When researching Self Directed IRAs, you may come across the term “prohibited transaction”. A “prohibited transaction” is an improper transaction between an IRA and a disqualified person. Later in this article we will discuss exactly what an improper transaction is and who is considered a disqualified person. A good rule of thumb is that an IRA may transact with third parties, but may not transact with close family members or closely held entities.
In essence, prohibited transactions do not limit WHAT an IRA can invest in, but rather WHO an IRA can transact with. For example, an IRA may purchase a well-priced rental property from a friend, but that same IRA cannot purchase property from a parent, spouse, or child.
Congress passed the Employee Retirement Income Security Act of 1974, commonly known as ERISA, with the intention of helping Americans save for retirement. Tax advantages were offered to encourage Americans to participate in such plans. Congress incorporated prohibited transaction rules into the act to prevent people from taking advantage of these specialized retirement accounts.
Prohibited transactions can be broken down into 3 categories:
- Per Se Prohibited Transactions
- Extension of Credit Prohibited Transactions
- Self-Dealing Prohibited Transactions
A Per Se prohibited transaction takes place when an IRA “transacts” with a disqualified person. The Internal Revenue Code defines a “transaction” as a sale, lease, lending of money or extension of credit, or the furnishing of goods and services.
Some common examples of Per Se Prohibited Transactions are:
- An IRA owner purchases property which he/she already owns personally with retirement funds.
- An IRA owner leases his/her IRA-owned property to their son or daughter.
- An individual rents his/her IRA-owned property to a company that they personally own.
of the above transactions are perfectly permissible when performed with
third parties; they only become problematic when performed with
The IRS allows IRA owners to obtain financing for investment purposes. However, loans issued to an IRA can only be guaranteed by the item being purchased and not by an IRA owner’s personal guarantee. For example, if an IRA owner is interested in purchasing real estate and only has 40% of the purchase price available, he or she may obtain the balance from a third party lender. The loan must be backed by the property, not by the borrower’s personal guarantee. If the IRA holder defaults on the loan, the lender may foreclose on the property, but may not pursue the IRA owner’s personal assets. The IRS explains that by personally guaranteeing a loan issued to your IRA, you are providing a personal benefit to your retirement account, which would be considered a prohibited transaction. To avoid this issue, loans issued to an IRA must be non-recourse.
Obviously, IRA owners can only borrow funds from non-disqualified persons. (Otherwise they would violate Per Se prohibited transaction rules.) Additionally, when an IRA obtains financing to place an investment, the profits attributable to the financed portion are subject to a tax known as UDFI (Unrelated Debt Financed Income).
IRA owners should be advised that there are lenders who specialize in issuing non-recourse loans. Such lenders are familiar with prohibited transaction rules and structure such loans properly, thereby avoiding negative tax consequences. To compensate for the lack of a personal guarantee, the lender may require that the property be income producing, and that the debt-to-equity ratio be between 60%-70%.
Some common examples of Extension of Credit Prohibited Transactions are:
- An IRA owner is seeking to purchase a property and does not have enough capital. The IRA owner approaches a local bank and obtains a loan issued to the IRA. The borrower then personally guarantees repayment of the loan. While the borrower did well by borrowing from a third party and attributing the loan to their IRA, they should not have personally guaranteed the loan as they were providing a personal benefit to their retirement account.
- An IRA owner is interested in purchasing a rental property from a friend. However, the IRA owner only has 50% of the funds necessary for the purchase. His friend recommends that they structure a “seller-financing” deal, where the IRA owner pays 50% upfront and the balance in installments. The IRA owner must alert his friend that the financing should be structured as a non-recourse loan. He may not personally guarantee repayment of the balance. Rather, in the case of default, the friend can take possession of the property.
Self-Dealing prohibited transactions occur when a disqualified person receives a personal benefit from their IRA investments.
Some common examples of Self-Dealing Prohibited Transactions are:
- An IRA owner purchases a property overseas to be used as a vacation rental. The IRA owner travels to the investment property and stays there free of charge. The IRA owner received a personal benefit from their IRA which would be considered a self-dealing Prohibited Transaction. The IRA owner may think, “I understand that I may not stay at the property free of charge, so I will pay rent from my personal funds to my IRA”. This is flawed thinking as renting a property from an IRA is a Per Se Prohibited Transaction. The final analysis is that an IRA owner should not stay at their IRA-owned property free of charge (self-dealing prohibited transaction) or for a fee (Per Se prohibited transaction).
- An IRA owner is considering several investment opportunities and decides to lend IRA money to an entity in which he personally has a minority ownership interest. He feels that this is a sound investment as he trusts the creditworthiness of the borrower, and his IRA will receive interest payments that are above market rate. While the transaction seems to be within IRS guidelines because the borrowing entity is not a disqualified person, the IRA owner may be violating prohibited transaction rules if the interest rate charged is higher than which is commercially available.
The rules governing self-dealing
prohibited transactions are nuanced and are based on subjective factors.
If an IRA owner is interested in investing with a company in which they
personally have an ownership interest, they should consider the
- The return on investment should not be higher than what is available on the open market. For example, if an IRA owner sells property to a company in which they have an ownership interest (less than 50%), the purchase price should be comparable to similar properties in the area. Otherwise, the IRS can claim that the deal was performed exclusively to net a higher return for the IRA.
- The IRA owner should not be involved in both sides of the transaction. For example, if an IRA owner is interested in lending money to an LLC in which he has an ownership stake (less than 50%), then the IRA owner should not sign the loan documents as both lender (on behalf of his IRA) and borrower (on behalf of the LLC). An authorized signatory should sign on behalf of the LLC instead.
Consequences of Prohibited Transactions
If a prohibited transaction was performed by an IRA owner, the IRA is considered distributed as of January 1st of the year in which the transaction occurred. Regardless of the amount involved in the prohibited transaction, the ENTIRE account is considered distributed and the IRA owner is subject to any applicable taxes on the distributed amount. The distribution amount is based on the fair market value of the account as of January 1st of the year in which the prohibited transaction took place. Additionally, a 10% early withdrawal penalty would apply if the IRA owner is below age 59.5 at the time of the transaction. Lastly, taxes apply to any income and gains earned by the IRA after the prohibited transaction took place.
If a prohibited transaction was entered into by an individual other than the IRA owner (e.g. broker, financial planner or advisor engaged by the IRA), then a 15% excise tax applies to the amount involved. If the IRA owner does not correct the prohibited transaction then a 100% penalty may apply.
Who is a Disqualified Person?
- The Self Directed IRA holder and his/her spouse.
- The accountholder’s direct ancestors, such as parents and grandparents.
- Aunts and uncles ARE NOT CONSIDERED disqualified persons.
- Step parents ARE CONSIDERED disqualified persons.
- The owner’s descendants, such as their children and grandchildren, and their spouses.
- Nieces, nephews, and cousins ARE NOT CONSIDERED disqualified persons.
- Adopted children ARE CONSIDERED disqualified persons.
- The fiduciary of the Self Directed IRA and anyone else that provides services to the account/plan (e.g. accountant or financial advisor).
- Any entity (e.g. corporation, partnership, LLC) that is owned 50% or more, singularly or collectively, by disqualified persons (i.e.. the persons described above).
- Note: Once an entity becomes disqualified, then all of its officers, directors, highly-compensated employees, and other owners (owning 10% or more) become disqualified persons as well.
For a complete list of disqualified persons, see Section 4975 of the Internal Revenue Code.