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Prohibited Transaction Rules
Prohibited Transactions Categories
As a retirement investor, it's important to follow the self-directed IRA prohibited transactions before making an investment. If you don't follow these rules, it can lead to the disqualification of your IRA. In this article, we'll explain what you can and cannot do with your self-directed IRA and the IRA prohibited transaction rules.
Self-Directed IRA Rules permit the IRA to engage in practically any investment. However, IRA prohibited transaction rules do exist. Every IRA is subject to IRS rules. Although you have many tax advantages when using a Self-Directed IRA, make sure you don't engage in any “prohibited transactions." This includes making prohibited investments in certain assets, such as life insurance or collectibles. Other Self-Directed prohibited transactions include IRA transactions with disqualified persons. Breaking these rules can lead to severe taxes or disqualification of your IRA.
It’s important to familiarize yourself with all Self-Directed IRA prohibited transaction rules. Additionally, it’s wise to be aware of the specifics of a prohibited transaction.
You may know that prohibited transactions fall under three primary categories: direct prohibited transactions, self-dealing prohibited transactions and conflict-of-interest prohibited transactions.
1. Direct prohibited transactions
A direct prohibited transaction is a type of transaction between a disqualified person and his/her retirement account. For example, Mark uses funds from his Self-Directed IRA to purchase an interest in an entity that his father owns.
This transaction is between two disqualified persons (Mark, the IRA holder and his father, a lineal descendant). Furthermore, it personally benefits one of the disqualified persons.
Let’s take a look at another example.
Patty purchases real estate with her Self-Directed Roth IRA funds and leases it to her son.
Similar example to the one above, correct? Therefore, you now realize why Patty’s purchase is prohibited. Patty can purchase real estate, however she cannot lease it to her son, because her son (a disqualified person) benefits from this transaction.
Prohibited transaction rules exist so individuals don’t directly or indirectly benefit from transactions regarding their individual retirement account.
These Self-Directed IRA rules are primarily in place so investments involving your IRA can benefit the retirement account, not the owner.
2. Self-dealing IRA prohibited transactions
Again, this transaction involves a situation where an individual uses his or her IRA income or assets for personal gains.
For example, meet Pam:
Meet Doug, whose situation is very similar:
In the case of both Pam and Doug, these are prohibited transactions. The being that both Sam and Doug use their Self-Directed IRA funds for personal interests. However, the purpose of an IRA is to increase retirement funds through tax-free or tax-deferred growth.
3. Conflict-of-interest prohibited transactions
This IRA prohibited transaction involves a disqualified person who is also a fiduciary and is connected to a transaction that involves the income or assets of the individual’s IRA.
Let's look at another example, this time with an IRA owner named Francine. Francine uses her IRA funds to loan money to a company she owns a small interest in. However, she also manages and controls the daily operations. Francine is the fiduciary, thus has a close connection to the investment and benefits from the transaction.
The IRA Prohibited Transaction rules encourage people to save for retirement, but also prevents them from taking advantage of tax benefits for their personal account.
Most Self-Directed IRA prohibited transaction rules pertain to dealings with disqualified persons. There IRC states the prohibited transactions between the IRA and a disqualified person. The reasoning behind this rule stems from the congressional assumption that some transactions between certain parties are suspicious and should not be allowed.
The definition of disqualified persons extends into a variety of scenarios and can be complex. However, it typically includes the IRA holder and his/her lineal descendants. Below is an illustration that better explains disqualified persons that fall under the Self-Directed IRA prohibited transaction rules.
Below are the following IRC provisions. Each of these rules fall under different Internal Revenue Code sections.
- Prohibiting IRAs from investing in life insurance contracts.
- Referencing tax on prohibited transactions.
- Defining an IRA’s loss of tax-exempt status upon engaging in a prohibited transaction.
- Describing effect of pledging an IRA or any IRA assets as security for a loan.
- Expressing impermissible investment in collectibles.
- Describing unrelated business taxable income.
- Imposing tax on unrelated business income.
- Describing an unrelated trade or business.
- Individual Retirements Arrangements (IRAs)
- Swanson v. Commissioner (1996)
Self-Directed IRA Rules
With a Self-Directed IRA, you’re able to invest in virtually anything. However, if your IRA engages in prohibited transactions, you may jeopardize the tax-deferred status of your account. The IRS doesn’t tell you what you can do, but it clearly states what you cannot do with your retirement account.
Some Prohibited Investments Include:
You can find the prohibited transaction rules in IRC Section 408. Stay informed with the rules to avoid incurring tax penalties.
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