November 29, 2021

How To Avoid Paying Extra Taxes and Penalties in a Self Directed IRA Part 4 – Prohibited Transactions

If there is one topic that dominates a lot of the Self-Directed IRA content, it’s prohibited transactions. The concept has become something of a bogeyman for Self-Directed IRA investors with articles warning in capital letters about its inherent dangers. There is no denying that in the context of a retirement account, committing a prohibited transaction is a bad idea. It can rack up a lot of unnecessary fines and potentially dissolve your retirement account. As such investors definitely need to avoid them. However, it’s not that hard to do so. A prohibited transaction in essence is just an IRS penalty. The guidelines are fairly clear and a little education goes a long way. Let’s break down some of the IRS guidance on prohibited transactions and find out how to keep your Self-Directed IRA funds safe. 

What is a prohibited transaction in a Self-Directed IRA? 

Prohibited transactions are actions that are forbidden in your Self-Directed IRA. They have two essential elements. The first is the person committing the action. Most people are legally not eligible to perform a prohibited transaction. That’s good news for Self-Directed IRA investors. It means there are only a few people that you have to be concerned for when evaluating a transaction. Collectively these people are known as disqualified persons. Here is the list: 

  • The account holder themselves 
  • A spouse 
  • An ancestor like a father, mother, grandparents, or great grandparents 
  • A lineal descendant like a son, daughter, or grandchildren 
  • A spouse of a lineal descendent 
  • A beneficiary 
  • A fiduciary 

Fiduciary is something of a genral term and for the purpose of interacting with a Self-Directed IRA, it includes the following: 

  • Any individual who manages the IRA account (even partially) or is involved with buying or selling its assets 
  • Any individual who is paid or compensated to provide investment guidance 
  • Any individual who has some kind of responsibility in administering the Self-Directed IRA 

What constitutes a prohibited transaction? 

The second element of a prohibited transaction is the nature of the action itself. A prohibited transaction possesses a dual nature in that a disqualified person may not receive personal benefit from the Self-Directed IRA funds or asset, nor may they give benefit to the account or asset. 

Here are examples of receiving benefit from a Self-Directed IRA that would be considered prohibited transactions. 

  • The account holder makes a short term loan from IRA funds for personal use. 
  • The account holder’s father sells a property to the Self-Directed IRA. 
  • The account is used as a security for a loan that benefits one of the disqualified persons. 
  • The account holder uses Self Directed IRA funds to buy a vacation home which they plan on using themselves two months of the year. (A Self-Directed IRA may invest in a vacation home and treat it like any other rental. Then, when the account holder is of retirement age, the home can be taken as a distribution and used for personal reasons. The only time the property is not allowed to be used for personal reasons is when it is still considered a Self-Directed IRA asset.) 

An account holder or other disqualified person may also not give benefit to the Self-Directed IRA. The reason for this is that any benefit given could technically be considered a contribution and the IRS has strict limits for contributions. With that in mind, the following scenarios would also be classified as prohibited transactions. 

  • The account holder mows the lawn of a property belonging to the Self-Directed IRA. 
  • The account holder’s father does some preliminary rehab work on the property. 
  • The fiduciary of the account lends it money to purchase a timely asset. 

Now this doesn’t mean that the account holder is prevented from having any interaction with the property. Regular administration is permitted, i.e. the account holder is allow to manage the Self Directed IRA asset. This is similar to buying or selling a stock and keeping tabs on it during the year. This is why thousands of Americans are currently managing investment properties in their IRA. If an account holder wants to know where an action crosses the line from permitted administration to prohibited transaction, they should ask an ERISA professional. One of the common rules of thumb used to distinguish between the two is to permit desk labor but not sweat labor. 

Consequences of a prohibited transaction in a Self-Directed IRA 

The tax consequences for a prohibited transaction start off at 15% of the amount involved. This would be paid with Form 5330. The disqualified person who committed the prohibited transaction then has to reverse it. Occasionally it may not be possible to totally reverse the changes. In those cases, the IRS accepts that the disqualified person should undo the prohibited transaction as much as possible without placing the account in a worse position that it was in the beginning. 

If the prohibited transaction is not reversed during the taxable period, an additional tax penalty of 100% is imposed. The taxable period starts at the time the prohibited transaction took place and ends with the occurrence of one of the following (whichever comes first): 

  • The IRS mails out a notice of deficiency. 
  • The tax is assessed by the IRS. 
  • The account holder fixes the prohibited transaction. 

At times the account may lose its tax-advantaged IRA status and be considered as having been fully distributed. 

Banking services – an exemption from prohibited transactions 

If the sponsor of your Self-Directed IRA (e.g. bank or custodian) provides banking services at minimal or no cost, this would not be a prohibited transaction as long as certain criteria are met. 

  • The IRA is for the benefit of you or your beneficiaries. 
  • The bank is allowed to offer the specific services from a legal perspective. 
  • These types of services are actually offered to all account holders at the bank (with accounts of that size) irrelevant is they are retirement accounts or not. 

Do you want to learn more about prohibited transactions?

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