With real estate prices climbing nationally over the last several years, it’s not unusual for IRA holders looking to make real estate and other alternative asset investments through a Self-Directed IRA to be forced into combining some of their personal funds to support the Self-Directed IRA investment.
When it comes to determining whether an investment involving IRA funds is permitted, the rules under Internal Revenue Code (IRC) sections 408 and 4975 must be addressed.
Pursuant to IRC Section 408, an IRA is not permitted to invest in collectibles, such as art, or life insurance contracts. IRC Section 4975 addresses the types of transactions that are deemed “prohibited.” It does not list what type of transactions are allowed with IRA funds, but it identifies categories of transactions that are prohibited. In general, IRC 4975 prohibits a “disqualified person” from engaging in certain types of transactions.
IRC Section 4975(e)(2) defines a disqualified person as the IRA holder and any of his or her lineal descendants. Additionally, any entity that the IRA holder or lineal descendants control fifty percent (50%) or more of is disqualified.
The prohibited transaction rules are based on the premise that investments involving retirement accounts should be made to benefit the retirement account and not the individual IRA holder or any “disqualified person.” In other words, the IRS is essentially saying that when you use your IRA or 401(k) funds to make an investment, it should be made for the sole purpose of benefiting the retirement account. Investments should not be made for the benefit of the IRA holder personally, or any of his/her lineal descendants or controlled entities.
An IRA holder is prohibited from using his or her retirement account in a way that benefits the IRA holder personally or any “disqualified person”. This includes using an IRA to pay for a personal vacation or to help pay off a personal debt. In most cases, determining whether a transaction would violate the IRS prohibited transaction rules are clear. However, in certain cases, determining whether a prohibited transaction occurred is more subjective and largely dependent on the facts and circumstances involved.
Using Personal Funds in a Real Estate Investment
An IRA investor finds a property she wishes to purchase with her IRA. The housing price increases over the last several years have made the investment property priced above the value of her IRA. Pre-retirees generally have well over $100,000 in their IRA, while Americans in the 65-69 age range have over $212,000. This could potentially limit many real estate opportunities for certain IRA holders. For example, IRA investor has $165,000 in her IRA but the investment property she is looking to purchase is selling for $215,000. IRA investor wishes to use personal funds along with IRA funds to purchase the property. Would that be a prohibited transaction pursuant to IRC Section 4975?
Before answering the question, one thing should be made clear. If an IRA investor did not elect to co-mingle any personal funds along with IRA funds, the IRS prohibited transaction rules will not be triggered. This is because there would be no direct or indirect personal benefit for the “disqualified person” (the IRA holder). In other words, the use of personal funds along with IRA funds in a transaction opens the transaction to potential attack by the IRS pursuant to the prohibited transaction rules.
Take the bankruptcy case of KELLERMAN, 115 AFTR 2d 2015-1944 (531 B.R. 219) (Bktcy Ct AR), 05/26/2015. In Kellerman, 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.
What if You Have Enough Personal Funds for the Investment?
On the other hand, there are instances where using personal funds in a transaction along with an IRA may not be prohibited pursuant to IRC Section 4975. For example, assume IRA investor who has $165,000 in her IRA also has $500,000 in available cash in a personal bank account. Would the argument that she could have made the entire real estate investment with personal funds, but wanted her IRA to also take advantage of the investment opportunity have some influence on how the IRS could apply the IRS prohibited transaction rules? It could, but it also could not.
The argument goes that if one could purchase the property entirely with personal funds then the use of IRA funds for the investment would not have any direct or indirect personal benefit on the IRA holder since it was not needed to make the investment and would not trigger the IRC Section 4975 prohibited transaction rules. However, that argument is not without risk and could potentially open the transaction to attack by the IRS pursuant to the prohibited transaction rules. It all comes down to the facts and circumstances involved, a subjective standard that could potentially open the transaction to attack by the IRS. Of course, not mixing IRA and personal funds is the safer and cleaner approach in avoiding a prohibited transaction
Overall, in certain circumstances, using an IRA to co-invest with personal funds could be acceptable. Nevertheless, the risk of triggering the prohibited transaction rules isn’t totally eliminated. That is why it is best practice not to co-mingle personal and IRA funds in the same transaction.