A Guide for Avoiding Prohibited Transactions in Your Self-Directed IRA

What is a prohibited transaction? Perhaps you’ve encountered this term a number of times as an investor, but you don’t really know the specifics. Generally, a prohibited transaction is considered as any improper use of your IRA account or annuity by you, your beneficiary, or any disqualified person, as well as any “self-dealings” in your IRA.

Prohibited transactions, even those made unintentionally, can have major consequences in the eyes of the IRS. Your account could lose its tax-protected status or be subject to a penalty if you engage in any prohibited transactions, so being thorough about the credibility of your investments (and who they’re with) is a vital part of your due diligence as an investor.

A common mistake I’ve seen occurs when investors inadvertently self-deal while renovating properties in their IRA. Let’s say your IRA purchases a property for $201,000. Several years later, your house needs a new roof and you (the IRA owner) pay for the new roof from personal funds. This type of transaction is prohibited. In this case, you (the IRA owner) are 46 years old at the time of the transaction. You are now subjected to paying taxes and a 10% penalty on the entire IRA, which includes another $11,000 in cash. Combining that additional $11,000 with the $201,000 value of the property, you’re being taxed and penalized on the $212,000. So, as you can see, a simple mistake can have costly consequences.

All of this can be avoided. By understanding the dos and don’ts of investing from your self-directed IRA, you can save yourself money, headaches, and legal trouble.

While it may be true that self-directed IRAs allow you to invest in non-traditional (i.e. alternative) investments that run the gamut, the IRS only tells you what you can’t invest in. Surprisingly, this list may be shorter than you think!

Not sure if your next investment qualifies in your IRA? Check below.

What You Can’t Invest In

There are two major types of investments that you must avoid owning in your IRA:

1. LIFE INSURANCE - Because life insurance doesn’t grow (due to policies’ fixed amounts) and doesn’t give returns, you cannot buy it with your SDIRA. Its function contradicts the way IRAs are supposed to work, and it is for the beneficiary versus the actual plan holder. Therefore, life insurance does not qualify as an investment.
   
   
2. COLLECTIBLES - Are you wondering if you can invest in a rare collection of items from your IRA or that priceless heirloom your grandmother passed down to you? Anything that’s difficult to put a value on is considered a collectible in the eyes of the IRS, and therefore is prohibited. My general rule of thumb? If you can put it in a museum, it’s a collectible. The IRS lists a collectible as any of the following:

• - Works of art
• - Rugs
• - Antiques
• - Metals or gems*
• - Stamps
• - Coins*
• - Alcoholic beverages
• - Any tangible personal property under IRC Section 408(m) determined as a “collectible”

* Certain gold, silver, platinum, palladium, and coins are not included in this definition of “collectible.” See IRC Section 408(m)(3) or consult a financial professional for more details for your specific precious metals investment.

Who You Can’t Invest With

Do you want to make an investment in your mother’s business? How about your son-in-law’s fund? Be careful, because transactions like these are actually considered prohibited in your IRA. Why? Because your mother and son-in-law are on a list of persons that the IRS deems as “disqualified persons.”

So, what is a disqualified person? And who counts as one? Disqualified persons include your fiduciary and members of your family who are of lineal ascent or descent. Here is a comprehensive list of these disqualified persons for your reference:

• - You
• - Your spouse
• - Your parents
• - Your grandparents
• - Your children and their spouses
• - Your grandchildren and their spouses

But that doesn’t mean you can’t invest with anyone in your immediate or extended family. According to the IRS, there are certain family members who are NOT considered to be disqualified persons. This includes:

1. - Siblings
2. - Aunts and Uncles
3. - Cousins
4. - Nieces and nephews
5. - Your in-laws (Spouse’s parents/siblings)
6. - Step-relations

Also, any entities you or those on the list of disqualified persons above own fifty percent or more stake of are considered prohibited due to the direct and indirect benefits they could get from the investment. Fiduciaries or persons who service your account, or anyone holding a high position in an entity and earning 10% or more of its profits also fall under this category of deals you cannot engage in. These “dealings” include the following misuses.

1. - Buying shares in your own company
2. - Loaning money to yourself or a fiduciary
3. - Sale, exchange, or lease of property with any intentions of personal use by you or disqualified person
4. - Receiving compensation for managing property within your IRA, or any furnishing, goods, and services contributed by a disqualified entity or person
5. - Using your IRA as security for a loan
6. - And more!

As you may have guessed, the more complicated a transaction gets, the more gray area you will encounter. Often, I see investors struggle with this gray area when they experience the difficulty or temptation of “stepping in” to rehab a property, like in the example I discussed earlier. I have encountered folks who wanted to hire their own construction company or their electrician father to fix up a property, but these rehabs would disqualify the entire IRA. Some investors I’ve met run into issues with their rental properties because they collected the income, instead of having it flow directly back into their IRA. There are first-time real estate investors who are interested in purchasing a beach house in their IRA, but don't know that they cannot actually vacation to that house. I always like to remind investors when it comes to tricky situations like these, “You can pick the color of the paint, but you cannot pick up the paint brush and paint it.”

There are ways that you can creatively fund a deal through means of partnering IRAs or lending to/loaning from another IRA, should you need more funds, that are still compliant with the IRS’ rules. For those investment opportunities that may not seem so cut-and-dry, always consult your financial advisor and make sure your intentions are clearly laid out.

Maybe you can even make adjustments to the deal so it is no longer prohibited. For example, if my IRA didn’t have enough money to purchase a property, I would partner personally to fully fund the investment, which is still a permissible transaction. Half of the income, interest, and sale proceeds would go to my personal funds and the other half would go to my IRA.

What could happen if you participate in a prohibited transaction?

Regardless of whether or not a prohibited transaction is done accidentally, you may face grave consequences that will penalize your account. The year the prohibited transaction occurs is the year those assets are considered “distributed” from your account. These assets are added to your taxed income for the year, which will potentially shove you into a higher tax bracket. If you are under the retirement age of 59 ½ , the IRS will also execute a 10% early distribution penalty on your account.

Your investment should always make you money and set you up for success, not hurt you when it comes time to retire. It all boils down to careful consideration and knowing your investment/investors. If you have any doubts, your best course of action is always to talk to your financial adviser or a tax professional before making any snap judgments.

Have questions about the eligibility of a transaction you’d like to make, or want any more information? Feel free to ask below!