A prohibited transaction is any improper use of a Self-Directed IRA by the account holder, their beneficiaries, or a disqualified person as defined by the IRS. These transactions typically involve self-dealing, indirect benefits, or transactions with disqualified persons, all of which violate IRS regulations and can result in severe tax consequences, including the disqualification of the IRA.
Understanding Disqualified Persons
A disqualified person is anyone who has a direct or indirect relationship with the IRA that could lead to conflicts of interest. This includes:
- The IRA account holder (you).
- Your spouse.
- Your lineal family members (parents, children, grandchildren, and their spouses).
- Any entity (corporation, partnership, trust, or estate) where you or a disqualified person have 50% or greater ownership.
- Any fiduciary or person providing services to the IRA.
Because of these rules, an IRA cannot engage in transactions that personally benefit you or other disqualified persons.
Examples of Prohibited Transactions
1. Using IRA Funds for Personal Benefit
- Borrowing money from your IRA.
- Using IRA funds to pay off personal debts.
- Taking a salary or compensation for managing an investment owned by your IRA.
2. Purchasing Assets from or Selling Assets to a Disqualified Person
- Buying real estate from your parents or children using IRA funds.
- Selling an asset owned by your IRA to a company you control.
- Using your IRA to invest in a business where you (or a disqualified person) own 50% or more.
3. Personal Use of an IRA-Owned Asset
- Buying a vacation home with IRA funds and staying in it, even for one night.
- Renting out a property owned by your IRA to your children or other disqualified persons.
- Personally holding precious metals that are owned by the IRA.
4. Providing Indirect Benefits to Yourself or a Disqualified Person
- Using IRA funds to invest in a business where you or a disqualified person work and receive a salary.
- Investing IRA funds in a company that then loans money back to you.
- Making a loan from your IRA to your spouse’s business.
5. Pledging IRA Assets as Collateral
- Using IRA funds as collateral for a personal loan.
- Personally guaranteeing a loan for an IRA-owned investment.
6. Taking a Distribution Directly from an IRA-Owned LLC
A common misunderstanding among IRA holders who invest in wholly owned LLCs (also called Checkbook LLCs) is how distributions should be taken.
✅ Correct Way: If you want to take a distribution from an IRA-owned LLC, the funds must first be sent from the LLC’s bank account back to the IRA. Then, the IRA custodian will process the distribution per your request, ensuring proper tax reporting.
❌ Prohibited Transaction Example: A client owns an IRA-funded LLC that holds rental properties. Instead of sending rental income back to the IRA first, they transfer money directly from the LLC’s bank account to their personal bank account. This is considered a prohibited transaction because it bypasses the IRA custodian, leading to potential tax penalties and disqualification of the IRA.
Consequences of a Prohibited Transaction
If a prohibited transaction occurs, the IRS may disqualify the entire IRA, treating the full account balance as distributed as of the first day of the year in which the transaction occurred. This can result in:
- Immediate taxation on the entire IRA balance.
- A 10% early withdrawal penalty (if you are under 59½).
- Additional interest and penalties for unpaid taxes.
Because of these risks, it’s essential to ensure that all IRA transactions comply with IRS rules.
Final Thoughts
Understanding and avoiding prohibited transactions is critical to maintaining the tax-advantaged status of your Self-Directed IRA. If you're ever unsure whether a transaction is allowed, consult with a tax professional or IRA custodian before proceeding.
If you have further questions about prohibited transactions, AET’s support team is here to assist you.
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