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New IRS Rule for Self-Directed IRA Prohibited Transactions – Episode 371

Adam Talks

In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses a provision in SECURE Act 2.0 that discusses prohibited transactions and how they affect you if you have multiple IRAs.

New IRS Rules Impacting IRA Prohibited Transactions

Hey everyone, Adam Bergman here, tax attorney and founder of IRA Financial. On today’s Adam Talks, going to focus on one particular provision, Section 322 of the SECURE Act 2.0, which has an impact on how the IRS looks, and can attack Self-Directed IRA prohibited transactions.

So, want to wish everyone Happy Holidays, Happy, Healthy, Prosperous New Year. I’m going to keep today’s podcast short and sweet because I know everyone’s got more exciting things to do. End of year, hopefully you had a great new year and getting ready for ’23. So, wanted to focus on SECURE Act 2.0. I did a bunch of podcasts and videos and blogs on SECURE Act 2.0, which was passed the end of December, signed into law by President Biden., And as I mentioned, there’s 300+ pages of provisions relating to retirement accounts as part of the $1.7 billion omnibus bill to essentially keep our government operating, but 90+ retirement provisions, and I’ve gone through probably the top 20 of them in previous videos. I’m going to do more on them in the coming months, so don’t worry.

But, today’s podcast, I wanted to focus on one specific provision, and that is the tax treatment of IRAs involved in prohibited transactions. So, prior to SECURE Act 2.0, there was some uncertainty whether if your IRA does a prohibited transaction, all your IRAs are kind of blown up, right? So if you have an IRA or multiple IRAs, let’s say at IRA Financial, and one IRA does a prohibited transaction, does it impact the IRAs that are invested in different stuff?

And prior to SECURE Act 2.0, Section 322, no one really knew. There was a lot of uncertainty; it was unclear. There was a concept that, yeah, there was an and, so all the IRAs involved would be blown up. When I say blown up, I mean subject to tax, penalties, potentially even an excise tax that can go between, you know, 15-100%. So, some pretty significant implications for doing a prohibited transaction.

Now, prohibited transaction is a transaction that violates section 4975(c), which essentially involves any IRA and a disqualified person. So, anytime the IRA does a transaction that directly or indirectly personally benefits a disqualified person: a parent, child, spouse, daughter-in-law, son-in-law, or any entities controlled by such persons, and there’s some personal benefit being derived by such a transaction, either directly or indirectly, can trigger section 4975 and the IRA would become disqualified.

So, what Section 322 does is it clarifies, it says “each individual retirement plan of the individual shall be treated as a separate contract.” So what that essentially means is that if you have multiple IRAs at IRA Financial, and one does, God forbid, a prohibited transaction, your other IRA with IRA Financial would not be impacted, okay? So, this is a very important clause. It gives taxpayers a way to segregate their IRAs and protect them from prohibited transactions. So, if you’re doing a transaction that you may think is kind of aggressive, hopefully you don’t do anything that you believe is prohibited, it’s another advantage of working with IRA Financial and opting into our important consulting services. We have tax professionals on staff that are here to assist you and help you navigate the IRS prohibited transaction rules.

But, let’s say you go rogue and say, hey, I’m going to do this thing, and don’t ask anyone for assistance or anyone to probe further into your type of transaction and you do something prohibited and the IRS catches you. Only that IRA, only that IRA contract would be disqualified and deemed distributed and subject to tax and penalties. So, it gives a blueprint for IRA investors to open up multiple IRAs to segregate risk. So again, if you’re doing a risky IRA transaction, you open “IRA one” less risky IRA two, three, four and five. So, now IRA investors can feel comfortable and confident that if they do something bad, unfortunately with one of their IRAs, it’s not going to blow up all the other IRAs held at that institution.

It’s unclear based off the language whether it pertains to investments or accounts. So, a lot of people believe that the concept, what they were really trying to get at, is that if you have one IRA, let’s say you have three investments, one’s invested in stocks, the other in cryptos, and the third in a real estate transaction. And that third transaction ends up turning out that you ended up renting the space to your kid’s business and it turns out it’s a prohibited transaction. The belief, and this is what many tax professionals believe this was the intent of section 322, is to say, oh no, only that real estate transaction, only that particular investment would get blown up, not the other two assets, i.e., the cryptos and equities in this example.

But, based up the language in SECURE Act 2.0, it’s unclear, because all it says is each individual retirement plan, so that doesn’t say investment. “Each individual retirement plan of the individual shall be treated as a separate contract.” So, that seems to mean that each individual retirement plan, each IRA or 401(k) is a separate contract for purposes of prohibited transactions. So, you could read it to say that, hey, in that scenario where you have stocks, cryptos and real estate, if it’s all in that one IRA and the real estate transaction is prohibited, the whole IRA, including the cryptos and stocks, could get blown up. Now, an easy workaround is just open a separate IRA for your real estate, keep the stocks and cryptos in another one, and you don’t have this issue.

But, I think I personally, along with other tax professionals, are looking for a little bit more clarity. We are hoping the IRS would expand on this and specifically say each investment that the IRA did would be looked at separately as a separate investment, not necessarily a separate contract pertaining to the individual retirement plan. So, to keep things safe as possible, I personally suggest that clients would open separate IRAs for their risky transactions or higher risk, don’t say risky. This way, if, God forbid, the IRS looks at things differently than you do, your other IRA assets, like the stocks or cryptos or whatever else you have in there, won’t be part of that prohibited transaction. So, it’s just something that I think more and more people should be doing, especially now that we have more clarity under Section 322 of SECURE Act 2.0; that they’ll look at each IRA separately and as a separate individual retirement plan, as a separate contract.

But again, I was looking for more guidance as to each investment in the IRA to be treated as a separate transaction for purposes of the prohibited transaction rules. And that language, it just wasn’t drafted the way I would have wished it to be drafted. So again, we have a workaround and just set up separate IRAs for your riskier type of transactions, and keep the safer ones in another IRA. This way, if, God forbid, something happens, you don’t have an issue.

So, just real quick, how do the IRA prohibited transaction works? Well, the IRS does not have an IRA audit division. IRAs are part of the SBSE: Small Business Self Employed division. Basically, same division that audits your 1040, right? Your tax return, they’ll look at the schedule C. That’s why IRA audits are super, super, super, super rare. They don’t even release IRS data with respect to IRA audits. They do for 401(k)s; they do for 5500s, 990-Ts, but not for IRAs, because they’re super, super, super, super rare. But they happen, and they will continue to happen. Most of the audits generally are for folks over the age of 73, the RMD age in 2023, and they’re really just looking at valuations. They want to make sure that if you are over 73, you’re taking fair RMDs, require minimum distributions, equal to the real fair market value of the assets.

So, obviously, stocks and real estate, gold, not a big deal because everyone could see what the assets were worth as of 12/31. More liquid, movable assets like real estate, private equity, hedge fund, venture capital. They’ll probe into that a little bit further if you’re over 73 because it has a tax implication, right? If you value your investments at $800 grand and the IRS thinks they’re worth $2 million, that’s a tax implication that the IRS wants to make sure they’re capturing all available tax. So, that’s something they are certainly, you know, a little bit more focused on than randomly auditing, you know, 45 year-olds’ tax return and asking IRA-related questions. It could happen. It just rarely doesn’t happen.

What happens if you do a prohibited transaction? Your IRA is deemed blown up on the date you did the transaction. So, if you invested in that real estate deal and you rented it out to your son on December 15, 2022, the IRS generally has three years to capture that and catch you. Let’s say they do in 2024; and that real estate, you paid $100, but now it’s worth $180, they technically will blow up the IRA and tax you at that $180, which would be subject to tax and potentially taxes anywhere from ten to upwards up to potentially 100%. Generally, if you’re over 59 and a half, my experience, they’ll just hit the tax. They really don’t go for excise tax if you’re under 59 and a half. Generally tax and a 10% penalty unless it’s something super egregious. But again, very, very difficult to get audited in this area. There’s no separate audit division.

But on the flip side, I’ve seen it work out for the taxpayers favor where they did a prohibited transaction at a higher value and now the asset dropped and they did the prohibited transaction at the lower value, and they’re paying tax at the lower value. So, it’s really the fair market value when the transaction occurred, when that prohibited transaction occurred. So, I’ve seen some interesting cases, but generally the IRA is deemed disqualified on that date when you did the prohibited transaction. Tax and potentially penalty is due on the fair market value of that asset.

Now again, based on Section 322 of the SECURE Act, it says, 2.0, that each IRA will be looked at as a separate contract. It’s unclear whether it means every investment in that IRA, but what we know for sure is that every IRA is treated separately. So again, just a piece of advice. If you are considering doing asset investment that potentially somewhat risky, isolate into a separate IRA even at the same institution, it will be treated as a separate contract, and this way you’re not going to have any spillover of prohibited transactions.

So, hope you guys enjoyed today’s podcast, really appreciate it. Again, hope you had an amazing New Year, Happy Holidays and I’ll keep the SECURE Act 2.0 content going. Got a lot of questions about it. I’ll try to tackle various specific provisions this way, so it’s not like a 45 minutes to one hour podcast video. Try to keep them under ten to 15 minutes and really focus on the key provisions involving IRAs and Solo 401(k)s. So, thanks again; have an amazing, amazing start to your year and take care.

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