It’s not uncommon for retirement investors to consider partnering with an IRA to purchase a costly investment, such as real estate property. It may seem fiscally wise to combine personal funds with retirement funds to acquire a Self-Directed IRA investment, but would this transaction be prohibited? In the following, we’ll discuss the concept, cite case law, and offer our opinion on the matter.
- Mixing personal and IRA funds may seem like a good idea on the surface
- Be careful of the IRS prohibited transaction rules
- In some instances, co-mingling funds is allowed, but generally, should be avoided
Prohibited Transaction Rules
When determining whether a transaction is prohibited, retirement investors must look to the rules under Internal Revenue Code (IRC) sections 408 and 4975.
What Transactions Are Allowable?
IRC section 408 lists the types of transactions that are prohibited with the use of Self-Directed IRA funds. Under IRC section 408, investors cannot use IRA funds to invest in collectibles (art, stamps, certain coins, etc.) or life insurance.
Other than these transactions, individuals can use their Self-Directed IRA funds to purchase any investment. However, you must still be aware of the prohibited transactions under IRC section 4975.
What Transactions are Prohibited?
IRC section 4975 does not list the allowable transactions you can make with IRA funds, but the categories of transactions that are prohibited. In general, a disqualified person cannot engage in certain types of transactions. Disqualified persons include the IRA holder and his or her lineal descendants.
Certain transactions between disqualified persons are seen as inherently suspicious and, therefor not permitted. The purpose of these rules is to ensure the investment(s) benefits the retirement account solely and not the IRA holder or his/her lineal descendants.
Partnering with an IRA – Is it Allowed?
There are instances when using your IRA and personal funds to make a transaction is allowed, however, the IRA must exclusively benefit from the transaction. The Kellerman case is an important example of IRA holders running afoul of the rules and will better illustrate when it is clearly prohibited to partner with your IRA to make an investment.
The Kellerman Case
Barry Kellerman and his wife Dana Kellerman each owned a 50 percent interest in a four-acre property. The IRA and the Kellermans personally formed a partnership in order to acquire and develop the property. In this occurrence, the IRA contributed property while the Kellermans contributed property and cash.
In the Kellerman case, the Bankruptcy Court held that the Kellermans engaged in a prohibited transaction when the Kellermans transferred or used the income or assets of the IRA for the benefit of themselves and as a fiduciary dealt with the income or assets of the IRA in their own interest or for their own account.
In order for such a transaction to be permissible, the IRA must receive the exclusive benefit of the transaction. In this case, the IRA does benefit, but not exclusively, as the Kellermans (IRA holders/disqualified persons) benefited, as well. As a result, the transaction can be deemed prohibited by the IRS.
Co-mingling Personal & IRA Funds is Risky
Again, there are instances where using personal funds with IRA funds in a transaction is not considered prohibited under IRC section 4975.
Assume you are an IRA investor who has $165,000 in your IRA and $500,000 in a personal bank account. Although you can make a real estate investment using only personal funds, you want your retirement account to benefit from the transaction, as well. It can be argued that you will not benefit directly or indirectly from the transaction because you can make the real estate investment entirely with personal funds.
However, you must remember that co-mingling personal funds with IRA funds to make an investment, even if it is not prohibited, may lead to an IRS investigation where you must prove that the transaction did not trigger the IRC section 4975 prohibited transaction rules. As a result, it is best not to combine your personal funds with your IRA funds for any transaction.
Assuming you still choose to use personal and IRA funds in a closely held transaction, make sure the transaction is reviewed by an attorney or tax professional. You should also have proof that your personal funds were sufficient to cover the entire cost of the investment. This will not guarantee that the transaction is 100% IRS compliant, but it will be helpful if the transaction is audited.
Get in Touch
Navigating the prohibited transaction rules to ensure your Self-Directed IRA remains IRS compliant can be complex, which is why it’s crucial to seek professional counsel. The first step is to contact IRA Financial directly at 800-472-0646 and tax and ERISA specialists will be available to assist you in your IRA transactions.