A self-directed IRA can open a world of investment possibilities, to go with the tax-related benefits of investing through an IRA. You can invest in private companies, gold, commercial property, raw land, multi-family housing developments and more. You even have the power to use your investments to shape your community or help green companies succeed. But with the ability to tailor your IRA investments to your interests comes a responsibility to keep a certain distance between you and your investments. The rules for IRA investing are designed to ensure that IRA owners (and certain others) aren’t getting an additional, personal benefit from the investment on top of the tax benefits associated with saving for retirement in an IRA (e.g., tax deductions and tax-deferred growth with Traditional IRAs and tax-free growth with Roth IRAs). These “prohibited transaction” rules dictate what not to do with your IRA to stay on the right side of the tax laws.
Certain transactions between the IRA owner or another disqualified person and the IRA are not permitted. Improper transactions include:
• Selling property to your IRA or purchasing directly from your IRA
• Borrowing money from or lending money to your IRA
• Providing materials or services to your IRA investment
• Transferring IRA income or assets or using such assets for the benefit of the IRA owner (outside of the benefit of growing assets for retirement) or disqualified person
• Receiving payment or consideration from any party dealing with a transaction involving the IRA
In addition to the IRA owner, the following individuals cannot engage in an improper transaction with the IRA:
• IRA beneficiary
• IRA custodian or other service provider
• IRA fiduciary (e.g., investment advisor)
• IRA owner’s spouse, parents, grandparents, children (and their spouses), and grandchildren (and their spouses)
• Entity (e.g., business) of which a disqualified person owns 50% or more
If you engage in a prohibited transaction,
• Your IRA immediately becomes taxable, based on the value as of the first day of the year
• The taxable amount will be subject to the additional 10% early distribution tax if you are younger than age 59½
Here are some examples to help illustrate how prohibited transactions can occur and the consequences.
Example: Freida has a self-directed Traditional IRA. One of her IRA investments is a vacation property off the Pacific coast of Mexico that has been used as a VRBO. The property is valued at $500,000. Freida is ready to move to the beach and wants to purchase the property from her IRA.
If Freida purchased the real estate held by her IRA, her entire IRA would become taxable to her that year. She may, however, request an in-kind distribution of the investment from her IRA. In this case, the IRA custodian would transfer the title of the property from the IRA to Freida and report that Freida took a taxable distribution worth $500,000 this year.
Example: Taking an interest in helping community businesses succeed, Ruth has used her IRA assets to invest in a few local start-up companies. Her IRA now has a 55% controlling interest in a restaurant specializing in farm-to-table locally sourced food. Ruth wants her son Tom, to be hired as head chef for the restaurant.
This would be a prohibited transaction because a disqualified person is performing services for the IRA investment, and the IRA owner is benefitting by securing a job for her son. Ruth’s IRA would cease to be an IRA as of January 1 this year, and she would have to include the value of her entire IRA in her taxable income for the year.
WHAT TO DO
Do your research. To avoid the tax consequences of disqualifying your IRA, it’s important to understand the prohibited transaction rules and avoid any type of investment or transaction that could be perceived as improper. IRA owners are responsible for determining the appropriateness of an investment, analyzing the risks associated with investments, and avoiding potential prohibited transactions. An IRA custodian generally cannot assist in determining if an investment or transaction would violate the prohibited transaction rules. If you have a question about a potential investment, seek assistance from your financial or legal advisor before directing your IRA custodian to purchase the asset on behalf of the IRA.
For more information, see IRS Publication 590-A, Individual Retirement Arrangements.
Disclaimer: The information provided herein does not, and is not intended to, constitute personalized financial or legal advice. The contents of the article are for general informational purposes only and should not be relied or acted upon without specific professional legal or financial advice, based upon an individual’s situation.