When IRAs were created in 1974 by ERISA, the Act did not distinguish between an IRA that invested in stocks and one that invests in alternative assets, such as real estate. A Self-Directed IRA is essentially an IRA where the custodian does not put limitations on what you may invest in. Generally, you will need to find one that specializes in the self-directed structure, such as IRA Financial. When Congress enacted the IRA rules, they understood the importance of investment diversification. However, they also understood that people may look to take advantage of the rules. Because of this, there are certain things you cannot do with an asset owned by your IRA.
- A Self-Directed IRA allows one to invest in rental properties
- The prohibited transaction rules state that a disqualified person cannot benefit from such an investment
- There may be instances where you could possibly rent a property owned by your IRA
The IRS Prohibited Transaction Rules
The types of investments that are not permitted to be made using retirement funds is outlined in Internal Revenue Code (IRC) Section 408 and 4975. These rules are generally known as the “Prohibited Transaction” rules. Other than life insurance, collectibles, and transactions that involve or directly or indirectly benefit the IRA holder or a “disqualified person,” one can use an IRA to make almost any type of investment, including rental real estate. A “disqualified person” is generally defined as the IRA holder and any of his or her lineal descendants and ascendants, and/or any entities controlled by such persons. Note – siblings and other family members are not considered disqualified persons.
When it comes to determining what one can or cannot do with a Self-Directed IRA, the first step is to determine if the transaction will violate the IRS prohibited transaction rules under Code Section 4975. One should consider the following principles before making an IRA investment:
- Neither you nor any disqualified person may benefit from the investment – directly or indirectly
- Cannot buy, sell or exchange property between the IRA and a disqualified person
- Cannot invest in a business, venture, or fund that is directly or indirectly controlled by a disqualified person
- No active personal service to the investment
- Investment must solely benefit the IRA
- No personal benefit to a disqualified person – directly or indirectly
Renting Property Owned by a Self-Directed IRA
Based off the IRS prohibited transaction rules set forth in IRC 4975, it is clear that one cannot rent a home or real estate property directly from his or her Self-Directed IRA. In such a case, that would be a direct prohibited transaction since the IRA would be transacting directly with a disqualified person, the IRA owner, personally.
However, what about the situation where a business owned by the IRA owner rents a home or office space from an entity owned by a Self-Directed IRA? For example, assume the IRA owned 25% of a partnership with unrelated people that owned a home, and the IRA owner wanted to rent the home from the partnership? Would such a transaction violate the IRS prohibited transaction rules?
The first item one must analyze is whether the IRA owner will be transacting with a disqualified person. As per IRC Section 4975(e)(2), an entity is deemed disqualified if it is 50% owned or controlled by disqualified persons. In this case, the partnership is owned less than 50% by the IRA owner and no other disqualified persons own any interest in the partnership. Based on these facts, the IRA owner could potentially rent the property from the partnership.
However, anytime there is a transaction between an IRA and a disqualified person in a closely held entity, even if the partnership is not per se a disqualified person, there is always some chance the IRS could argue that the rental transaction in some way personally benefited the IRA owner. Although, if the IRA owner paid fair market value for the rental and the IRA was not the manager of the partnership negotiating the rental transaction, then the IRA owner would have good support to argue the transaction is not a prohibited transaction.
In general, the IRS prohibited transactions under Code Section 4975 are relatively straightforward. However, there are instances where an IRA rental transaction could indirectly violate the prohibited transaction rules, such as the example provided above.
If a prohibited transaction is deemed to have occurred, there are serious consequences and the IRA could be forced to be abandoned and all assets held would be distributed. Taxes and potential penalties would be due. Accordingly, it is very important to work with a tax professional or Self-Directed IRA company that has significant experience navigating the IRS prohibited transaction rules.