Prohibited Transaction Basics April 24, 2008
Posted by Jeff Nabers in : Self Directed IRA Solo 401k , trackbackThe most notable difference between endeavors down the path of using a self directed IRA versus traditional investing is the unique rules that apply to the former. The extremely simple rule is that an IRA (specifically) cannot buy life insurance or collectibles (such as rugs, works of art, alcohol, bullion).
The more involved rule is known as “no self dealing” and is described in Internal Revenue Code section 4975. This rule basically says that for each retirement plan/account, there is a list of “disqualified persons” with whom that plan cannot do business. These DQPs include:
- The accountholder/participant and any other fiduciary (person who makes investment decisions for the plan)
- Companies who provide services
- A member of the family of #1 or #2 above (family defined as spouse [husband/wife], ancestor [parents, grandparents, etc], lineal descendants [children, grandchildren, etc], and spouses of lineal descents)
- A corporation (or other entity) that is 50% or more owned (directly or indirectly) by #1, #2, or #3 above
- An officer, director, 10% or more owner, or highly compensated employee of #4 above.
- A 10% or more (in capital of profits) partner or joint venturer of #4 above
Every self directed IRA/401(k) investor should make this DQP list before making any investments.
Too many people seem to think of the list as only “the accountholder and his family”. As you can see it is a bit more involved than that. This doesn’t require calculus, but you should actually write out the list step by step to ensure that it is complete. This list can actually get quite extensive if you, your family member, or anyone who provides services to your plan has ownership in several companies.
So, what is a prohibited transaction?
In a nutshell, when a DQP transacts with a plan it is a prohibited transaction (abbr “PT”). The trick here is what is considered to be a “transaction”. This is generally defined in IRC 4975 as when one of the following happens between a plan and DQP directly or indirectly:
- sale, exchange or lease of property
- lending of money or extension of credit
- furnishing of goods, services, or facilities
So I consider that to be the general rule. There are a couple of special rules and they consider a PT to also include:
- When plan assets are transferred to, used by or creating benefit to a DQP
- When the accountholder/participant directs his plan in his own interests (to benefit him now instead of through a proper distribution)
- When the accountholder/participant receives compensation from anybody in connection with plan income or assets
The reason I call these last three items “special rules” is because they transcend the 50% rule in determining when corporations are DQPs. In other words, if XYZ Corp is owned 49% by the accountholder’s mother then XYZ Corp isn’t techinically a DQP. Buuuuuut, if the plan then transacts with XYZ Corp it is obvious that the transaction might violate one of these special rules simply because you can’t ignore that the mother’s position in XYZ Corp was probably considered in the decision to direct the plan into that transaction.
All in all, a little common sense goes a long way. The intent of IRC 4975 is to obviously keep the plan out of transactions connected to people that the #1 & #2 DQPs might be able to control or use as a strawperson. So, clever concoctions that aim to evade prohibited transactions rules by a technicality often times still violate the last 3 special rules. It all comes down to intent, and this is something that DOL (the Department of Labor – the government agency that solely bears the responsibility and authority to interpret prohibited transaction expemtions) concludes based on assembling a fact pattern.
So the “directly or indirectly” part of the rule allows them to let some common sense override the technical rules. It also means that if a plan invests into an entity (Corp, LLC, etc) and that entity invests with disqualified person, it may still be a PT. More on that (plan asset rule) in a later post.
In summary, every self directed IRA/401(k) investor should make a disqualified person list before doing any transactions that involve the plan. Overlooking this is on par with a teenager not making and reviewing a budget because he thinks he can learn from and apply the concepts without actually doing the budget. Once this list is made, prohibited transactions can easily be avoided as long as the plan is never involved in any deals connected to anyone on the DQP list.
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Under current Federal Law do you think a domestic partner could be considered a DQP?
For example do you think a domestic partner could peform active labor in a property flipping investment? If so could they be paid prevailing wages? Could they work for free?
Would it make a difference if the person is the beneficiary for the IRA?
I don’t think a domestic partner could be considered a DQP. The list of DQPs in the Internal Revenue Code is very simple and straightforward.
The definition of DQP is definitely intended to include most people who the accountholder could easily use as a conduit. For a domestic partner to not be on the DQP list may seem to be a loophole, but no more than the fact that siblings are not considered DQPs.
I think any non-DQP performing labor on an IRA/401k owned property is fine. But before pursuing such a thing, I recommend you read the “bigger picture” near the bottom of my post about landlording.
What if an ira company is wholly owned by a private bank. Let’s say one of the directors/shareholders of the bank has an IRA account with the ira company (which is owned by the bank). Could the IRA invest into the bank’s money market account, when that bank is partially directed and/or owned by the accountholder? Would that constitute a prohibited transaction, and would the bank be a DQP?
Could an IRA, LLC, who invests in first deeds of trust, invest in a loan with the individual who ownes the IRA.
Do you have any private letter rulings to reference, or any case law concerning an IRA that invests into an LLC which is managed by the IRA AccountHolder, who also has checkbook control for the LLC. This sounds very attractive, but I would like to see some type of official ruling on this. Thanks!
I have a prospective client who has an existing 401K0. The client is a commercial bank. The bank has an inhouse investment adviser. The bank via their investment adviser is haring in commissions of their plan. Is this a prohibited transaction?
@Mike – I focus mostly on self directed individual plans (not employee benefit plans).
To move yourself towards the answer,
– See IRC 4975(e)(2) to determine who is a disqualified person in the situation. Make a list.
– See IRC 4975(c)(1) [specifically (A) through (D)] to determine if any disqualified person “transacted” with the plan
– See IRC 4975(e)(3) to determine who is a fiduciary
– See IRC 4975(c) to determine if any fiduciary violates [specifically (E) and (F)]
If you need further assistance, contact me at 877-903-2220.
@Dee – No.
@Angela – Re: Bank Money Market account… I always recommend erring on the side of caution; in this case it means open a MMA at a different bank. Typically one bank’s MMA interest rates aren’t going to beat the pants off another’s… so there’s no real incentive to not err on the side of caution.
@Angela – Re: Legitimacy of IRA LLC strategy – There is a fairly straightforward summary of this issue here and also here.
I have a client who has a self directed IRA and inadvertently invested in some silver coins that I have determined to be a prohibited investment. It appears that this investment will be taxable and subject to a 10% penalty in 2007. Can this transaction be unwound to avoid the taxes and penalty?
Mike,
Did the silver coins hold collectors value?
IRS & DOL both have voluntary correction programs for prohibited transactions, but I have little experience with either.
This is in regards to Mike’s question. Yes this would be a prohibited transaction and, actually, could disqualify the plans triggering full distribution and tax penalties. This has been addressed on point in PLRs but I don’t have it around handy. Hope this helps.
I sold a piece of real estate that I personally owned to by brother.
I now want to buy it back in my IRA. Is this a prohibited transaction?
@Mike & John – Technically IRA investment into collectibles/metals is not a prohibited transaction. Firstly, if the metals meet definitions in IRC 408(m)(3), there should be no problem. If they do not, then, according to IRC 408(m)(1), it will be treated as a distribution in an amount equal to the cost of the “collectible” purchased.
@Phllip – If this ultimate result was never conceived or intended, buying the property back in your IRA might not be a prohibited transaction. However, that may be a difficult case to argue. If the ultimate result of getting it into your IRA plan was conceived or intended at the point at which you decided to sell the property to your brother, then directing your IRA to now buy the property from your brother would likely be a prohibited transaction.
Is it viable to obtain an exemption for the use of facilities by a disqualified-person (DQP) that benefits the self-directed plan’s participants? A prohibited transaction is furnishing of goods, services, or facilities between a plan and a DQP. However, there are exemptions which are granted if the transactions are:
1) In the interests of the plan, the participants and the beneficiaries
2) Protective of the rights of participants and beneficiaries of the plan
For example, if a plan owned a banquet hall and charged a customary fee to rent out the hall, could the DQP be granted an exemption to use the hall if they pay the customary fee? This seems to me to benefit the plan but may not be worth the risk.
Celeste,
It’s possible to obtain an exemption, but I would predict that the Department of Labor (the governing authority in this case which could grant the exemption) would not be likely to respond to your exemption request. I think they get too many of these types of requests to respond to them, and to reward such requests would likely create an increase in future similar requests.
All in all, I strongly encourage moving on from prohibited transactions to pursue investments that do not involve any DQPs.
Jeff,
My husband and I would like to structure the following transaction and wanted to get your thoughts.
We have each set up a self-directed Roth IRA. We would like to form an LLC, owned in equal shares by each of our IRAs. The LLC would register a trademark from the USPTO for an S Corp that currently conducts business and is owned by us. The S Corp would pay royalties to the LLC for the use of the name in a commercially reasonable manner to be determined.
Question:
How could we structure the S-Corp and/or the LLC such that they are not DQPs or such that this wouldn’t be a prohibited txn? In fact, we’re not clear if it IS a prohibited txn because in this case $$ would be flowing TO the IRAS (albeit from the S-Corp that we own). Most of what we have read seems to imply that the DOL becomes concerned when the fiduciaries benefit, but here our IRAs are getting the benefit rather than us personally.
We would really appreciate your feedback. Great blog!
Katherine,
Thanks for the compliment.
Quick answer – Because your intent is to invest your IRA money in a way that involves you (through the S Corp), most strategies and structures will be a prohibited transaction. Here it’s not about your benefit; it’s about your involvement.
For a more thorough answer, call my office at 877-903-2220.
Jeff
is a self-directed ira owner’s premature distribution to himself a prohibited transaction?
Rebecca,
No, but a distribution from an IRA is generally a taxable event – taxed at ordinary income tax rates. An additional tax of 10% would typically apply to the distribution if the accountholder is under age 59 1/2.
Jeff
Jeff,
You said in your original post that a DPQ includes “a corporation (or other entity) that is 50% or more owned (directly or indirectly) by #1, #2, or #3 above,” with #3 referring to family members.
IRC 4975(e)(2)(F) covers family members as DPQs. But IRC 4975(e)(2)(G) (which is the look-through provision) only references 50%+ owners identified in clauses (A), (B), (C), (D) or (E) of IRC 4975(e)(2). Where or how does the IRS get to look-through an entity that is 50%+ owned or controlled by a family member and claim its a DPQ? Am I reading something incorrectly?
On a related note, once you setup and fund an IRA-LLC, is it possible for the IRA to make additional contributions to that IRA-LLC? Or would that constitute a prohibited transaction because the IRA-LLC is then a DPQ by application of IRC 4975(e)(2)(G)?
Bijal
Bijal,
Great questions.
An entity owned by a family member is a DQP when cross-referencing IRC 267. In section 267, it says that generally a person’s family members are considered to be themselves personally for tax matters.
As far as further contributions to an already setup and funded IRA LLC, there is disagreement in this matter among people in our field. Some say the LLC is a DQP itself because it is owned by the IRA. This theory is inferred, but not stated in the Swanson court case. I think such a theory cannot be taken seriously. There are no diverging interests between an IRA and itself. The entire idea behind PT rules are to ensure transactions are pursued for the sole benefit of the IRA.
Jeff
[...] his blog, Jeff kicked off an informative Q&A about the topic with his article, “Prohibited Transaction Basics.” It’s worth following this discussion if you’ve been thinking about diversifying but [...]
Jeff, Very informative blog. I have a situation coming up that is confusing to me. I am currently a 36% limited partner of a small LLP futures day trading fund. It only owns cash overnight. I have no operational connection to it. It is performing well, and I wanted to withdraw most of my investment which is taxable, and invest with ROTH IRA funds instead. I was informed that I had to make sure that I did not own more than 49.9% total, and that I could not exit my partnership interest in my taxable account and enter my IRA interest at the same time. I can not make any sense for why this would be prohibited, and I can not get a followup answer about this from the original source. It is not like the partnership interests are a fixed asset, or that I was selling my partnership to myself. If it was not for the 49.9% part, I would not withdraw any funds at all. Can you shed some light on this for me? And what constitutes “at the same time?”
Here is a video that was just posted by Sunwest Trust, Inc Self Directed IRA Custodian that I thought was pertinent to the discussion here on self directed IRA prohibited transactions.
Hi Jeff, I’m a little confused about disqualified persons. Can my IRA loan money to a unrelated friend who is also a 50/50 partner of mine in an LLC? And likewise can he loan me money from his IRA. Does the fact that we have a partnership in the LLC make us disqualified persons. To take it a step further, we each would contribute the loan proceeds into our LLC . We would not be required to make this contribution into the LLC. Does this create a prohibited transaction?
Thanks, Larry V
Larry,
I’m not sure I understand exactly what you are asking.
Regardless, rather than get an answer to a prohibited transactions related specific question, only to need somebody else to answer your next PT question, I recommend you read my prohibited transactions guidebook to get a well rounded understanding of PT rules. You can find the book at http://www.iraaa.org/store
Jeff
Jeff, I ordered your book yesterday. The real question I had is related to disqualified persons. Can I borrow money personally from the IRA of a friend? This friend also is a 50/50 partner of mine in an LLC that buys real estate. Does the fact that we are partners in a business make us disqualified persons in relation to each others IRA. Thanks, Larry V
Larry,
Any question related to disqualified persons is, in effect, a question about prohibited transactions. Disqualified persons is a concept within the Internal Revenue Code section 4975, which is about prohibited transactions.
The most difficult to grasp thing about prohibited transactions is that they can happen even without a disqualified person involved. In the book you will read about “Category A” prohibited transactions (which is the focus ofyou and everyone else) as well as “Category B” prohibited transactions (which is what government officials enforce just as readily as Cat A).
The book is on its way, and it should do a good job of shedding light on what most industry pundits completely overlook – Category B prohibited transactions.
Jeff-
I want to set up (1) a Self-Directed Roth IRA with a custodian that allows a truly self directed Roth IRA. I then plan to (2) Set up a Roth IRA LLC where my Roth Ira is the only member and I am the manager. After instructing my Roth IRA’s custodian to fund the Roth IRA LLC, I will then direct the Roth IRA LLC to purchase shares in and become the only shareholder in (3) a company abroad which I am a director/fiduciary, and from which I will recieve a salary. The company abroad will make dividend payments to the Roth IRA LLC for its investment, which will go back to my Self-Directed Roth IRA, and when/if the company abroad is sold, the proceeds will also go to its sole shareholder- the Roth IRA LLC, and thus its only member, my Self-Directed Roth IRA. All of this tax-free. Would this be a Prohibited transaction?
If so, would it be possible to take an additional step where my Roth IRA LLC invests in an LLC that is (1) managed by my twin brother, and (2) where my Roth IRA LLC is the only member? My twin brother has nothing to do with my company abroad.
Thanks,
Andy
What you described is prohibited. You can’t take a salary from a company your retirement plan owns, directly or indirectly.
It doesn’t matter how many people or complexities you put between your IRA and where you draw your salary… if the effect is the same it’s a prohibited transaction.
I recommend you focus on making investments that don’t involve you in any way other than the investment decisions.
Jeff
If I were to establish a solo 401k plan, or set my IRA up to be self directed with check book control, can I invest with oil/gas LPs, or similar direct ownership programs even though those offering these investments say they don’t accept IRA or qualified money. They say that I can only invest non-qualified money with them. Also, given that these investments provide some tax write offs, it would seem that an IRA owned LLC would benifit from the write off that can be used later against income from the investment flowing to the LLC and back to the IRA? Is this possible to structure? Also, how do you handle min-required distrubutions after age 70 if the LLC or investment isn’t liquid for the distribution? Simply reduce the value of the LLC in the IRA?
I am currently over 59.5 yrs old working for a company that has a 401K.
Can I move part of that 401K amount to establish my Solo 401K? — how do I go abount doing it?
I intend to trade real estate with the Solo 401K, essentially running my own business. Eventually when I reach the retirement age I will move remaining 401K amount from the company I am currently working to my 401K.
Appreciate your advice and comments.
The most important first step in establishing a Solo 401K is how do I convince my current custodian that I am moving funds from 401K for that purpose and hence make him not deduct taxes from the distribution?
James,
Outside of the issuer’s (LP promoter) policies, there is not legal restriction on investing into limited partnerships.
There’s no way to use a tax writeoff for LLC distributions to the LLC’s owner, the IRA, if the investments are tax-exempt. Generally, the IRA has no tax return and no taxes. So you start out as good as you possibly could… with zero taxes.
The situation also could change depending on how the LP is structured. In one structure, there may be no UBIT created; in another UBIT may be triggered. This type of more comprehensive assistance we only offer to clients. If you are interested in becoming one, start off by calling 877-903-2220.
As for RMDs, they have to be actual distributions. It is your responsibility to ensure sufficient liquidity to make them.
Jeff
Ken,
The amount of rollovers and transfers that you can do from a 401k that is adopted by an employer at which you are still employed is going to depend on the terms that 401k plan document.
You can ask your employer’s 401k administrator how much you can rollover or transfer while still in service. You can also ask for a copy of the plan document and adoption agreement to search for the terms yourself.
As for executing the transfers and rollovers in whatever amounts is allowed by the existing plan, we support and assist our clients in doing so. If you are interested in becoming a client, simply call my office at 877-903-2220.
We look forward to assisting you!
Jeff Nabers
Jeff, I have a self directed solo 401K where my wife and I both rolled over our individual 401K accounts separately. We are ready to purchase our first real estate investment. We are planning to combine the money from our separate 401K accounts together, create a LLC to hold the title of the property, and fund the purchase. The LLC will be managed by me for the sole purpose of holding the title of the properties, limiting our liability and the process property transactions. Is this considered as Prohibited transactions?
Wing,
If your retirement plan and your wife’s retirement plan are considered disqualified persons with respect to each other, then yes it could be a PT.
An easier way to combine the funds would be to use a single Solo 401k plan. If you need more help, call 877-903-2220.
– Jeff
My wife just received an ESOP distribution from the company she works for. The company she works for was bought out by another company within the same industry.
We have been planning a business for over 2 1/2 years.
We want to use a small portion, $120,000, of that money to inject as owner capital for this start up business. The amount above would be 40% of the total cost for start up.
Is there, or do you have any information on exemptions being allowed for a start up company using a self directed IRA / 401K if the account holder has an “LLC Operating Agreement” with a scheduled re-payment plan, with interest, back into the self directing account? We also have a meeting scheduled with our CPA to discuss this issue.
It is very hard to swallow the penalties and interest associated with the early withdrawal of money needed for our business.
Is there, in your knowledge, any other way to invest part of this ESOP money in our own start up?
John,
There are options, some of them bad and some good. Call my office at 877-903-2220 and we’ll walk you through them.
Jeff
Jeff, I am a real estate agent and am considering using my solo 401K to purchase real estate. Is it a PT if the seller pays my broker real estate commission at closing and in turn my broker pays me my share of commission on the house I am purchasing using my 401K money?
Wayne, yes.
A client and his wife are planning on borrowing from their solo 401-K accounts to either:
a. Lend the money to their company to purchase a building for their business or
b. Use the money for a down payment on a mortgate for them to buy the building in their name.
Does it make any difference who buys the building (company or persoanl) and, would either of these alternatives create a prohibited transaction?
John,
Participant loans can be for any reason. If they were to use the loan proceeds to buy the building in their company name, just make sure the loan proceeds go from the plan to the individual participant(s) first and then get over to the company in the form of a capital contribution or in the form of a loan from the individual to the company.
No use of participant loan proceeds will create a prohibited transaction.
Jeff
Thanks for your response but need the answer to the second part of my question. ie. can the 401 account buy the building for the employer or is that a prohibited transaction? I had read that it may be OK of there is a fiduciary.
Thanks for your help
John,
I would discourage them from using their 401k to buy a building for their company. It is primarily a prohibited transaction although some people interpret it to be exempt from PT rules.
Check out my PT book at http://www.iraaa.org/store for a better understanding.
– Jeff
My mother is interested in purchasing real estate with her IRA that she plans to flip. She would also like to hire my husband to remodel the home through his LLC in which he has a 50% interest. Is this prohibited.
Yes, that is prohibited. See more here
I am really confused. Say my wife takes her 401k and goes through the process to make a C-corporation and rolls that money into a self-directed 401k and then used some of the funds to purchase equipment for a self-employed business, ie; mobile kitchen, etc. Would that be something that would cause trouble with the IRS or others?
I am really confused. Say my wife takes her 401k and goes through the process to make a C-corporation and rolls that money into a self-directed 401k and then used some of the funds to purchase equipment for a self-employed business, ie; mobile kitchen, etc. Would that be something that would cause trouble with the IRS or others?
I am really confused. Say my wife takes her 401k and goes through the process to make a C-corporation and rolls that money into a self-directed 401k and then used some of the funds to purchase equipment for a self-employed business, ie; mobile kitchen, etc. Would that be something that would cause trouble with the IRS or others?
I am really confused. Say my wife takes her 401k and goes through the process to make a C-corporation and rolls that money into a self-directed 401k and then used some of the funds to purchase equipment for a self-employed business, ie; mobile kitchen, etc. Would that be something that would cause trouble with the IRS or others?
I am really confused. Say my wife takes her 401k and goes through the process to make a C-corporation and rolls that money into a self-directed 401k and then used some of the funds to purchase equipment for a self-employed business, ie; mobile kitchen, etc. Would that be something that would cause trouble with the IRS or others?
I want to open a new Solo 401k retirement account and place in it two non-owner occupied single family homes which are titled under the name of my existing LLC for more than 5-years.
Would that work and not be considered a DQP? If it is DQP could I as an alternative list the real estate in the MLS and subsequently turn around and buy the real estate from my LLC and later transfer them property to the solo 401k?
Thanks for your reply.
Your LLC (if you own it) nor you personally could sell property to your retirement plan.
You have to enter into transactions that have no conflict of interest in order to stay clear of PT rules. I hope this helps
– Jeff
I have a small investment fund (LLC) that I manage through another LLC (I’m the sole member). I generally invest in equities and options. I currently have less than a 1/3 interest in the investment fund, and the remaining interests are owned by individuals that are of no relation to me whatsoever.
I would like to set up a checkbook LLC and invest my IRA into the investment fund. I believe that the fund itself is not a DQP because I have less than a 50% interest. Also, I will make sure the amount I put into the fund stays below the 25% limit so that the LLC is not considered a plan. Finally, I will make the IRA a special member such that it will be charged no management fee and will not be subject to a performance allocation.
Based on what you said in this post, it seems that you believe I would still be tripped up by 4975(c)(1)(C) because my management company would be providing investing “services” to the IRA. Is that the case? If so, how would my selection of investments for the fund be any different from the selection of investments that is permitted by the fact that I can direct the LLC money into whatever investments that I want? Also, my IRA money is currently in a self-directed brokerage account. I want to move it into the fund so that I have more investment options. How could the services I provide for my IRA currently be prohibited if I move the assets into an my investment fund where I do the same thing with my IRA money?
Thanks in advance!
But if that was done anyway (LLC owned real estate transfer) what could be the penalty or potential negativity if any for doing it in a worse case situation? Thanks.
An answer to the above about potential penalties would be much apprciated along with an explanation about what a Checkbook LLC is? Thanks.
Do I violate any IRS rules if I sell property I own to a 3rd person (not a relative) and then have my IRA buy the property from that person?
Can I please get a reply? Thanks.
David, I’m not 100% sure I know what you are asking, and I am certainly not an expert on the issue, but the penalty for a prohibited transaction is that your 401k or IRA proceeds involved in the sale would be considered a distribution subject to taxes and penalties.
@David, the default penalty for doing a prohibited transaction with a retirement plan is 100% of amount involved plus an additional 15% per year for each year until the transaction is undone. For future reference, you can get your questions answered much more quickly by calling my office at 877-903-2220.
@Evangelos, yes what you described would violate the prohibited transaction rules. In that scenario, the 3rd person is known as a “strawperson” because he or she was only inserted into the transaction sequence in an effort to get around the law. In the event of an audit, the strawperson would not be considered and the real parties to the transaction would be revealed, thus revealing a prohibited transaction. I recommend you focus your retirement account on making money from new investments as there is a world of great opportunities out there.
@Bill, here’s how the government would likely look at your argument. If putting your IRA into your investment fund were identical to self-directing it in the first place, then why do you want to put it into the investment fund? They may consider that to be a sign that you really to intend to benefit some other way from that decision. If the sole reason is to truly have access to a wider array of investment options, opening a brokerage account for an IRA LLC will accomplish the same thing. For more information, call my office at 877-903-2220
– Jeff
Hi again Jeff, a couple months ago I bought your book on Prohibited Transactions. I’m still a bit confused on one issue. I want to purchase an investment property with a friend of mine who also is a 50/50 partner with me in an LLC that owns 2 rental properties. He wants to use his self directed IRA money for this new investment. When going through the list of Disqualified Persons, I do not seem to be a DQP with respect to his IRA untill I get to the 6th DQP criteria which lists all owners of a DQP entity. Do I understand this to mean that since I am a 50% owner of an LLC that he also is a 50% owner, I can’t do any transactions with his IRA? Whether it be buying a new investment, starting a new LLC, buying properties with his IRA as tenants in common? Thanks, Larry V
Hi Jeff,
I have a Roth IRA and would like to invest in a foreign pooled forex fund. It has a good track record for paying so I would like to use the Roth IRA as a means to allow my investment to grow tax-free. Is this a prohibited investment? I’m aware I would have to go through my custodian and not make a direct investment to the fund.
Mary,
A prohibited transaction involves a disqualified person transacting with your IRA or benefiting as a result of the investment decisions of your IRA. That said, it doesn’t sound like what you described would be a prohibited transaction.
You are however required to invest into things in which the U.S. has jurisdiction. If the fund is based offshore, you may need to create an LLC for your IRA to invest in that will subsequently invest in the offshore fund.
I’m only working off of a one sentence explanation here, so I’d strongly recommend calling my office for further assistance at 877-903-2220 x1.
– Jeff
Can I/we give a personal guarantee to support an investment by the Plan? More specifically, suppose we want to buy one or more distressed properties, which would require financing.
Norris,
The short answer is “no” but there is a lot more to consider about the bigger picture of achieving your objectives. I suggest you call our office at 877-903-2220
Jeff
Jeff,
Above you said the “default penalty for a prohibited transaction is 100% of the amount”. I read somewhere that if I have a prohibited trasaction in an IRA account in 2009, that by default the following would occur: a.)100% of that IRA account would lose its tax exempt status as of 1/1/09, b.) that the value of the IRA as of 1/1/09 (say 100k) would be consider as a distribution on that date (subject to 34% ordinary income tax and 10% early withdrawl), and, c.) that any subsequent gains in the now defunct IRA account would be treated as regular capital gains for 2009. So given the 100k value on 1/1/09, if I have a prohibited transaction in this account in 2009, I would owe ~$44k (plus any capital gains for earnings of the now defunct IRA))?
Or, are you really saying I would owe ~$100k as a penalty?
Am I right that the IRA account in total would cease to exist as of 1/1/09 and that any subsequent gains made that year in that accout would be taxed as normal cap gains?
George,
The default prohibited transaction penalty is 15% of the amount involved plus 100% of the amount involved if not corrected/undone within 1 year plus 15% of the amount involved for each subsequent year that the transaction remains uncorrected.
There is an exception for IRAs that says the account is deemed as fully distributed and taxed as such.
I hope this helps!
– Jeff
p.s. I hope you interpret this as “regardless of the type of plan, it doesn’t make sense to do a prohibited transaction.”
Jeff,
No doubt my situation is unique because I have large capital loss carryovers that come into play….so the details are important.
From Pub 590 “Effect on an IRA account. Generally, if you or your beneficiary engages in a prohibited transaction in connection with your traditional IRA account at any time during the year, the account stops being an IRA as of the first day of that year. ”
I would love my IRA to be treated as having stopped being an IRA as of the first of the year
Specific example -
a.) My IRA account was worth 100k on 1/1/09
b.) It has $200k of subsequent capital gains to date in 2009.
c.) I have unused capital loss carryovers of $750k from 2000/2001 on my regular taxes..
If the IRS pub (and other info I have read on the internet) is correct. If I engage in a prohibited transaction in the last 3 months of this year; a.) that IRA stops being an IRA as of 1/1/09. b.) I owe 44k in taxes on the 100k “distribution” based on the 1/1/09 value (34% ordinary, 10% early). when it ceased to be an IRA c. The remaining 200k of capital gains for the year are offset by unused capital loss carryovers. The result is I get $300k moved from my IRA account to my cash account but only have to pay $44k in tax for it, and futher gains are tax free due to my remaining capital loss carryover.
Obviously before I deliberatly engage in a prohibited transaction to take advange of the way this rule is written I would want to make 100% sure the rule would be applied as Pub 590 says it would, and what the word “generally” means.
My big question is – I can read the Pub (and the law behind it) but I know of no tax guys who KNOW this stuff well enough to give me 100% confidence in the proper treatment before I take action. Do you know any?
George,
I suspect that wishful thinking is affecting your interpretation of Pub 590. First off, Pub 590 isn’t the law… it’s just a non-binding document where the IRS tries to explain the law that Congress wrote.
The default PT rule (which applies to qualified plans) is that the taxes are charged on the “amount involved” and they specifically define “amount involved” as the highest amount of several different options.
If that line of thinking carried over into how the IRA PT distribution were calculated, they will want ordinary income taxes on a distribution of the highest value that your account had throughout the year.
I don’t think you have solid ground to walk on if you treat your taxes as you described.
I know that was probably not what you wanted to hear, but I hope it helps
Jeff
Jeff,
Here is the actual law. Its pretty clear that for an individule retirement account, prohibited transaction = account ceases to be an IRA as of the first day of the year and shall be treated as distribution at fair market value of assets as of the first day of the year.
TITLE 26, Subtitle A, CHAPTER 1, Subchapter D, PART I, Subpart A, Sec. 408. Individule returement accounts Section e(2)
“(2) Loss of exemption of account where employee engages in
prohibited transaction
(A) In general
If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. For purposes of this paragraph -
(i) the individual for whose benefit any account was established is treated as the creator of such account, and
(ii) the separate account for any individual within an individual retirement account maintained by an employer or association of employees is treated as a separate individual retirement account.
(B) Account treated as distributing all its assets
In any case in which any account ceases to be an individual retirement account by reason of subparagraph (A) as of the first day of any taxable year, paragraph (1) of subsection (d) applies as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day).”
George,
You can’t take my bog comments to tax court to defend yourself against the IRS. I wouldn’t recommend you purposefully do a PT without an attorney on your side who agrees with you and is willing to defend you.
Good luck
Jeff
p.s. Don’t forget to think about what you will do with the funds. If you plan on spending them, what you are thinking about makes sense. If you were to further invest them, I don’t see much of a benefit to getting them out of a tax favored retirement account. You should give some thought as to whether you intend to be in wealth building or wealth depleting mode.
Jeff, We have just formed an LLC to invest in rental property. There are 4 of us so we each have a 25% share in the LLC.
The current thought would be that each of our self directed IRAs would make a loan to the LLC to purchase the rental properties. Since there are 4 of us and we only own 25% of the company we each pass the 50% owership rule. However, is this still considered a prohibited transaction because we get a share of the LLC profits?
Regarding the loans, are there any caveats regarding the terms (i.e. interest rate, payment terms, etc)? I’m guessing they need to be as close to what’s available in the current market as possible.
Mike,
What you described would be a prohibited transaction per IRC 4975(c)(1)(D) & (E). Percentages don’t matter when you design an arrangement that will benefit you or any other disqualified person. Hope this helps clear things up!
– Jeff
Jeff,
My wife and I have IRAs privately placed through our broker with a hedge fund. We are 56% owners of the fund due to attrition of other investors. We would like to convert a portion or all of our IRAs to ROTH IRAs in this fund. Would this be a prohibited transaction due to our high ownership percentage?
Dennis,
A Roth conversion will be a matter of telling your IRA custodian to convert to Roth and then paying the taxes. An actual transaction will not really occur. Nothing needs to happen between your IRAs and the hedge fund.
– Jeff
Jeff-
My father-in-law owns a company and they are intitiating a new 401k plan. I am an advisor at Brokerage firm and I understand that I would be considered a disqualified person, per IRS regulation. However, if I was put on the plan as Broker of Record, would that be considered a Prohibited Transaction?
Thanks,
Jeff,
I want to open a self directed IRA to buy a house. My intent is to fix it up and sell it. I would like to do much of the work myself. I have read that I can not provide services for the house. Does that mean I can’t do the work, or does it only mean I can’t be compensated for the work? I can see that paying me to do the work would be a PT, but it isn’t clear if providing no charge labor is also prohibited.
Thanks.
Reggies,
There is an exemption for:
(2) any contract, or reasonable arrangement, made with a disqualified person for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor;
The question is whether your brokerage services would be considered “necessary to the operation of the plan.”
Seek legal advice.
——-
Brain,
See this:
http://jeffnabers.com/index.php/2008/05/30/landlording-your-ira-llcs-properties-is-it-allowed/
Jeff
I have been looking into a way to purchase a property to rent/sell to my daughter. I know it would be a pt to purchase it with an LLC IRA.
However while looking at IRC 4975 it states that up to 10k can be taken from an IRA without the additional penalty. It reads to me that this can also be distributed to a child. Is this correct?
I’m the sole owner of a company that sponsors a 401k plan that I also participate in, and would like to make a loan to my sister from the plan. She has nothing to do with the plan or the company, but I’m wondering if the “joint venturer” part of the disqualified person definition may apply since both she and I are 50/50 co-owners of a rental property. The rental property is unrelated to both the plan and the company.
Jeff
I hold many First mortgages that come due after several years with a balloon payment. If the borrower has been a good client I often renew the mortgage for another 3-5 yrs.
All mortgage notes held are at arms length no family or DQP involved in the ownership of any of the properties
Q1: On the Due date of the note could my wife’s SD IRA step in & hold that re-written mortgage Note for the property owner?
Q2: Can I sell a mortgage note to my wife’s self directed IRA at face value before the due date?
thanks
[...] This statement is technically correct. Putting IRA money into his primary residence would be a prohibited transaction. The disturbing thing about the situation is that these three people (a person, their realtor, and [...]
@Mike – I think you are referring to some exemptions to the 10% penalty. But you’d still be paying taxes to distribute it. And you’d be spending money instead of investing it. As long as you are honest with yourself as to what you are doing, you can probably avoid huge regret down the road. As for the exemption from the additional 10% penalty, you’ll need to get a better grip on the specific exemption you are going for.
@Stacy – I would always recommend staying away from lending retirement funds to family. Although the PT code specifically doesn’t consider siblings as disqualified persons, the potential for conflict of interest is real.
@Patrick – These are gray areas. I recommend staying out of them.
Jeff
Dear Jeff,
If I am a registered investment advisor with a mutual fund, can I invest my rollover IRA in the mutual fund I manage?
Thanks
Chris
Chris,
I’ve heard there’s an exemption of some sort for publicly traded securities. If that’s the case you could do that.
But I don’t spend any time or energy helping people invest in publicly traded securities, so I’ve never checked into that exemption to verify it exists and says/does what I’ve heard.
I won’t spend any time trying to persuade you that the stock market is a giant ponzi scheme with an upward movement fueled only by inflation and that inflation is grossly under-reported by the government, but that’s the reason I can’t give you a definite answer about the exemption.
Take care
Jeff
I have a question regarding a real estate SDIRA:
I purchased a piece of residential property through my SDIRA. I want to lease it to a personal friend with favorable rent in return for maintaining my property (versus leasing it to strangers who might be careless) until I can use it can take it as a distribution and use it for my retirement.
Since siblings, cousins, friends are not disqualified persons under the IRS code, could the IRA holder then visit them in the property? Or does this represent “use” or a “benefit” of the property, making it a prohibited transaction?
What can the IRA holder legally do in such a case, without triggering a PT?
Narda,
If your visiting a friend who rents a property from your SDIRA is not calculated into your decision to rent the property to your friend, it should be okay.
If giving favorable rent is only part of a deal to “maintain the property” you should be okay, given that the “property maintenance” in question is above and beyond what a renter would normally do in the course of paying standard rent.
If the favorable rent is not justified by maintenance tasks, then it runs the risk of being interpreted as you just doing a favor for your friend, which is in the interest of you rather than your retirement plan.
It could be argued that it is in the interest of your retirement plan. But it’s up to you to win that argument if the IRS ever challenges you on this. If, at that time, you have also been spending a lot of time in the property, I think it weakens your position.
All in all, I’d recommend leasing to “strangers” and using standard screening procedures to try to get good tenants who won’t damage your property.
On another note, I wouldn’t recommend distributing a property out of your IRA to live in. There’s a longer explanation for that and I’ll do a new post on that topic soon.
– Jeff
Hi there
I have been doing some research on SDIRA’s and investing in LLC’s that manage rental property. I have a scenario that perhaps you may be able to offer an opinion:
Scenario is as follows:
The SDIRA buys majority shares in an LLC and the LLC invests that money in a high yielding rental property in a popular tourist area.
The high yielding rental property is managed by an independent rental company, who can only find tenants during a short 3 month long high season. The rest of the year, the rental company has excess inventory and close to zero demand, and generates 0 income for the rental property.
Separately, the owner of the SDIRA has a services contract with a company C. Company C frequently sends the owner of the SDIRA to the popular tourist area to conduct business throughout the year, even in the offseason.
Currently, company C pays for the owner of the SDIRA to stay in a high priced hotel.
The owner of the SDIRA, in the interest of the IRA, wants to rent the house owned by the SDIRA’s LLC at a fair market value to Company C in the offseason, so Company C will allow the owner of the SDIRA to stay there instead of the high priced hotel. This scenario benefits Company C, saving money on the high priced hotel, and benefits the SDIRA, because the rental property would be otherwise unrented. The only drawback is that the owner of the SDIRA is staying in the house, which is generally considered forbidden and personal benefit, but the real benefits are to the Company C renting the house (saving money) and especially the SDIRA (receiving the income it otherwise would not).
This is a scenario where self directing IRA assets will result in income that otherwise would not be realized. For further separation, Company C can rent the property through the rental management corporation.
Is this something the IRA holder can legally do in such a case, without triggering a PT?
Hi, Hal.
This scenario is up to interpretation, but I’d recommend staying away from it.
Let’s say the normal tourist price for this property is $200 per night. And let’s say your “off season” rate that you’re proposing here is $50 per night.
Here’s the devil’s advocate position…
If Company C would like to find a low (but fair) priced off-season deal, why can’t it find another property for $50 per night?
If $50 per night is a fair off-season price for your self-directed IRA to get, then why don’t you have your property rented to another tenant for that price?
If the benefit (to you) to doing this were substantial, then it would be a PT. If the benefit to you (indirectly through Company C) were not substantial, then it really isn’t worth the PT risk in my opinion.
I hope this helps
Jeff
Jeff, can you clarify what level of sales activity can connect an IRA-LLC owner and an *investment* of the IRA? Specifically, if the IRA-LLC buys shares of a private corporation X, and owns some small part, say 5%, of it, is it thereafter a PT if a separate company Y owned 100% by the owner of the IRA-LLC sells small quantities of supplies at market prices to company X? A more silly example would be, if the IRA-LLC buys 1000 shares of Starbucks, is the IRA-LLC owner forever barred from buying a cup of coffee there?
Kevin,
Probably any number of shares you would realistically buy in a publicly traded company like Starbucks could not possibly result in enough interest to create a conflict.
As for the 5% example of a private corporation, I’d recommend staying away from that. There are 6 prohibited transaction rules, and 2 of them don’t have any clear percentage boundaries.
The fact is that if you used your IRA LLC to buy 5% of Corp X and had on your mind the idea that Corp Y (which you own) would later be selling products to it, that’s a bad sign that the product sales are factored into your decision to buy into Corp X.
My recommendation is to always stay away from scenarios that aren’t clearly compliant. This is one of those.
I hope this helps.
Jeff
I want to set up a self-directed IRA with checkbook control, and a bank account for the LLC in the US. I then want to buy property in Mexico. I will need to form a MX corporation owned by the US LLC in order to buy the MX property, and will need a MX bank account in the name of the LLC in order to pay contractors to repair/maintain the property, and to deposit the rent my tenants will pay in cash to the LLC.
Will this be a problem, as long as I have no plans to do any transactions from the LLC which would benefit me directly (aka prohibited transactions) ? Do I need to have the additional expense of hiring a local MX management company for the MX property to handle the repairs, paying local taxes and collecting the rents?
Hi, Kirk. I think your question boils down to “What can and can’t be done in the LLC?”
What can be done is ministerial duties. That basically means administrative duties. This includes activities like collecting rents, screening renters, etc. You don’t want to cross the line though into where you are doing manual labor on the property.
You don’t need to hire a MX management company if you are able to manage everything yourself as LLC manager without crossing the line into “active landlording.”
Jeff