Are you familiar with the concept of a prohibited transaction in relation to an IRA, particularly a self-directed IRA? It refers to a transaction that benefits the owner of the IRA instead of benefiting the retirement account, and this jeopardizes the tax advantages associated with the IRA’s status. According to the IRS, prohibited transactions are specific transactions between a retirement plan and a disqualified individual that are prohibited under the law.
Who is considered a disqualified person? The Internal Revenue Code Sections 408 and 4975 provide a definition for this individual, typically encompassing the IRA holder, their ancestors, their descendants, and their spouses; individuals responsible for managing the account, such as financial, investment or tax advisors; and any entity controlled by them with a minimum ownership stake of 50%. This definition also encompasses business partners and individuals who render services to the account, such as accountants or attorneys.
Three Types Of Prohibited Transactions
Understanding three important types of prohibited transactions is crucial.
- Per se: The IRA engages in a transaction with a disqualified person as described above.
- Extension of credit: The IRA lends money or extends other credit to a disqualified person, such as guaranteeing a loan to the IRA.
- Self-dealing: The IRA owner or other disqualified person benefits from the investments within the retirement account. Examples of this are earning personal commission on investments made by the IRA; selling, exchanging or leasing property between the retirement plan and disqualified person; or furnishing goods, services or facilities between the parties.
Prohibited Transactions Related To Alternative Assets And Self-Directed IRAs
Some examples include investors unknowingly engaging in prohibited transactions through certain asset classes such as real estate, precious metals, private equity, and promissory notes, among others, with self-directed IRAs offering the opportunity to invest in a wide range of alternative assets.
Real Estate
If the individual uses personal funds to purchase or lease the investment property, it would be considered a prohibited transaction as all income and expenses associated with the asset must be processed through the self-directed IRA.
There are other instances relating to real estate, such as:
- A person loans money to a real estate developer and in lieu of loan repayment and/or interest on the loan, that individual lives in the property rent-free. This would be considered self-dealing.
- A person creates an IRA LLC (for purposes of making real estate investments), taking out a mortgage for the property and personally guaranteeing it. Another similar example in this situation would be applying for a credit card to use for materials and repairs. This would be considered an extension of credit.
- The self-directed IRA account owner or other disqualified person performs certain services (repairs or maintenance) to reduce expenses. This would also be considered self-dealing. Performing any sweat equity while an IRA is the owner of the real estate is prohibited.
Precious Metals
Investments in precious metals violate IRS regulations when the spot prices do not align with the prevailing market rates for the asset. The spot price refers to the immediate availability and purchase price of the precious metal, as opposed to future contracts.
In the event that the broker dealer selling the coin or bullion at a spot price that deviates significantly from the market rate, the IRS may categorize the asset as a collectible. As a result, it would not be permissible to invest in such assets within an IRA and engaging in such a transaction would be considered prohibited.
Private Placements
A private placement involves the private sale of a security (such as common stock, preferred stock, or promissory note) to a limited group of investors, rather than being publicly traded or registered with the SEC. These placements usually involve investments in joint ventures, limited partnerships, hedge funds, and startups. It is considered a prohibited transaction if the owner of an IRA account receives a direct commission from the investment, personally benefiting from the IRA’s investment.
Although there are certain guidelines to adhere to, a self-directed IRA offers considerable flexibility. Investing in real estate through this type of IRA closely resembles investing in real estate outside of it, with the exception that the IRS prohibits certain actions as outlined in IRC Section 4975. These rules pertaining to investments are the primary distinctions between IRA investing and conventional real estate purchases, aside from the significant tax advantages involved.
Self-Directed IRA Real Estate Rules
1 – Buying or Selling a Property to or From Your Self-Directed IRA
Q: May I move the properties I already own to my self-directed IRA?
B: It is not possible to transfer any possessions that you already own into your IRA.
What will happen if the property is owned by my company?
B: It is prohibited if your company owns it, with the same rules applying.
A: “However, consider the scenario where the property is being used for investment purposes.”
B: Regardless of the purpose, if you already own it, the transaction is forbidden.
Is it possible for me to receive a commission for listing a property that my IRA wants to purchase or sell?
A: Although you can advertise your property independently, you are not eligible to receive any payment for doing this.
What makes these transactions classified as prohibited? The IRS strictly forbids “self-dealing,” which refers to any transaction between the individual and their IRA. If you already possess the property you desire to purchase using your IRA, that particular transaction is prohibited.
2 – Combining IRA and Personal Funds Or Property
Is it permissible to utilize funds from your IRA LLC and subsequently reimburse them in order to cover a non-IRA expenditure?
As previously stated, being a disqualified person for your IRA means this action is prohibited. It is not permissible to mix personal and IRA funds; they must remain completely separate.
Is it possible for me to deposit the rental check from my IRA into my personal bank account in order to promptly pay a contractor?
B: Whether the funds are en route or urgently required, merging personal funds with IRA funds is prohibited and constitutes a prohibited transaction.
Is it possible to utilize my property, owned by an IRA, as collateral for a personal loan?
B: Your IRA and personal assets and investments are separate entities, therefore it is not permitted.
3 – Personally Living, Using, Or Working on the Property
Can I purchase commercial real estate, lease the building to others, and also utilize one office space personally?
A: It is forbidden to use the property even a single time.
Is it permissible to purchase a vacation property using my IRA funds?
A: Yes, however, it is not possible for you to stay in the property owned by your IRA, even if it’s just for one night. Therefore, you would be unable to use it for vacationing purposes.
Can I personally renovate the IRA property?
A: No. Since you are saving money by performing the task yourself rather than paying someone else, it is not permitted.
Is it possible for me to act as the handyman for my rental property?
A: It is against the rules to save money on maintenance costs by personally doing the work.
Is it permissible for me to purchase undeveloped land and construct a building on it on my own?
A: Although it is possible to purchase vacant land, it is recommended to enlist the services of a construction company as it would be advantageous for you to undertake this task yourself. Q: Am I allowed to purchase vacant land for personal farming or employment purposes? A: Regrettably, you are not permitted to do so. The account-holder is prohibited from engaging in any form of work, whether temporary or continuous. However, you have the option to hire an eligible individual to carry out such tasks.
What is the reason behind these transactions being labeled as prohibited? The IRS prohibits individuals with IRAs from contributing “sweat equity” to their investments, unless there are specific circumstances. Sweat equity involves labor or services provided for the property that would typically require payment by the IRA if it wasn’t for your efforts. The money you save through this labor is perceived by the IRS as an indirect benefit, which is not allowed within your self-directed IRA.
4 – Buying or Selling a Property to Or From A Disqualified Person
What if I desire to use my IRA to purchase my parents’ house?
A: This is not permissible according to the IRS as both of your parents are disqualified individuals.
Can I sell a property that is in my IRA to my daughter?
A: Since your daughter is considered a disqualified person, this action is not allowed.
Is it possible for my individual retirement account to purchase property that is owned by my wife’s individual retirement account?
A: Regrettably, your wife does not qualify for this.
What makes these transactions classified as prohibited? The IRS aims to avoid any personal advantage, whether it be tangible or intangible, that may result from conducting a transaction with your IRA. This pertains to the self-directed IRAs’ “arm’s length” condition, which demands that all transactions be carried out independently from the account holder, ensuring no personal benefit is gained from the investments.
5 – Disqualified Persons Living, Using, Or Working on the Property
Q: May I buy a house for my daughter to live in during college and then rent out?
A: Due to your daughter being considered a disqualified individual, it is not permissible for her to reside in the property that you may choose to purchase. While you have the option to buy a property and lease it out, please note that your daughter is strictly prohibited from residing there, even temporarily.
Am I allowed to have my parents, children, or financial advisor stay in the property, even for a single night?
A: It is absolutely prohibited for you and any disqualified individuals to occupy the property in any capacity, whether for residency, vacationing, or even just for a single night.
Can I hire my son’s construction company to carry out work on my property owned by my IRA?
A: No, if your son holds a controlling ownership in any company, that company would also be considered disqualified due to his status as a disqualified person.
Why do these transactions fall under the category of prohibited? The IRS operates under the assumption that any advantage provided to a disqualified individual, whether direct or indirect, may ultimately benefit you. Hence, the same regulations that apply to self-dealing and sweat equity extend to disqualified individuals. Such individuals are barred from utilizing or engaging in work related to the property, irrespective of receiving compensation for their services. The objective is to prevent obtaining advantages through tax evasion, unspoken reciprocal arrangements, or any other potential agreements.
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