The phrase “prohibited transactions” may seem threatening and cause worry among self-directed investors seeking to stay out of trouble with the IRS. In reality, it is quite simple and painless to dodge any penalty that comes with a prohibited transaction. The penalty incurred from a prohibited transaction is immediate distribution of the asset accompanied by a harsh tax. To avoid this happening to you, there are essentially 4 rules to follow in order to keep yourself on the straight-and-narrow in the eyes of the IRS.
1. There Are Only 2 Things You Can’t Invest In
First, know what you can’t invest in with your Self-Directed IRA. It’s easier to think of it this way because there are only two items that populate this list: collectibles and life insurance.
- Collectibles include anything from baseball cards to art to model trains; anything that derives its value from its “collectibility” is out when it comes to self-directed investing.
- As for life insurance, it defines itself. As long as you are not investing in these two – the only two – prohibited investments, then you have the green light.
2. You Can’t Buy What You Already Own
Next, you are not allowed to purchase a property you already own with your Self-Directed IRA. This falls under what is called the “Rule of Self-Dealing,” which also finds it impermissible to purchase a property that you once owned, but sold to someone else. Sorry, but that would still be off-limits. If you were the owner of the property at any point, then keep it away from your Self-Directed IRA to be sure you are complying with IRS rules.
3. No Personal Use
The second category of the Rule of Self-Dealing makes up our third rule, which is that even if you’ve never owned the property before, you can’t make personal use of it if once it’s owned by your IRA. For example, a Broad Financial client once wanted to buy a ski lodge in Colorado. If he stopped right there, this would have been absolutely permissible and very possibly quite lucrative…except he insisted on skiing there himself one weekend a year. Even that one weekend a year is enough to make this action prohibited and therefore trigger the penalty. As the IRA owner, you can’t not make any personal use out of your investment properties.
4. Disqualified Persons
The final rule that will be discussed here revolves around people who are considered “Disqualified Persons.” These are the individuals who you are not permitted to buy from or sell to with your IRA. The list is not a particularly lengthy one, but it is nonetheless important to know:
- Your spouse
- Your parents
- Your grandparents
- Your children (and their spouses)
- Your grandchildren (and their spouses)
- Your investment advisers
- Anyone who provides a service to your retirement accounts
A purchase or sale that benefits any of the people that appear in this list in the present is considered a withdrawal from your retirement account, and is subject to taxes and penalties. Because your retirement funds are being set aside on a tax deferred basis to benefit you in the future, they cannot be used to benefit you—or anyone close to you—today.
Be sure to follow these 4 rules and you will never encounter any opposition from the IRS regarding your Self-Directed IRA. Hopefully, this should alleviate any concerns over possibly complex regulations resulting in an inadvertent violation and penalty.
For even more detailed information about prohibited transactions, feel free to click here. If not, you are still equipped with the knowledge necessary to avoid an unnecessary penalty.