When investing retirement funds, the IRS has established a number of rules that must be considered.
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 – also known as the IRS prohibited transaction rules. 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 using IRA funds to make non-traditional investments such as real estate, private business investments, loans, 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 using a Real Estate IRA or Solo 401K Plan to make an investment, there are a number of important items that should be considered before making the investment:
- Speak to a tax professional to confirm that the transaction does not violate IRS rules
- Only retirement funds should be used for the investment – no co-mingling of personal funds
- The IRA transaction should not involve a “disqualified person”. 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.
- All income and gains generated by the IRA investment should flow back to the Self Directed IRA.
- Only IRA funds should be used to pay expenses related to the Self Directed IRA investment.
- No Disqualified Person, including the IRA holder should be compensated in any way in connection with a Self Directed IRA real estate investment.
- No Disqualified Person, including the IRA holder should provide any services to the IRA investment.
- No Disqualified Person, including the IRA holder should personally benefit in any way, directly or indirectly, in connection with a Self Directed IRA investment.
- If precious metals are being purchased using IRA funds, the metals should be held in the physical possession of a U.S. bank and not in the possession of a Disqualified Person
The prohibited transaction 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.