Understanding Prohibited Transactions and How to Avoid Them

A self-directed IRA can open the door to many investments that you may have not considered. A short list of investments your IRA may not invest in is spelled out in IRC Section 408 including S-corp stock, life insurance contracts and collectibles such as artwork, rugs, antiques, etc. Discovering such a large magnitude of investment options can generate a lot of excitement. It’s important when exploring possible options for your self-directed IRA that you understand the rules surrounding the investments so that your IRA does not do business with any disqualified member or engage in any prohibited transactions. These rules are discussed in IRS Publication 590-B and Internal Revenue Code 4975.

The IRS does not indicate what investments and transactions are allowable with IRA funds; instead, they identify those that are prohibited. A prohibited transaction can bring into question the tax-deferred status of your IRA, potentially resulting in the disqualification of your account and substantial tax consequences. If it is determined that a prohibited transaction has occurred your IRA would be treated as a distribution as of the first day of the year in which the prohibited transaction took place.

What is a Prohibited Transaction?

Prohibited transactions usually occur when the IRA engages in transactions with a disqualified person.

Who would be considered Disqualified Person?

•  The IRA owner
•  The spouse of the IRA owner
•  Any lineal descendants and their spouses
•  Any lineal ascendants and their spouses
•  Investment advisors and managers
•  Anyone providing services to the IRA such as a trustee or custodian
•  Any entity in which any above person has a 50% or more interest

What Prohibited Transactions commonly occur?

•  Borrowing money from your IRA
•  Selling property to your IRA
•  Receiving unreasonable compensation for managing an IRA asset, such as a rental property
•  Using your IRA as security for a loan
•  Buying property for personal use (present or future) with your IRA funds

These rules were put into place for the IRS to ensure that all of the business conducted with the IRA is for the benefit of the IRA. Because the funds are intended for future retirement, actions that create an indirect benefit for the IRA owner could disqualify the IRA. Common examples of indirect benefits include:

– Indirectly tapping funds for personal use

If two or more IRA owners loaned each other funds to avoid a prohibited transaction, it would be considered an indirect benefit. The parties may not be on the disqualified persons list, but if a party indirectly benefits from the transaction, this action could potentially disqualify the IRA.

– Sweat equity

If your IRA holds a property that needs improvements, providing the labor or having another disqualified person or their company provide the labor would be a prohibited transaction. You would also not be able to use any personal tools or equipment to improve a property held by the IRA.

It may seem like there are a lot of rules to remember on what you cannot do with your IRA. But keeping your IRA from engaging in prohibited transactions is the best way to protect your interest in your retirement. You can easily avoid prohibited transactions by following these three simple rules when contemplating a transaction in your IRA.

First, make sure that anyone your IRA will be doing business with is not a disqualified person.

Second, avoid investing in collectibles, S-corp stock or life insurance contracts.

Third, look closely at the potential transaction with your tax advisor to decide if it would result in an indirect benefit to you or any other disqualified person.

Following these steps can help steer you away from potential prohibited transactions while still leaving the door open for numerous investments.

More information on self-directed IRA investment options and prohibited transactions can be found in our IRA Resource Center.