Getting Around Prohibited Transactions August 31, 2009
Posted by Jeff Nabers in : Self Directed IRA Solo 401k, real estate , trackback
Prohibited transactions is a chief topic when exploring self-directed IRA & Solo 401(k) investing. When a person first discovers that his retirement accounts have been chained to Wall Street brokerages without necessity, his mind starts to imagine the possibilities.
Real Estate? Yes.
Private Businesses? Sure.
Precious Metals? Absolutely.
Getting my hands on my retirement money now? Slow down there.
There are two types of limitations on the average retirement account. One is an unnecessary restriction of investment options to securities products. That can be eliminated through restructuring your accounts and funds. The second limitation is legal and cannot be removed.
Setting up a self-directed IRA or 401(k) is about removing limitations. Once you have it setup outside the nearly monopolistic network of securities dealers, you can invest in almost anything… but you must fully understand the legal limitations.
The general premise behind prohibited transaction rules is that the government wants you to grow your retirement account as big as possible because they plan to tax it later on when you distribute the funds to yourself for spending. Without prohibited transactions rules, anyone in their right mind would grow their retirement account and then make “losing investments” that actually put their retirement funds into their own hands.
For example, imagine you grow your IRA to $1 million and now you’re ready to get that money into your own hands so you can spend it. You could distribute it to yourself and pay ordinary income taxes on the distributions. Or you could invest it into your business that you personally own and operate. The latter could be an “investment” from the IRA. Once the money is in your business you could do whatever you want with it. And maybe your business doesn’t pay anything back to your IRA. Maybe it was a “losing investment” for your IRA. Taxes avoided. Woo hoo!
The only problem with the above scenario is that the real loser isn’t your IRA–it’s the government who didn’t collect distribution taxes because your IRA “lost” all its money. For this reason, the prohibited transaction rules make the above scenario illegal. The government made the PT rules to ensure that you don’t end up “losing” your retirement money. There are six PT rules. Four of the rules are commonly quoted, written about, and understood easily. The remaining two rules seem to elude or mystify most people, so let me bring clarity to the matter.
In order to be legally compliant, every retirement plan transaction must involve a genuine effort to benefit the retirement plan itself without benefiting the plan owner or his relatives. Let’s go ahead and knock out the most common strategies that are wrongly believed to successfully “get around” the rules:
Benefit Swapping
Joe & Frank are friends and each of them setup a self-directed IRA. Joe’s IRA loans $50,000 to Frank and Frank’s IRA loans $50,000 to Joe. This doesn’t break the 4 rules that are most focused on, but it does break the usually-ignored rules. For each loan transaction the borrower is not a “disqualified person” for the IRA to transact with, but the loan is a conflict of interest for the IRA owner because he expects to receive a loan back from the other person’s IRA. Because his decision to extend the loan from his IRA involves the expectation of a chain of events that is designed to benefit him personally, this is a prohibited transaction.
Another example would be if Joe’s IRA and Frank’s IRA each bought a vacation condo, and each IRA let the other person stay in the condo. Real estate is a popular investment for self-directed IRAs, but if an IRA owns real estate its owner (and his relatives) are not allowed to make personal use of the property, regardless of whether fair market rent is paid. If Joe vacationed in property owned by Frank’s IRA and Frank vacationed in property owned by Joe’s IRA, it would be a prohibited transaction. Just like the loan swapping, what makes it prohibited is the fact that when the IRA owner made the decision to enter into the transaction, he expected to receive a personal benefit as a result of the transaction. This applies to direct benefis and indirect benefits that come about as an expected chain of events.
Strawperson
Joe wants to sell his house, but he can’t find a buyer. His IRA has enough money in it to buy the house from Joe, but that would be a prohibited transaction because Joe is a disqualified person. So Joe arranges for his friend Frank to buy the house from him who will later sell the house to Joe’s IRA. Joe thinks he didn’t break any rules because Frank is not related to Joe and thus is not a disqualified person. In this scenario, in the eyes of the law Frank is a “strawperson”… a person who is not involved in the transaction for genuine reasons. Frank doesn’t really want to buy and then own Joe’s house. He is just entering into the transaction to add separation to the real transaction. The law removes the strawperson to examine the real transacting parties. In this case the real parties are Joe and his IRA. Effectively, Joe sold his house to his IRA. That is a prohibited transaction and it remains a prohibited transaction even with Frank the strawperson inserted into the chain of transactions.
The same strawperson strategy fails the test no matter how it is constructed. If Joe’s IRA loaned money to Frank and Frank subsequently loaned money to Joe, it would violate the PT rules.
The lesson
Setting up a self-directed IRA or Solo 401(k) brings your retirement funds to an unlimited investment platform in the sense that you can invest in virtually any type of asset. You will save yourself a lot of time and headache (and possibly tons of money) if you clearly understand the remaining limitation: you must invest solely to grow your retirement account without engaging in conflicts of interest.
Now that’s not so bad is it? The merits of whether the income tax is good for our country in the first place is a topic for another discussion. But within our current system, it’s not so much to ask that you avoid all conflicts of interest. Use your retirement account for its intended purpose–to grow massive wealth. There is a whole world of opportunities out there that don’t involve a potential conflict of interest!
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Comments»
Great article. It really clears some of the grey areas people are dealing in with their IRAs
Very nicely put, Jeff. Real Estate investors can be a very creative bunch, and can start getting very creative when they first learn about the rules of a truly self-directed IRA. It’s almost natural for them (us!)to start thinking about how they can skirt the rules to benefit themselves. It’s an instinct that needs to be suppressed with this kind of education. I try to warn all my investor friends about avoiding these pitfalls. Even when I do lecture on it, it doesn’t always get through.
I had a colleague recently tell me, in an email, that he and his brother were going to use his brother’s IRA money to rehab a house they both owned. Both would profit from it, too. I was on the phone with them in under a minute to make sure he didn’t do that. He subsequently found another investor willing to lend from his IRA and they are doing the project legally now.
My investor friend apparently got confused with the fact that siblings aren’t listed as disqualified individuals in the law and decided that he could do this with his brother. If he was just borrowing from his brother for his own project, I probably would have let that go, but they were both going to profit from the project which definitely made it a prohibited transaction.
By the way, how do you feel about whether a family member, who is not on the lineal line of descent, is a disqualified person or not? It has been my impression since learning about Self Directed IRA Prohibited Transaction rules that my siblings, cousins, aunts and uncles, nieces and nephews are all eligible for trasacting with my IRA and I theirs. What are the rulings on this?
Thank you!
— Paul Smudski
Yes, the root problem with PT confusion is that most of the major players (especially the self-directed IRA custodians that have been at it for a decade or two) spend a great deal of time explaining the first 4 PT rules and don’t explain (or possibly understand) the remaining 2 rules. The entire topic of PTs is then misunderstood by the vast majority of people involved in transacting with or researching self-directed IRAs.
As far as siblings and other non-disqualified person family members transacting with your IRA (or you with theirs), it is okay as long as the IRA accountholder is making the direction decision solely for the benefit of the IRA. In the above sentence I said “OR you with theirs” rather than “AND you with theirs” because the latter would imply a benefit swapping scenario which, as discussed in the post, does trigger a prohibited transaction.
Yes, fully understanding and complying with PT rules is a challenge for real estate people because real estate has a much stronger semblance of free enterprise, and thus real estate people develop mental/strategic habits that are normally fine, but they often don’t fly with the PT rules for IRAs and 401(k) plans.
I’m glad I could help
– Jeff
Thank you, Jeff. It has helped!
— Paul
I am interested in purchasing precious metals with my IRA-LLC. What type of reporting regulations do I have to comply with? Financial statements? Inventory reports?
Hi, Sarah. The best way to learn about how to run your IRA LLC will be to call our office at 877-903-2220.
– Jeff
Jeff,
I have a checkbook IRA LLC that was set up for me where I am the manager and the only owners are my wife’s and my SDIRA’s. I only have invested in DOT’s so far. As you can imagine, I need to foreclose on one which has land for collateral. The land is in a desirable area and I am being advised that I can hire a builder to build on it. Is this true? Also, does the DOL or IRS have issues with the existence of these checkbook IRA’s? Thank you in advance for your time.
Hi, Ron. I think you’ll find the following links useful:
http://jeffnabers.com/2008/07/24/coinvesting-with-your-plan-partnering-with-disqualified-persons/
http://jeffnabers.com/2008/06/09/whats-so-special-about-the-ira-llc/
– Jeff
Jeff,
Thank you for the link on partnering/coinvesting. Would it be considered partnering if the IRA LLC, which owns the land, hires a builder to build a house on the land? I would not be building it myself. The builder would be providing all of the services. Even the plans had already been selected by the previous owner of the property. My involvement would be writing the checks to the builder.
Ron
Jeff,
I find this very interesting but don’t see the answer to my two questions below:
1. I want do use my self-directed IRA to purchase stock in a private company that will, at the same time, do a reverse merge into a public shell. I would own less than 5% of the outstanding stock. I am pretty sure that would be ok, right?
2. If I were to become an officer of that public company, would that be a problem?
Thanks for your help.
Chuck
Ron,
I’m in the process of writing a blog post elaborating on the issue you just rose. Make sure you subscribe to this blogs RSS feed for real time updates.
—–
Chuck,
1. Ok in terms of what?
2. Probably. By virtue of the question you are asking now, you are providing evidence that if you were to direct your IRA to make that investment you would have an expectation of that decision possibly leading to being an officer in that company. That’s a conflict of interest and likely a prohibited transaction.
Jeff,
Do you have to do it at a brokerage firm (with the accompanying yearly fees) or is there a place where you can set it up with no-feess (like other 401K’s thru Fidelity or Scottrade or whatever.) ?
Jeff-I want to buy a house and rehab it. I would like to hire out the major stuff but can I do any work-repairs to the property before I resell it? I would not pay myself, I just want to hands on managing this property
Ali & Tim,
I recommend you contact my office at 877-903-2220 for further assistance.
Jeff