When researching Self-Directed IRAs, you may come across the term "prohibited transaction." Self-Directed IRA prohibited transactions are improper transactions that occur between an IRA and a disqualified person. IRA account holders need to understand exactly what an improper transaction is and who is considered a disqualified person. A general 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, IRS Self-Directed IRA 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. But Congress incorporated prohibited transaction rules into the act to prevent people from taking advantage of these specialized retirement accounts.
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.
Here are some common examples of per se prohibited transactions:
All of the above transactions are perfectly permissible when performed with third parties; they only become problematic when performed with disqualified persons.
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, they may obtain the balance from a third-party lender, but 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% and 70%.
Here are some common examples of extension of credit prohibited transactions:
Self-dealing prohibited transactions occur when a disqualified person receives a personal benefit from their IRA investments.
Here are some common examples of self-dealing prohibited transactions:
An 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." But this is flawed thinking, as renting a property from an IRA is a per se prohibited transaction. An IRA owner should not stay at their IRA-owned property either free of charge (self-dealing prohibited transaction) or for a fee (per se prohibited transaction).
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 following:
If a prohibited transaction was performed by an IRA owner, the IRA is considered distributed as of Jan. 1 of the year in which the transaction occurred. The distribution amount is based on fair market value. 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. Additionally, a 10% early withdrawal penalty would apply if the IRA owner is below age 59 ½ 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., a 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.
The Self-Directed IRA account holder and their spouse.
The account holder’s direct ancestors, such as parents and grandparents.
The owner’s descendants, such as their children and grandchildren, and their spouses.
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).