’s general requirements for prudence and diversification.

Another point needs mentioning. Real estate investing is not for everyone. It takes special skills, special knowledge and experience, and lots of time. If I buy 100 shares of GE stock, I am buying the company along with the professional management that runs it. But, when I buy a rental condo in Hilton Head, I am the manager, rental agent, and plumber. I am competing in that particular real estate market against established and experienced pros. I had better be pretty good to make money.

Direct Ownership An IRA or qualified plan can be the direct owner of real estate. Let’s review the legal and practical issues that arise.

First, ERISA’s comprehensive "prohibited transaction" rules prevent related party transactions. The plan or IRA cannot buy from, sell to, or lease the property to a related party.

The prohibited transaction analysis gets complicated. The prohibited transaction rules appear in two parts of ERISA, one administered by the IRS and the other administered by the Department of Labor (DOL). The two sets are similar, but not identical. The rules contain arcane definitions of who or what constitutes a related party. There are also exceptions and administrative exemptions to prohibited transactions. It takes time to work through all of this.

Second, the plan or IRA must address the unrelated business taxable income ("UBTI") issue. This is a trap. The Internal Revenue Code imposes a tax on otherwise tax exempt entities that engage in businesses that are "unrelated" to their exempt purposes. For example, if the United Way sells shoes in competition with Wal-Mart, the United Way must pay income tax on those profits. The UBTI rules keep the playing field level, so to speak, when charities compete in business with the for-profit entities.

The UBTI rules apply to IRAs and qualified plans because they are tax exempt. The trap in the real estate context is that there is a special kind of UBTI that is generated from "debt financed property." This means that if the real estate is mortgaged (and what commercial real estate isn’t?), the rental income generated may be UBTI. The plan or IRA must then pay income tax.

Third, the plan or IRA must look at the economics of a direct real estate investment. Real estate held outside a plan gets favored tax treatment. The owner gets depreciation deductions along the way and capital gains on the sale. In a plan or IRA, those deductions are wasted and the gains are eventually taxed as ordinary income when distributed to the IRA owner or plan participant.

Fourth, there are administrative issues. Plans holding non-marketable assets must have them appraised annually for the Form 5500. If non-marketable assets comprise more than 5 % of the plan, it must be audited, even though there are fewer than 100 participants (or a bond must be posted.) Finally, minimum distributions must begin when participants or the IRA owner reach 70-1/2.

Fifth, with respect to IRAs, there will be additional expenses because the IRA owner must find a custodian to hold the IRA investment. Unlike the case with qualified plans, the owner cannot be his own custodian. This means finding a bank, trust company, or brokerage firm that agrees to act as custodian, and that may not be easy or cheap.

In short, for most of us small guys, direct investment of IRAs or qualified plan money in real estate is not likely to be a wise move. Let the huge pension funds play that game.

Mortgages This is a horse of a different color. Small qualified plans, and even IRAs, may find investing in mortgages attractive. The rates they can charge for mortgages will exceed those available from conventional CDs and bonds. I have many clients who successfully hold mortgages in plans and IRAs.

A mortgage is merely a debt ---an I.O.U.---secured by real estate. A mortgage holder does not own the real estate. The real estate is only the property put up by the borrower. A certificate of deposit at a bank is a debt instrument---the CD owner is the creditor and the bank is the debtor. A government bond is a debt instrument. The bond holder is the creditor and the government is the debtor. If the government defaults, I have a claim against the government. If the bank defaults on the CD, the FDIC guarantees it. If the mortgagor defaults on the mortgage I hold, I can sell (i.e., foreclose) the real estate put up as security.

When qualified plans or IRAs invest in mortgages, they do not run afoul of the UBTI rules. Reason: the plan or IRA is only loaning money (i.e., is a creditor). It doesn’t own the real estate that is put up as security. And, if an appraisal is needed for 5500 purposes because the mortgage is a non-marketable investment, the face amount of the debt should be its value. The out-of-pocket costs for a mortgage investment are therefore minimal, when compared to owning real estate directly.

The only trap for plans or IRAs investing in mortgages is the prohibited transaction rules. As long as the loan is not made to a related party, there is no problem.

For example, my next door neighbor needs a second mortgage on his home to add an addition or pay college expenses. My 401(k) or profit sharing plan can loan the money, take a mortgage, and charge interest that is higher than the current CD rates. If the home has sufficient equity, and my neighbor is financially responsible, this can be a good deal for both of us.

There are some traps. Be careful if the owner of the plan or IRA is in the real estate business. If a real estate broker or developer is making mortgage loans to his clients (i.e., making a loan so a deal can close and the plan owner earns a commission), there is a risk of self-dealing. That is a violation of ERISA.

IRAs can get into the mortgage market. There are many more IRA custodians who are willing to hold mortgages than ownership positions in real estate. Many bank trust departments will act as custodians for these kinds of investments.

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