Prohibited Transactions and Disqualified Persons are important topics to consider when working with a Self Directed IRA. Failing to understand Prohibited Transactions, or to find an advisor or firm that does, may lead to the disqualification of your self-directed IRA, resulting in possible taxes and penalties. This article will outline the importance of disqualified person(s), prohibited transaction(s), and common mistakes self-directed IRA owners should avoid with their self-directed IRA. The prohibited transactions rules are intended to ensure that the assets of a plan are invested in a manner that benefits the self-directed IRA itself and not the self-directed IRA owner. This is intended to prevent a person, such as the IRA holder, from using the assets of their self-directed IRA for personal benefit. It is incredibly important that the IRA holder not engage in any ‘transaction’ with his or her IRA. Consequently, transactions involving the self-directed IRA must be “arms-length” and free from any direct exploitation by the self-directed IRA owner.
An IRA owner may not invest in property that he/she, a relative, or his/her business, already owns. Prohibited transactions are transactions that occur between the self-directed IRA and disqualified person(s). 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
- Any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest
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Understanding what constitutes a prohibited transaction is very important when it comes to making investments within a self-directed IRA. A prohibited transaction can bring into question the tax-deferred status of the account, resulting in the disqualification of the self-directed IRA and severe tax and penalties. Prohibited transactions fall into two general categories: Prohibited Investments and Prohibited Transactions. The Internal Revenue Code (IRC) defines a prohibited transaction to include any direct or indirect:
- Sale or exchange, or leasing, of any property between a plan and a disqualified person;
- Lending of money or other extension of credit between a plan and a disqualified person;
- Furnishing of goods, services, or facilities between a plan and a disqualified person;
- Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan in his own interest or for his own account, or
- Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
- Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving income or assets of the plan.
Often, self-directed IRA custodians communicate to the self-directed IRA holders that they should consider their self-directed IRA separately from themselves as individuals. It is important to understand that for purposes of the IRS code you and your self-directed IRA are separate entities whose interests are not related. Understanding this nuance will reduce the number of potential issues that may arise when you make investments using your self-directed IRA.
Common Prohibited Transactions
- Borrowing money from an self-directed IRA
- Using the self-directed IRA as security for a loan
- Selling personal assets to the self-directed IRA
- Buying property in the self-directed IRA for personal use
- Purchasing property from a disqualified relative i.e. Spouse, Children, Parents of the self-directed IRA holder.
- Issuing a mortgage on a disqualified relative’s residence
When an IRA is involved in a transaction that is considered ‘prohibited’, the IRA loses its tax-exempt status and the IRA holder is deemed to have received a distribution on the first day of the tax year in which the prohibited transaction occurred. The value of the IRA is treated as if was distributed to the IRA holder and must be included in the IRA holder’s income for that year. Unless the IRA holder has reached age 59½ or is disabled, this distribution is subject to the 10 percent penalty tax on early distributions. These are hefty penalties that can rapidly diminish the benefits of the self-directed IRA.
Individuals who consider making, or have made, alternative asset investments in their self-directed IRA must be vigilant and responsible for each action they take. Becoming aware of the prohibited transaction and disqualified person rules will help them avoid tax consequences by not tripping over these fundamental rules. Individuals should contact a knowledgeable self-directed IRA custodian, attorney, CPA, or financial advisor, with a track record of working with self-directed IRA’s, for more details.