One of the most discussed retirement topics involving the use of retirement funds to make investments is the Self directed iRA prohibited transaction rules. The self-directed IRA prohibited transaction rules are outlined in Internal Revenue Code Section 408 and 4975. The IRS and the Internal Revenue Code do not describe what a Self Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.
The IRS has always allowed the use of retirement funds to purchase real estate and other nontraditional investments such as precious metals and tax liens. One can use IRA funds to take real estate and other investments through a Self Directed IRA tax-free and without custodian consent.
When it comes to using IRA funds to make non-traditional investments such as real estate, tax liens, precious metals, it is important that one works with a tax professional that specializes in the IRS prohibited transaction and Disqualified Person rules. The reason for this is that the penalties for engaging in a prohibited transaction are severe (entire IRA will be treated as a distribution subject to tax plus a penalty may be imposed).
When it comes to determining whether a potential transaction involving IRA funds violates the self-directed IRA rules, the first two questions that must be addressed is whether the transaction involved a disqualified person and whether any disqualified person will personally benefit directly or indirectly from the proposed investment.
The IRS has restricted certain transactions between the IRA and a “disqualified person”. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.
The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
Pursuant to Internal Revenue Code Section 4975, a Self Directed IRA is prohibited from engaging in certain types of transactions. In general, the prohibited transaction rules typically involve the participation of a disqualified person. The IRS’s intent for codifying the prohibited transaction rules was to ensure that if an IRA holder or any disqualified person would receive some sort of direct or indirect benefit when using retirement funds, the IRS would not be in jeopardy of losing the tax income attributable to the IRA distribution rules. The IRS was concerned that if people were allowed to engage in transaction with certain family members, it would be just as if they were able to personally benefit from the use of the IRA funds which would eviscerate the IRA distribution rules.
The prohibited transaction and IRA disqualified person rules are extremely broad and the penalties extremely harsh. Therefore, it is crucial that a tax professional be consulted prior to making an investment using IRA funds.