Self-directed IRAs offer ample freedom, flexibility, and a wide range of alternative investment options, empowering individuals to manage their retirement funds. However, it is crucial to remember that these IRAs are subject to specific IRS regulations regarding prohibited transactions, adherence to which is necessary to prevent the forfeiture of the tax-deferred status of your account.
The Internal Revenue Code (IRC) 4975 is where the IRS provides a comprehensive explanation and overview of these prohibited transactions within Individual Retirement Accounts (IRA).
Two Types of Prohibited Transactions
- Prohibited investments
- Transactions with disqualified persons
It is highly advisable to familiarize oneself with the rules and regulations regarding prohibited transactions and associated penalties outlined in IRC Section 4975 if utilizing a self-directed IRA or solo 401(k) and to ensure thorough comprehension.
Here are a few instances of investments that are not permitted for your IRA and transactions that your IRA must avoid. The purpose of these sections is to offer general guidance and comprehension of IRS regulations. It is recommended to consult with a CPA or another professional to receive assistance in understanding the permissible investments and transactions that your IRA can engage in with disqualified individuals.
Prohibited Investments in an IRA
The IRAS place clear guidelines on what investments are prohibited, and this list is relatively short in comparison to the wide range of alternative assets that your IRA is permitted to hold. Prohibited investments in IRAs include life insurance and collectibles, as mentioned in specific examples provided by the IRS.
- Works of art
- Rugs
- Antiques
- Gems
- Stamps
- Alcoholic beverages
- Coins and other precious metals that do not meet IRS standards for precious metals investments as described in IRC Section 408(m)
Transactions with Disqualified Persons
Prohibited transactions are intricate and involve transactions that your IRA is not allowed to engage in with disqualified individuals or entities, which includes yourself.
You and other disqualified persons are not allowed to:
- Borrow funds from your IRA, including private lending transactions where a disqualified person is the borrower
- Use your IRA as security for a loan
- Rent property your IRA owns
- Vacation in your IRA-owned property
- Receive personal income from rental property your IRA owns
- Perform work or other services including sweat equity for assets in your IRA
- Purchase assets from your IRA (like a house)
- Sell assets to your IRA
Please bear in mind that the mentioned examples of prohibited interactions with disqualified individuals are merely a handful. This inventory is not exhaustive, as there are numerous possibilities for you and/or your IRA to unknowingly infringe IRS regulations if you fail to fully comprehend the intricate details of IRA rules.
Self-Directed IRA LLC Prohibited Transactions
Investments made through an IRA LLC may be considered prohibited. This encompasses putting the IRA LLC’s funds into the following investments:
- life insurance [see (IRC Secs. 408(a)(3) and 408(e)(5)(b]; and
- certain collectibles [ See (IRC Sec. 408(m)]
Please be aware that when life insurance is invested in IRA LLC assets, only the portion of the funds utilized for the investment will be deemed as distributed and subject to taxation, rather than the entire IRA LLC.
It should be noted that collectibles encompass various items such as artwork, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, or any other tangible personal property as determined by the U.S. Treasury Secretary.
A prohibited transaction can also result if the IRA LLC assets are pledged as security for loans, and if the IRA participant takes loans from the IRA LLC.
If the IRA LLC investments are utilized by the participant or a disqualified party (such as the participant’s spouse, children, parents, trust, or business) in a way that serves their own interests, it can lead to a prohibited transaction. These regulations have been established to guarantee that the assets of the IRA LLC are invested in a way that benefits the IRA LLC and not the participant.
Additional details about the IRA LLC prohibited transactions can be found in IRC Sections 408(e), 408(m), and 4975, along with the corresponding Treasury regulations. Furthermore, IRS Publication 590, Individual Retirement Arrangements (IRAs), offers a general overview of the topic.
Following are some examples of prohibited transactions with IRA LLC funds.
- The IRA LLC participant or other disqualified party borrowing money from the IRA LLC
- IRA owner (or disqualified persons) selling property to the IRA LLC
- Receiving compensation for managing the IRA LLC
- Using the IRA as security for a loan ((IRC Sec.408(e)(3) and (4))
- IRA LLC participant buying real estate for personal use with IRA assets
- As described above, investing the IRA LLC in life insurance or collectibles
Please be aware that although a solo 401k plan permits participant loans, this is not the case for an IRA LLC. If an individual with an IRA LLC decides to borrow from their IRA LLC, the IRA will no longer be recognized as an IRA starting from the first day of the tax year in which the loan is taken. The fair market value on that specific date will be considered as distributed and will be subject to relevant taxes.
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