The median home sale price in April 2023 was $430,000. That’s an increase of $3,700 from just a year ago. Even though home prices are off their highs of 2022, they are still relatively high. Hence, investors seeking to invest in real estate using retirement funds often are in need of additional funds to make the investment. The Federal Reserve’s most recent data reveals that the average American has $65,000 in retirement savings. By their retirement age, the average is estimated to be $255,200. Thus, in many cases, IRA investors looking to get a real estate done will need to look at a way to use IRA and personal funds in a real estate transaction.
This article will examine the IRS prohibited transaction rules involved when making real estate IRA investments. It will also explore two important cases that highlight certain rules involving co-mingling of IRA and personal funds in a real estate transaction.
- Co-mingling of IRA and personal funds to make a real estate investment is acceptable
- One must be aware of the prohibited transaction rules before engaging in an investment
- Case law demonstrates how the rules work and what you should avoid
What is a Self-Directed IRA?
A Self-Directed IRA is an IRA that allows its owner to invest in alternative assets, such as real estate. When IRAs were created by ERISA in 1974, there was no distinction between an IRA and a “Self-Directed” IRA. The only difference is that traditional banks and financial institutions do not generally allow their clients to invest in alternative assets. The Self-Directed IRA industry evolved to allow everyone to invest in anything not prohibited by the IRS, whether it was real estate, precious metals, private businesses and so much more. So long as your IRA custodian allows for it, the sky’s the limit as far as investment opportunities with your IRA funds.
The IRS Prohibited Transaction Rules
The Internal Revenue Code (“IRC”) does not describe what an IRA can invest in, only what it cannot invest in. IRC Sections 408 and 4975 prohibits a “disqualified person” from engaging in certain types of transactions.
Under IRC 4975, a prohibited transaction is defined as:
- (A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
- (B) lending of money or other extension of credit between a plan and a disqualified person;
- (C) furnishing of goods, services, or facilities between a plan and a disqualified person;
- (D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of
- a plan;
- (E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
- (F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Case Law Effects
Prior to 1996, there was no legal precedent that clearly stated that an IRA can own 100% of an entity and be managed by the IRA owner. The only way to make a Self-Directed IRA real estate investment was for the IRA to own the real estate property directly without the use of an entity. For example, in the case of a joint venture real estate partnership, the title of the real estate would be held in the name of the IRA and the individual partner’s name. The 1996 Swanson case changed that.
The Swanson Case – Checkbook IRA is Born
In Swanson V. Commissioner 106 T.C. 76 (1996), the Tax Court, in holding against the IRS, ruled that the capitalization of a new entity by an IRA for making IRA related investments was a permitted transaction and not prohibited pursuant to Code Section 4975. The Swanson Case was later affirmed by the IRS in Field Service Advice Memorandum (FSA) 200128011.
The underlying facts involved James Swanson (the taxpayer’s) combined use of two entities owned exclusively by his IRAs to defer income recognition. James Swanson was the sole shareholder of H & S Swansons’ Tool Company, an S corporation that builds and paints component parts for domestic and foreign equipment manufacturers. Following the advice of tax counsel, Swanson arranged in 1985 for the establishment of Swansons’ Worldwide, Inc. (“Worldwide”), a Domestic International Sales Company (“DISC”). A DISC is a domestic corporation, usually a subsidiary, that is typically used to defer tax on income generated by the entity.
Although, Mr. Swanson did not use an LLC, the Swanson case was really the first case that addressed the ability to use any entity wholly owned by an IRA and managed by the IRA holder to make tax-deferred investments.
Mr. Swanson appointed Florida National Bank as trustee and custodian of IRA #1, who retained the power to direct its investments. Mr. Swanson then directed Florida National to execute a subscription agreement to purchase 2,500 shares of Worldwide original issue stock. The shares were issued and IRA #1 became the sole shareholder of Worldwide. Mr. Swanson then engineered a similar transaction with a second IRA at another bank.
The IRS Attack
The IRS stated that prohibited transactions had occurred causing IRAs #1 and #2 to be terminated and made the following arguments:
- Mr. Swanson is a disqualified person within the meaning of section
- 4975(e)(2)(A) of the Code as a fiduciary because he has the express
- authority to control the investments of IRA#1.
- Mr. Swanson is also an Officer and Director of Swansons’ Worldwide.
- Therefore, direct or indirect transactions described by section 4975(c)
- (1) between Swansons’ Worldwide and IRA #1 constitute prohibited
- Mr. Swanson, as an Officer and Director of Worldwide, directed the
- payment of dividends from Worldwide to IRA #1.
- At the time of the purchase of the Swanson Worldwide stock, Mr. Swanson was a fiduciary of his IRA and the sole director of Swansons’ Worldwide
Mr. Swanson’s Position in Response to the IRS
Mr. Swanson took the position in his Tax Court petition that no prohibited transaction had occurred. His position was that since the Worldwide shares issued to IRA #1 were original issue, no sale or exchange occurred. Also, he stated that as the director and president of Worldwide, Swanson engaged in no activities on behalf of Worldwide that benefited him other than as beneficiary of IRA #1. Mr. Swanson made similar points with respect to IRA #2.
The IRS Concedes the Prohibited Transaction Issue
The IRS conceded the prohibited transaction issue in the Swanson case on July 12, ’93 when it filed a notice of no objection to an earlier motion by the Swansons for partial summary judgment on that issue. In other words, the IRS concluded that it would no longer pursue its position that the Swansons use of a newly established entity (wholly owned by an IRA and managed by the IRA holder to make investments) was a prohibited transaction. In light of this, Mr. Swanson sought litigation costs against the IRS on the Prohibited Transaction Issue. The IRS argued that its litigation position with respect to the IRA prohibited transaction issue was substantially justified. The Tax Court disagreed with the IRS’ position, finding that it was unreasonable for the IRS to claim that a prohibited transaction occurred when Worldwide’s stock was acquired by IRA #1 for the following reasons:
- The stock acquired by the IRA was newly issued. Before that time, Worldwide had no shares or shareholders. A corporation without shares
- doesn’t fit within the definition of a disqualified person under the
- prohibited transaction rules pursuant to IRC 4975. As a result, the corporation, Worldwide, only became a disqualified person with respect to IRA #1 investment into Worldwide only after the Worldwide stock was issued to IRA #1.
- It was only after Worldwide issued its stock to IRA #1 that Mr.
- Swanson held a beneficial interest in Worldwide’s stock. Mr. Swanson
- was not a “disqualified person” as president and director of Worldwide
- until after the stock was issued to IRA #1
- The payment of dividends by Worldwide to IRA #1 was not a self-
- dealing prohibited transaction under IRC Section
- 4975(c)(1)(E). The only benefit Mr. Swanson realized from the
- payments of dividends by Worldwide related solely to his status as
- beneficiary of IRA #1, which is not a prohibited transaction.
- It was only after Worldwide issued its stock to IRA #1 that Mr. Swanson
- held a beneficial interest in Worldwide’s stock. Therefore, the issuance
- of stock to IRA #1 did not constitute a prohibited transaction.
- It was only after Worldwide issued its stock to IRA #1 that Mr.
- Swanson held a beneficial interest in Worldwide’s stock. Mr. Swanson’s
- only benefit would be as beneficiary of the IRA which is not a
- prohibited transaction.
The Impact of Swanson on Joint Ventures
The Swanson case essentially created the legal foundation for the Self-Directed IRA LLC solution. It was the first case that established that an entity, such as an LLC or partnership, can be established, owned by an IRA, and even managed by the IRA owner, a “disqualified person,” without triggering the IRS prohibited transaction rules.
Just as importantly, the Swanson case clearly established that, for purposes of joint venture type investments, an entity wholly becomes a disqualified person when it is funded and not when it is established. Hence, when using an entity that will be owned by an IRA and a disqualified person, the holding in the Swanson case is clear that the entity would only become a disqualified person after it has been funded. Accordingly, the funding of the investments between the IRA and the disqualified person would not trigger a prohibited transaction and seemingly, so long as the entity received no additional contributions from either the IRA nor a disqualified person, no prohibited transaction would have occurred.
The Kellerman Case
In KELLERMAN, 115 AFTR 2d 2015-1944 (531 B.R. 219) (BktcyCt AR), 05/26/2015, a bankruptcy case, the court held that a partnership formed by a self-directed IRA and an entity owned by the IRA holder and his spouse personally was a prohibited transaction.
In the case, Barry Kellerman and his wife each own a 50 percent interest in Panther Mountain personally. To effect the acquisition and development of the four-acre property, the IRA and Panther Mountain formed a partnership whereby the IRA contributed property and Panther Mountain contributed property and cash.
In adopting the list of prohibited transactions, Congress intended “to prevent taxpayers involved in a qualified retirement plan from using the plan to engage in transactions for their own account that could place plan assets and income at risk of loss before retirement.” Thus, “[t]he fact that a transaction would qualify as a prudent investment when judged under the highest fiduciary standards is of no consequence.”
The primary distinction between Kellerman and Swanson is Kellerman did not involve the formation of an entity. In Kellerman, a joint venture partnership was created between the IRA and the Kellermans without the use of an entity, such as an LLC. Without the use of an entity and a formal contribution of assets, the Court believed the contribution of cash and real estate constituted prohibited transactions with disqualified persons.
In addition, the facts in Kellerman seem to suggest that Mr. Kellerman received some direct compensation from the partnership which would have directly triggered a prohibited transaction. Moreover, the Court also believed the partnership transaction was more akin to a loan transaction involving Kellerman and the partnership, which would also have triggered a prohibited transaction.
The real question is how the Kellerman case would have turned out if instead of using a joint venture-type structure without the use of an entity, the Kellermans would have used an LLC and contributed the cash and real estate to a newly established LLC based on the facts of the Swanson case. The holding in the Swanson case would seem to suggest that by using a newly established entity and funding the cash and real estate simultaneously, the entity would only become a disqualified person at that point. Thus, assuming the Kellermans did not make any additional contributions to the entity and did not take any fees or receive any personal benefit, the Kellermans would likely have been able to engage in their real estate investment without triggering the IRS prohibited transaction rules.
The use of IRA and personal funds in a joint venture type-real estate transaction is allowable based on the holding of the Swanson case. However, it is important to remember that a newly established entity must be used, and once the entity has been funded by cash or in-kind assets from the parties, no additional contributions to the entity are made by the IRA or any disqualified person. The entity can seek additional funding from a third-party investor or lender, just not a disqualified person.
Nevertheless, any time IRA and personal funds are co-mingled in a transaction, there is a heightened level of risk from an IRS prohibited transaction standpoint versus just using IRA funds in an investment. However, with the right structure, the use of personal and IRA funds in a joint venture real estate investment can be accomplished without triggering the IRS prohibited transaction rules.