Watch out for IRA prohibited transactions
When IRAs were first created in the early 1970s, most IRA account holders invested in traditional securities like mutual funds or publicly-traded stocks and bonds. Times have changed. An increasing number of people are now using their IRAs to buy real estate, hedge funds, precious metals or even closely held businesses.
There is nothing wrong with using these “alternative” investments in an IRA, but they can be tricky. If you get it wrong, the penalties can be severe, so make sure you know the rules. Here are some of the basics that should help you stay out of trouble.
IRA tax breaks encourage people to save for retirement. To make sure these tax breaks are not abused, the IRS prohibits IRAs from investing in certain types of assets. For example, IRAs cannot invest in “collectibles,” including artwork, antiques, rugs, gems, stamps, and coins (though gold, silver, or platinum coins and bullion are permissible.) IRAs are also prohibited from investing in life insurance contracts and in S-corporations. Beyond this fairly narrow list of exclusions most other assets are possible, if you avoid what are called “prohibited transactions.”
You may be the owner of your IRA, but you are also a fiduciary. This means that you must avoid any transaction that commingles your personal financial interests, or those of any other “disqualified person,” with those of your IRA.
The Internal Revenue Code defines “disqualified persons” as:
- Any fiduciary on the account (including the IRA owner);
- Any immediate family member, including spouse, ancestor, direct lineal descendant, or spouse of a direct lineal descendant;
- A corporation, partnership, trust, or estate where 50% or more of the shares, profits, or beneficial interests are owned by any of the above; or
- An officer, director or 10%-or-greater shareholder or partner of an entity described above.
With this in mind, the following transactions are expressly prohibited between the IRA and a disqualified person:
- Sale, exchange, or leasing of a property—even at a fair market price;
- Lending of money or extending credit;
- Providing goods, services or facilities;
- Transfer, use, or benefit from assets;
- Receiving personal consideration from a third-party that engaged in a transaction with your IRA.
What does this mean in practical terms? Let’s suppose you use your IRA to buy a beach house as a vacation rental property. The purchase is certainly permissible. However, let’s suppose the beach house needs some repairs. As the IRA owner (and fiduciary) you are prohibited from doing any of those repairs yourself and so is every other disqualified person. Want to furnish the beach house using that old sofa that’s been hanging around? Prohibited. Using personal funds to pay for ongoing maintenance? Prohibited. Paying the beach house mortgage with personal money to keep it going when rentals are slow. Also prohibited. And don’t even think about using it (or letting another disqualified person use it) on those weekends when it sits vacant.
So what happens if you get caught on the wrong side of the prohibited transaction rules? The penalties can be steep. The standard penalty is a tax of 15% of the transaction value imposed on any disqualified person engaged in the prohibited transaction. If you don’t correct the prohibited transaction before the end of the year in which it occurs, the penalty increases to 100%. However, the killer penalty is reserved for prohibited transactions when the IRA owner is the disqualified person. In those cases, the IRA itself may be “fully disqualified,” meaning it loses its tax deferral benefit. It is as if the entire IRA were fully distributed (and taxed!) on January 1 of the year the prohibited transaction occurs.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.