Prohibited Transaction in IRA

What is a Prohibited Transaction?

In simple terms, a Prohibited Transaction is any improper use of your Self-Directed IRA (or other qualified retirement plan) by you, your beneficiaries, or any “disqualified persons” for their own direct or indirect benefit.

The IRS defines these transactions to prevent self-dealing and ensure the retirement account is used solely for investment purposes, not for personal gain or immediate benefit. Engaging in a prohibited transaction can have severe consequences, including the immediate disqualification of your entire IRA, making its entire fair market value taxable, and potentially subjecting you to penalties.

The Key Rules: IRS Code Section 4975

The rules for Prohibited Transactions are primarily defined in the Internal Revenue Code (IRC) Section 4975.

1. Who is a “Disqualified Person”?

This is the most critical concept. You cannot transact with these people or entities using your IRA assets. They include:

• The IRA Holder (you).

• Your spouse.

• Your parents, grandparents, and other ancestors.

• Your children, grandchildren, and other lineal descendants.

• Spouses of your lineal descendants (e.g., your son-in-law).

• Any fiduciary of the plan (e.g., you, as the person directing the investments) or anyone providing services to the plan (e.g., certain custodians).

• Entities (like corporations, partnerships, trusts, or estates) that are 50% or more owned by any combination of the people listed above.

Important Note: Your siblings, aunts, uncles, cousins, and friends are NOT considered disqualified persons. Your IRA can transact with them.

2. What Are the Prohibited Actions?

According to IRC 4975(c), the following are direct prohibited transactions between your IRA and a disqualified person:

• Sale, Exchange, or Lease: Selling, leasing, or exchanging any property between your IRA and a disqualified person.

  • Example: Your IRA cannot buy a property from your father. Your IRA cannot rent a property it owns to your daughter.

• Lending of Money or Credit: Lending money or extending credit between your IRA and a disqualified person.

  • Example: You cannot personally loan your IRA money to cover a repair. Your IRA cannot loan money to your business partner who is also your brother.

• Furnishing of Goods, Services, or Facilities: Providing goods, services, or facilities between your IRA and a disqualified person.

  • Example: You cannot act as the property manager for your IRA-owned rental property, even if you do it for free. Your IRA cannot pay your company to provide repair services.

• Transfer of Income or Assets: Transferring IRA income or assets to, or for the use or benefit of, a disqualified person.

  • Example: Using your IRA-owned property for a personal vacation, even for just one weekend.

• Self-Dealing: A fiduciary (you) using the IRA’s income or assets for their own interest.

Official Links and Resources on IRA Prohibited Transactions

1. Internal Revenue Code (IRC) Section 4975

• URL: https://www.law.cornell.edu/uscode/text/26/4975

• Description: This is the primary legal source from the U.S. Code. It provides the statutory definition of “disqualified persons” and lists the specific transactions that are prohibited for IRAs.

2. IRS Publication 590-A (Contributions)

• URL: https://www.irs.gov/publications/p590a

• Description: This is the IRS’s official guide for taxpayers on contributing to IRAs. It offers a more accessible explanation of the rules. For prohibited transactions, scroll down to the section titled “What Acts Result in Prohibited Transactions?”

3. IRS Publication 590-B (Distributions)

• URL: https://www.irs.gov/publications/p590b

• Description: This publication covers the rules for taking distributions from IRAs, including the severe consequences of engaging in a prohibited transaction. See the section “Prohibited Transactions” which explains that if you engage in one, your entire account is treated as distributed to you, making it taxable.

4. Department of Labor (DOL) Guidance

• URL: https://www.dol.gov/general/topic/retirement/prohibitedtrans

• Description: The DOL has jurisdiction over retirement plans under ERISA (like 401(k)s). While IRAs fall more directly under the IRS, the DOL’s guidance on prohibited transactions is consistent and provides a valuable official perspective from another regulatory body.

Examples in the Context of Real Estate

• PROHIBITED: Your IRA buys a house and you (the IRA holder) live in it.

• PROHIBITED: Your IRA buys a vacation property and lets your parents use it for a week.

• PROHIBITED: You personally pay for a new roof on a property owned by your IRA.

• PROHIBITED: Your IRA loans money to your LLC, in which you own a 60% stake.

• ALLOWED: Your IRA buys a rental property and rents it to your cousin at fair market rent.

• ALLOWED: Your IRA pays a third-party, unrelated property management company (that is not owned by a disqualified person) to manage the rental.

Disclaimer: This information is for educational purposes only and does not constitute legal or tax advice. The rules surrounding SDIRAs and prohibited transactions are complex. You must consult with a qualified tax advisor or attorney who specializes in self-directed retirement accounts before entering into any transaction.