Self-Directed IRAs: Prohibited Transactions Can Get You in Trouble


When planning for retirement an individual retirement account (IRA) is a very common tax friendly way of saving.  For most people that have a retirement plan, whether an IRA, 401(k), 403(b) or others, their money is invested in traditional types of investments such as stocks and bonds.   However, the rules regarding IRA’s do not limit investments to only traditional investments but allow for investment in alternative investments such as life insurance contracts, or real estate.

A self-directed IRA may be a tremendous vehicle for retirement planning, but is not right for many investors.  “Self-directed IRA’s allow individuals to invest in investments they know and understand, while at the same time taking advantage of the tax benefits of a traditional IRA,” stated Yosef Manela, a CPA and tax attorney in Los Angeles.

While self-directed IRA’s provide investors a broader investment platform there are limitations and prohibited transactions that could result in significantly adverse tax implications.  “Investors need to be aware of the prohibited transactions,” warns Yosef.  “Violation of the rules will result in the IRA’s entire value being treated as taxable.”

First, the tax code prohibits transactions between the IRA and certain “disqualified persons.”  Internal Revenue Code Section 4975(e)(2) defines disqualified persons to include the IRA account holder; the account holder’s spouse, children, grandchildren, parents, grandparents and spouses of those people; business entities owned 50% or more by these people; business partners, directors, and employees in these business; and others.

There are a number of transactions with disqualified persons that would in the self-directed IRA being treated as entirely taxable.  The simplest is selling, exchanging, or leasing of IRA property with a disqualified person.  Although this is simple to understand it is very easy to get in trouble.

“Violating this provision can occur by having the IRA pay the IRA account holder’s grandson money for painting the real estate held in the IRA.”  Other transactions include:

  • Lending money or other extensions of credit to disqualified persons;
  • Furnishing goods or services held by the IRA to disqualified persons;
  • Transferring to, or use by or for the benefit of a disqualified person of IRA income or assets;
  • Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
  • Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

There a number of simple arrangements or deals that may get a self-directed IRA into trouble.  Before setting up a self-directed IRA it is important to discuss with an experienced tax professional and consider whether potential prohibited transactions exist.

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