Using your self-directed IRA for alternative investments such as real estate can be extremely beneficial. However, before you go jumping into any investment with your IRA you should take the time to understand “the rules”. Let’s begin with the basics of what a prohibited transaction is and why it must be considered when working with your IRA. We went straight to the IRS website for this definition:
“Prohibited Transactions are certain transactions between a retirement plan and a disqualified person. More specifically for an IRA, a prohibited transaction is any improper use of your IRA account by you, your beneficiary, or a disqualified person. Disqualified persons include your fiduciary and members of your family, including spouse, ancestor, lineal descendant, and any spouse of a lineal descendant.”
So, per the IRS not only does the investment activity matter, but also those parties involved with the activities. Seeking greater clarity of this, we turned to a couple industry resources to provide examples. A list of example prohibited transactions from Entrust’s website included:
- Sale, exchange or leasing of a property between an IRA and a disqualified person.
- Extension of credit or cash loan between an IRA and a disqualified person.
- Furnishing goods, services, or facilities between an IRA and a disqualified person.
- Transfer of IRA income or assets to, or use by or for the benefit of, a disqualified person. (Example: Renting a property owned by your IRA to your child)
Building on that list and offering a bit of explanation behind each transaction, Investopedia.com offered these scenarios as IRA prohibited transactions:
- Borrowing Money from Your Plan
Many qualified plans offer loans to participants, but these participants are allowed a certain period within which they must repay the loan with interest. IRAs, on the other hand, are prohibited from making loans to any party, including IRA owners and any disqualified person. Borrowing is not to be confused with legitimate and allowable investments, such as private placements. Nevertheless, caution must be exercised to ensure that funds are not invested with a disqualified person.
For instance, if your wife is starting a property rental business, she may need investors to provide start-up capital. While you may be able to use your regular savings to invest in the business, you cannot use your IRA assets because your wife is a disqualified person. The investment would be allowed if the business owner were not a disqualified person.
- Selling Property to Your Plan
If you sell the property to your IRA, the sale is a prohibited transaction.
- Paying Unreasonable Compensation for Management of Your Plan
The compensation the asset manager receives for managing IRA assets should be comparable to the compensation for managing assets of similar balances for all the managers’ other customers.
- Using the IRA as a Security for a Loan
Unlike your regular savings account, you are not allowed to use your IRA as collateral for a loan as the amount you pledge as security will be deemed a distribution by the IRS.
- Buying Property for Personal Use
Using IRA assets to buy property for your personal use is considered an improper use of IRA assets and could result in disqualification of the IRA.
So what are the consequences of your IRA participating in a prohibited transaction. Per the IRS they offer the below potential effect:
“Generally, if an IRA owner or his or her beneficiaries engage in a prohibited transaction in connection with an IRA account at any time during the year, the account stops being an IRA as of the first day of that year. The effect of this is the account is treated as distributing all its assets to the IRA owner at their fair market values on the first day of the year. If the total of those values is more than the basis in the IRA, the IRA owner will have a taxable gain that is includible in his or her income.”
Bottom line, prior to making an investment using your IRA take some time to understand what constitutes a prohibited transaction. When in doubt on what qualifies as a prohibited transaction, contact your IRA custodian or trustee for additional measure. Stay tuned for our next article regarding “Disqualified Persons”.