What is Self Dealing in a Self Directed IRA?

In an Individual Retirement Account (IRA), self-dealing refers to transactions where the account owner uses IRA assets for personal gain, rather than for the sole benefit of the retirement account. The Internal Revenue Service (IRS) prohibits such transactions, which can result in severe tax penalties or the disqualification of the entire IRA.

Examples of self-dealing include:

• Transactions with disqualified persons: A disqualified person is defined by the IRS as the IRA owner and certain close family members, such as a spouse, ancestors (parents), and lineal descendants (children and grandchildren).
  • Buying or selling property between yourself or a disqualified family member and your IRA.
  • Using IRA funds to invest in a business that you or a disqualified person owns or controls.
  • Lending money from your IRA to yourself, a disqualified family member, or a business you control.
• Personal use of IRA assets:
  • Using an investment property owned by your IRA as a personal residence or vacation home.
  • Drawing a salary or commission from an IRA-owned business or an investment made with IRA funds.
  • Using IRA funds to pay personal debts.
• “Sweat equity” on IRA property:
  • Personally performing work, such as repairs or renovations, on a property owned by your IRA, even if done for free. The IRS considers the money saved by not hiring a third party as an indirect personal benefit.
  • Paying a disqualified family member to do work on an IRA-owned property.
• Indirect benefits:
  • Investing IRA funds in a company to receive a separate, personal benefit, such as a lifetime membership or personal usage.
  • Co-investing with both IRA and personal funds in a single property.

Penalties for self-dealing in an IRA are severe and can include immediate taxation of the entire account, a 10% early withdrawal penalty, and additional excise taxes. 

• Disqualification of the IRA: The most significant consequence is that the IRA loses its tax-exempt status as of the first day of the year in which the prohibited transaction occurred.
• Immediate taxable distribution: The entire fair market value of the IRA is treated as a taxable distribution to the account owner on the first day of that year. This means the owner owes income tax on the entire account balance at their normal tax rate.
• 10% early withdrawal penalty: If the IRA owner is under age 59½, an additional 10% penalty applies to the deemed distribution.
• Excise taxes: If a prohibited transaction occurs with a disqualified person other than the IRA owner, that person may face separate excise taxes from the IRS.
  • Initial tax: The disqualified person must pay an initial tax of 15% of the amount involved in the transaction for each year it is not corrected.
  • Additional tax: If the transaction is not corrected, an additional 100% tax is imposed on the amount involved.

Common mistakes that lead to self-dealing in IRAs often stem from a misunderstanding of the rules, particularly the “exclusive benefit rule,” which mandates that all IRA transactions must be solely for the benefit of the retirement account, not the owner or other disqualified persons.

Key mistakes include:

• Using IRA assets for personal use: This is one of the most frequent errors. Examples include using an IRA-owned vacation home or rental property, even if only for one night or if the owner pays rent.
• Transacting with “disqualified persons”: Many investors are unaware of the full scope of who is considered a disqualified person (the account owner, spouse, ancestors, and lineal descendants, plus any entities they control). Common mistakes include:
  • Buying or selling property between the IRA and a disqualified person.
  • Lending money from the IRA to a disqualified person or to a business the owner controls.
  • Hiring a disqualified person (such as a child’s construction company) to perform work on an IRA-owned property.
• “Sweat equity” on IRA-owned property: Performing personal labor, such as repairs or renovations, on an IRA asset is a form of self-dealing, as the IRS views the money saved by not hiring a third party as an indirect personal benefit.
• Mixing personal and IRA funds (commingling): All expenses and income related to an IRA investment must flow directly into and out of the IRA account. Depositing rental income checks into a personal bank account or using personal funds to pay for a property’s maintenance are common mistakes that can trigger a prohibited transaction.
• Improperly titling assets: When an IRA purchases an asset, such as real estate, the ownership documents must name the IRA (via its custodian) as the legal owner, not the account holder personally. Incorrect titling suggests personal possession, which is a deemed distribution.
• Borrowing from the IRA: Taking a loan from an IRA is strictly prohibited. Even using an IRA asset as collateral for a personal loan is considered a prohibited transaction.
• Lack of knowledge and documentation: A general failure to understand the complex IRS rules or to maintain detailed records for all transactions is a primary reason for inadvertent violations. Consulting with a knowledgeable professional is highly recommended to avoid these pitfalls.

“Workarounds” for common IRA self-dealing mistakes involve strict adherence to IRS rules through careful planning and, in some cases, formal correction processes. The key principle is ensuring that the IRA owner and disqualified persons remain completely separate from the IRA assets and any direct or indirect benefits derived from them.

Here are legal strategies to avoid or correct common mistakes:

Avoiding Personal Use and Self-Dealing

• Hiring Third Parties: Instead of performing work or managing an IRA-owned asset (like a rental property) yourself, hire unrelated, independent third parties (e.g., a professional property management company, contractors, etc.) to handle all operations, maintenance, and rent collection.
• Arm’s Length Transactions: All transactions must be conducted at “arm’s length,” meaning the terms should be the same as they would be for a completely unrelated party. Always use market rates for services and never engage in pre-conceived “linked” transactions (a “quid-pro-quo” with another person).
• No Personal Residence/Vacationing: The IRA owner and disqualified persons must never use an IRA-owned property, even for a single night. The only way to personally use the property is to take an in-kind distribution of the asset (transferring ownership from the IRA to yourself personally) and pay all applicable income taxes and early withdrawal penalties at that time.
• Careful Business Structuring: If investing IRA funds in a business, structure the entity so that the IRA is the named incorporator or owner. The IRA owner cannot receive compensation from the business unless other, unrelated investors have a legitimate reason to set and pay a salary to the owner.

Managing Funds and Expenses

• Strict Segregation of Funds: Never commingle personal funds with IRA funds. All income and expenses for an IRA-owned asset must flow directly into and out of the IRA’s dedicated account with the custodian.
• Establish a Maintenance Reserve: To avoid having to use personal funds for unexpected repairs, keep a cash or highly liquid maintenance reserve within the IRA itself. The property manager can then request funds from the custodian for expenses.
• Proper Titling: Ensure all investment documents and deeds for real estate are titled in the name of the IRA for the benefit of the account holder (e.g., “Custodian Name FBO John Doe IRA”), not the individual’s personal name.

Correcting Mistakes

If a prohibited transaction has already occurred, immediate action is crucial to minimize penalties:

• Undo the Transaction Immediately: Correcting the transaction requires unwinding it to the greatest extent possible and restoring the IRA to a financial position no worse than if the prohibited transaction had never happened.
• IRS Voluntary Correction Programs (VCP) / DOL Voluntary Fiduciary Correction Program (VFCP): For certain types of plan failures (not typically individual IRA self-dealing), the IRS and Department of Labor offer formal programs to report and correct mistakes with IRS approval and potentially avoid plan disqualification penalties. This usually involves a formal submission, a fee, and a binding compliance statement.
• Consult a Professional: Given the severe penalties, if a mistake is made, it is critical to consult a tax attorney or CPA experienced with self-directed IRA rules to determine the best course of action.