Ever hear of a “prohibited transaction” within a Self-Directed IRA? It’s a simple concept. Although the Self-Directed IRA gives you all sorts of opportunities to invest in a wide range of assets from precious metals to real state and more, these investments aren’t without limits. There are indeed what the IRS calls “prohibited transactions,” or transactions that run counter to your IRA’s goal of keeping money aside for retirement. However, because it can be complicated to understand what constitutes a prohibited transaction, we figured we would give you some prominent examples of what you would be expected not to do with a retirement account. Here’s what you’ll need to know.
What is a Self-Directed IRA Prohibited Transaction?
A prohibited transaction under the internal revenue code is a transaction that the law does not allow, usually between a retirement plan, or your IRA, and a “disqualified person.” Understanding the role of the “disqualified person” is key here, because there may be valid transactions you can carry out if the other party is not a disqualified person. Typically, a disqualified person refers to anyone in your lineal family (parents, grandparents, children, grandchildren, and everyone’s spouses) or someone with whom you do significant business. Interactions between your IRA and such an individual would be perceived as an early withdrawal from the account, potentially incurring taxes and penalties. You want to avoid these transactions whenever possible.
Example #1: Leasing a Property to a Disqualified Tenant
Let’s say you use your Self-Directed IRA to purchase a piece of real estate with your retirement account. That might sound like a good idea at first—and it very well can be!—but you can turn it into a bad idea if you decide to turn around and lease that property to a disqualified person. In other words, you can’t use this property for personal benefits, which includes renting a piece of property to someone like a child of yours. You can certainly do this if you keep the property as a personal possession or investment, which would keep everything strictly taxable. However, if you want the benefits of a retirement account, you will have to avoid transactions like this.
Example #2: Lending to Someone You Know
It’s possible to use Self-Directed IRAs for private notes, lending money to people in a way that creates an asset for your IRA (the lender) and a debt for the borrower. However, if you were to lend someone money from your IRA—such as a parent—then this would again be a disqualified person you’re interacting with, which means it becomes a prohibited transaction. Even extending credit between an IRA and a disqualified person is considered a prohibited transaction.
Example #3: Furnishing Goods with a Disqualified Person
Let’s say you don’t strictly lend money or sign a contract between an IRA and a disqualified person. What if you simply let a disqualified person stay in a piece of property you own in an IRA, for example? This, again, is a prohibited transaction, yielding you a personal benefit when the investment is supposed to be earmarked for retirement benefits.
When you understand the rules of thumb when it comes to Self-Directed IRA investing, you will generally be able to avoid prohibited transactions and other issues like these. But it helps to arm yourself with knowledge from the outset. The more you learn about Self-Directed IRAs, the better you’ll be able to manage them yourself.