A “prohibited transaction” is the improper use of an IRA investment by the IRA owner or certain related parties. The prohibited transaction rules are designed to ensure that the tax advantages provided by IRAs are producing retirement savings—not benefitting IRA owners’ shorter-term investment strategies. Prohibited transactions may be a greater concern for self-directed IRAs because of the types of investments held in these IRAs.
The types of investments held by self-directed IRAs such as real estate, private equities, and limited liability companies do not, by themselves, pose a problem under the tax rules. Rather it’s the IRA owner’s relationship to the investment and other parties involved that can cause issues. Investors who understand these basic principles can confidently invest in alternative investments without worrying about prohibited transactions.
Improper use of IRA assets occurs when a disqualified person enters into any of the following types of transactions with the IRA:
- The sale or lease of property
- Lending of money
- Furnishing of goods, services or facilities
- A transfer of IRA income or assets to, or use for the benefit of, a disqualified person
- An act by a fiduciary by which IRA assets are used for his or her own interest
- The receipt of consideration by a fiduciary for his or her own account from any party dealing with the IRA in a transaction involving the income or assets of the IRA
A disqualified person includes the IRA owner and beneficiary, the custodian of the IRA, any other IRA fiduciary and the IRA owner’s family members, including their spouse, ancestors, lineal descendants, such as children and grandchildren, and spouses of lineal descendants.
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 IRA assets at the fair market value. The taxable amount may also be subject to an additional 10% early distribution tax if the IRA owner is younger than age 59½. 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.
EXAMPLE: Randall has a traditional IRA worth $500,000. All of the assets are pre-tax. Randall owns $100,000 of gold bullion outside his IRA. He wants his IRA to invest in gold bullion and arranges for his IRA to purchase his gold bullion.
This is a prohibited transaction because an IRA owner cannot sell an asset he owns personally to his IRA. Randall’s IRA ceases to be an IRA as of January 1 of the year his IRA purchased the gold bullion, and he must include the value of his entire IRA, $500,000, in his taxable income for the year.
EXAMPLE: Nancy has a traditional IRA worth $1 million dollars. Her IRA owns a large office complex. Nancy hires her son to be the property manager of the office complex, effective in July this year.
This is a prohibited transaction because a disqualified person is performing services for the property and the IRA owner is benefitting both by securing a job for her son and by retaining some influence over property management decisions. Nancy’s IRA ceases to be an IRA as of January 1 this year, and she must include the value of her entire IRA, $1,000,000, in her taxable income for the year.
Permitted Personal Use of Investments
If an IRA owns an investment that the IRA owner 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. The investment is taken out of the IRA without being liquidated by transferring title to the IRA owner. The current fair market value of the investment must be reported to the IRS on Form 1099-R as a taxable distribution, and the IRA owner must include this amount in their taxable income for the year of distribution.
EXAMPLE: Jan has an IRA worth $800,000. All of her IRA assets are pre-tax. Among her IRA assets is a rental property in the Caribbean valued at $400,000. Jan is now 65 years old and is ready to retire. She wants to purchase the property from her IRA, so she can live in it.
Jan cannot purchase real estate directly from her IRA without triggering a prohibited transaction. She may request an in-kind distribution of the real estate from her IRA. The title must be transferred from the IRA to Jan, and she would have to include $400,000 in her taxable income for the year.
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. 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), at www.irs.gov/retirement-plans