With a self-directed IRA (SDIRA), you can invest your savings in almost anything* AND you can defer paying taxes on that growth until you withdraw the asset or proceeds from your IRA. This means you could use tax-deferred money to purchase an apartment building, invest in a start-up business, or lend money to borrowers, AND defer income tax on the rental income, business profits, or interest flowing back into your IRA. If you invest with a Roth SDIRA, you don’t ever have to pay tax on the investment growth. Many investors leverage their personal expertise and personal contacts to find investment opportunities like these for their SDIRAs – but investors can get into trouble if their actions cause them to engage in a “prohibited transaction” with their SDIRA investment.
Prohibited transactions are a complex area of tax law, but SDIRA investors should have at least a general understanding of the rules before making an investment. Your IRA custodian cannot safeguard or prevent you from committing a prohibited transaction. After reading this basic overview of the rules, you may want to consult with a financial professional, accountant or attorney to help you understand if a specific investment or transaction would violate the rules. If the IRS finds that your actions have violated the prohibited transaction rules, your entire IRA loses its tax-deferred status as of the first day of the year, and you must include the taxable assets in your income for the year.
What is a prohibited transaction?
The prohibited transaction rules are meant to ensure that the tax advantages for saving and investing in an IRA are used to produce retirement savings—not to benefit the IRA owner or certain other parties outside of the IRA. In general, a prohibited transaction is the “improper use” of an IRA investment by the IRA owner or another “disqualified person.” It’s not the investment itself that is typically the problem, it’s who is interacting with or benefiting from the IRA investment.
What is an “improper use” of an IRA or IRA investment?
An improper use occurs when any of the following types of transactions occur between you and the IRA or a disqualified person and the IRA:
- Sale or lease property
- Lend or borrow money
- Provide goods, services, or facilities
- Use or benefit from the IRA investment or income
- Receive consideration as a fiduciary for a transaction involving the income or assets of the IRA
For example, if you invest your SDIRA in real estate, you and other disqualified persons cannot use the property in any way. You also cannot put any sweat equity into remodeling or maintaining the property. You may flip houses with your IRA assets, but your IRA will need to hire and pay others to do the work. Also, you cannot pay for any expenses incurred by an investment held in your IRA. All expenses must be paid by the IRA.
Who is a “Disqualified Person”?
Besides you and your IRA beneficiary, a disqualified person includes the IRA custodian, a fiduciary to the IRA, and most of your family members, including your spouse, parents, grandparents, and your children and grandchildren and their spouses.
For example, your IRA cannot lend money to your daughter’s business or pay your dad to manage the business owned by your IRA
Other types of “disqualified persons” include a corporation, partnership, trust, or estate where 50% or more of the shares or interests are owned by a disqualified person. If an entity is a disqualified person because of this rule, an officer, director or more than 10% shareholder or partner of the entity is also a disqualified person.
Can my IRA partner with other investors on an investment?
Your IRA can partner with another IRA, a private party, or a business to purchase a partial interest in an investment, such as a Limited Liability Company (LLC). But beware that complex business ownership interests can make it even more challenging to identify or avoid prohibited transactions. Seeking tax or legal advice may be warranted to make sure you’re not violating any rules.
What if I want the investment for myself?
If your IRA owns an asset that you would like to own personally, outside of the IRA, the only way to transfer ownership without triggering the prohibited transaction rules is to take an “in-kind distribution” from the IRA. Title to the investment will be transferred into your name and your IRA custodian will report a distribution from the IRA of the current fair market value of the investment. You must include this amount in your taxable income for the year (except for amounts attributable to Roth contributions or a qualified Roth distribution).
When in doubt, seek help.
These rules were enacted to prevent IRA owners from abusing the tax shelter of the IRA for personal gain or for the benefit of a disqualified person. If you have questions about how the prohibited transaction rules apply to a specific situation, be sure to seek financial, tax or legal advice before making the investment.
*Tax laws prohibit IRA assets from being invested in life insurance, collectibles, and S corporations.