Prohibited Transactions in an IRA

Some people can get pretty creative when it comes to taking tax deductions for all types luxury purchases or in making investments. A person might buy a boat and then try to deduct the purchase price from his taxes on the basis that he held a lot of business meetings on the boat — therefore, it is a business expense. Or, a person might loan money to his grown son, have the son sign a loan document, the son deducts the interest paid as loan interest expense, and the two split the tax savings. The IRS does not treat such attempts lightly. They impose some harsh penalties against people who try to go around the tax rules.

IRA’s are no different. People take a tax deduction for the contributions to a Traditional IRA and then use the money in the IRA for personal use or gain. The IRS is always on the lookout for such scams, and imposes some very stiff penalties. Most of these type transactions are either done by the IRA owner himself alone, or with a family member if another person needs to be in on the deal. If you want to do an unusual transaction or buy an unusual investment, you will have to open a Self Directed IRA.

What are Prohibited Transactions

The prohibited transaction rules designed by Congress to prevent you from attempting to use the IRA for personal gain, other than earning interest or normal returns on an investment. The rules stop you from self dealing while using IRA assets. Essentially, you can’t take a tax deduction for a contribution, and then get an additional or double benefit of using the contribution for personal gain outside of the IRA. They do this by forbidding any IRA transactions among one or more “disqualified persons”. A disqualified person is:

  • You, as owner of the IRA account
  • designated beneficiaries of the IRA
  • your spouse
  • your parents, grandparents, great grandparents
  • your children, grandchildren, great grand children
  • your spouse’s parents, grandparents, etc
  • your offspring’s spouses – your son-in-law or daughter-in-law
  • the investment manager of your IRA
  • the custodian or trustee of the IRA – the company holding the IRA investments
  • any company or entity in which any of the above people own more than a 50% share

It is important to know that the IRS could find that other people are Disqualified Persons depending upon the facts of the situation. If your brother has significant influence on your decisions for some reason, the IRS could consider your brother disqualified. As a rule, any person who might create a conflict of interest concerning your IRA assets would be considered a disqualified person.

Even if a transaction is on the up and up, with legal documents signed, and it appears to be a good investment, the transaction is prohibited if it is between two of the above people.

Here are the types of prohibited transactions:

  • an exchange of any property between an IRA and a disqualified person
  • lending of money between an IRA and a disqualified person
  • IRA assets cannot be used as collateral for a loan
  • furnishing of goods or services between an IRA and a disqualified person
  • a disqualified person cannot benefit from the IRA assets except for investment return
  • if the disqualified person is a fiduciary, he cannot benefit from or use the IRA assets

Some examples of how these prohibited transactions might work:

  • Your IRA buys a house and you, or another disqualified person, lives in the house. It does not matter if rent is paid or not. You would be receiving a double benefit from the use of your IRA assets.
  • Your IRA buys a house, and rents it to an outside party at a discount. The outside party agrees to provide some benefit to you (such as adding an addition to the house) in exchange for that discounted rent. You are receiving a double benefit from the IRA assets.
  • Your IRA buys a house, and sells it to an outside party at a discount. The outside party agrees to provide some benefit to you or another disqualified person in exchange for that discounted sales price. You are receiving a double benefit.
  • Your IRA buys a house and runs out of cash to pay the mortgage. You, or another disqualified person, put up the money to cover the shortfall. You are providing a benefit to your IRA.
  • You want to buy a house and put half the money out of your savings account. You direct your IRA to invest the rest of the purchase price. You are receiving a double benefit from the use of your IRA assets.
  • You take out a loan and us your IRA assets as collateral to secure the personal loan. You are receiving a benefit from the use of your IRA assets.
  • You loan money to the IRA so that the IRA has enough cash to buy a house. Loan is between 2 disqualified entities. You and your IRA equal 2 entities.

These are just some examples of a prohibited transaction that could your IRA to be disqualified, causing a taxable distribution and penalties of the funds involved.

What are the Penalties if a Prohibited Transaction Occurs?

If you have a prohibited transaction, you jeopardize the tax free status of the entire IRA. The whole IRA might become taxable based on the total account value as of the start of the year in which the transaction occurs. The IRS might also apply a 10% early withdrawal penalty. This is worse than the penalties applied to qualified plans, which are restricted to a 10% penalty on just the prohibited amount.

If a fiduciary such as a trustee or investment manager (other than you) participates in a prohibited transaction, a 15% additional tax on the amount involved can be charged to that person or company. This tax can increase to 100% if the transaction is not corrected in the year in which it occurred. This penalty tax on third party fiduciaries is intended to ensure your custodian or investment manager take the rules seriously.

Custodians and Managers Make You Pay the Penalties

If you want to do an unusual investment, you might be able to find a custodian willing to hold the investment. Most custodians in this type situation have policies and procedures to relieve themselves from liability. You will probably be required to sign what is known as a “hold harmless agreement” which means you guarantee to cover any taxes or penalties that might by imposed on the custodian by the IRS. This agreement usually requires you to state that you are not a disqualified person, and that you consulted an attorney before making the investment. So, if you still want to proceed with an unusual investment, you had better know what you are doing since you will be on the hook for all penalties if the IRS disallows the transaction.

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