While many investors find self-directed IRAs appealing because of the wide range of investment options, some investors are wary of alternative investments because they’ve heard about “prohibited transactions.”
If you’re a self-directed IRA owner or are thinking about establishing a self-directed IRA, it’s important to know that the type of investment generally does not pose a problem under the prohibited transaction rules, rather it’s the IRA owner’s relationship to the investment and other parties involved that can cause issues. Internal Revenue Code 4975 spells out what creates a prohibited transaction. Investors who understand these basic principles can confidently invest in alternative investments without worrying about prohibited transactions.
Investments Clearly Off Limits
There are very few types of investments truly off limits for IRA investors. Under the tax code, an IRA cannot be invested in life insurance contracts or collectibles. Collectibles include tangible property such as art, antiques, gems, stamps or coins (with some exceptions).
If an insurance contract or collectible is acquired by an IRA, it will be treated as distributed from the IRA. The IRA owner must include the distribution in their gross income for the year (excluding the portion purchased with after-tax or Roth dollars). In addition to income tax, the distribution may also be subject to a 10% early distribution tax on the taxable portion if the IRA owner is under age 59½ at the time of distribution.
Improper Use of Investment Not Allowed
Almost any type of investment is allowed in an IRA, other than the few that are listed above. Some of the most common alternative investments include real estate, private equity, limited liability companies, certain precious metals, and mortgage notes.
Even though an IRA owner is investing in an allowable asset, they can run afoul of the prohibited transaction rules when they or others they’re close to use the IRA investment improperly, which generally means for a purpose other than for retirement savings. Examples of improper uses or prohibited transactions for IRA owners include
- Borrowing money from the IRA or to the IRA
- Buying property from the IRA or selling property to the IRA
- Using IRA assets to buy property for personal use
EXAMPLE: Patti, age 50, has an IRA worth $1 million. She invests $500,000 of her IRA assets to purchase a beach house that is operated as a rental property. This is an allowed investment, which is earning rental income for the IRA. This year, however, Patti used the beach house for her own family vacation. This is a prohibited transaction because she used an investment owned by the IRA for her personal enjoyment, not just as an IRA investment.
While the IRA owner cannot perform these types of transactions with the IRA, neither may certain other individuals that have a relationship with the IRA owner. These individuals are referred to as “disqualified persons.” A disqualified person includes the IRA owner’s
- Beneficiary
- Spouse
- Ancestors
- Lineal descendants and their spouses
- IRA fiduciary (anyone who exercises discretionary authority or control in managing or administering the IRA or its assets, or who provides investment advice to the IRA for a fee).
EXAMPLE: Gerry, age 60, has $200,000 in a traditional IRA. Gerry’s son-in-law asks to borrow $40,000 for the down payment on a house. Gerry figures he can help his daughter and son-in-law and earn a guaranteed 7% return on the investment by making the loan from his IRA. Gerry’s son-in-law signs a promissory note for the loan at 7% interest for a 5-year term with monthly payments. This arrangement is prohibited because the IRA is lending money to a disqualified person (the IRA owner’s son-in-law). An IRA may invest in loans or serve as a lender so long as the loan does not involve a disqualified person.
Consequences of Prohibited Transactions
If an IRA owner engages in a prohibited transaction, the IRA stops being an IRA as of the first day of that year and is treated as distributing all assets in the IRA (not just the amount involved in the prohibited transaction) to the IRA owner at the fair market value as of the first day of the year. The taxable amount may also be subject to an additional 10% early distribution tax. If a fiduciary or disqualified person other than the IRA owner or beneficiary engages in the prohibited transaction, the IRS may also impose an excise tax.
Remember…
IRA owners can use their self-directed IRAs to invest in many types of alternative investments that align with their investment goals. They just can’t use the tax shelter of the IRA for personal gain or for the benefit of a disqualified person. Understanding this basic premise should help IRA owners avoid prohibited transactions with their IRA investments. If you have questions about an investment and the prohibited transaction rules, be sure to seek tax or legal advice before making the investment.
To read more about prohibited transactions, check out IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), and Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs).