Traditionally IRAs invest in stocks and bonds. However, through the use of self-directed IRAs, it is possible to have your IRA invest in real estate and businesses.
What is a Self-Directed IRA?
Self-directed IRAs are simply IRAs whose custodian permits a wide array of investments beyond bonds and securities and provides for maximum control by the account holder. Self-directed IRAs can include any investment, other than life insurance and collectibles, that are not specifically prohibited by federal law.
As with all other IRAs, self-directed IRAs must comply with various rules and regulations, including a rule against “prohibited transactions”.
There are several types of transactions that the federal government have determined to be improper if conducted with the IRA account holder, his or her beneficiaries, or any disqualified person.
The Internal Revenue Code defines disqualified persons as:
- A fiduciary of the plan (an IRA owner who exercises discretionary control over an IRA’s investments is a fiduciary);
- A person providing services to the plan;
- An employer whose employees are covered by the plan;
- An employee organization whose members are covered by the plan;
- A direct or indirect owner of 50% or more of any entity that is described in numbers 3 or 4 above.
- A family member of any of the above;
- A corporation, partnership, trust, or estate that is more than 50% owned directed or indirectly by any person described in numbers 1 through 5 above;
- An officer, director, 10% or more shareholder, or highly compensated employee (earning 10% or more of the employer’s yearly wages) of a person described in numbers 3, 4, 5, or 7 above;
- A 10% or more partner or joint venture of a person described in numbers 3,4, 5, or 7 above; or
- Any disqualified person who is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under Section 4223 of ERISA.
There are several types of transactions that are prohibited if done between the self-directed IRA and a disqualified person. Here are a few examples (this is by no means a comprehensive list):
- Selling property to or from the IRA;
- Lending money to or borrowing money from the IRA;
- Receiving unreasonable compensation for managing the IRA;
- Using the IRA as security for a loan; or
- Buying property for personal use with IRA funds.
What are the consequences if there is a prohibited transaction?
The penalties for engaging in a prohibited transaction are severe! The Internal Revenue provides that if any prohibited transaction occurs, the account is no longer an IRA and it will be treated as if the assets within the account were distributed on the first day of the taxable year in which the prohibited transaction occurs. This will trigger a 10% early withdrawal penalty, tax on the constructive distribution, and often an accuracy-related penalty for each of the tax years affected.
Let’s look at an example:
In 2010, Mark decided to roll over all $2,000,000 from his 401(k) plan to a self-directed IRA. On July 1, 2011, the IRA purchased a rental property for $400,000 and left the remaining assets invested in securities. The IRA then hired Mark to manage the property and agreed to pay him 10% of the total rents received. Mark managed the property until late 2013 when the IRA sold it for $450,000. For the years 2011 through 2013, Mark reported his “management fee” as income, but did not report any of the rental income or the gain on the sale of the property because he knew that income earned by an IRA is tax-deferred.
In 2014, Mark received a notice from the IRS informing him that he was being audited for the tax years 2011, 2012, and 2013. After its audit, the IRS concluded that the IRA’s hiring of Mark and providing him compensation were prohibited transactions. As a result, there was a deemed distribution of all of the IRA’s assets on January 1, 2011 (not only the $400,000 used to purchase the rental property). Mark was assessed the following penalties:
- Tax on $2,000,000+ deemed distributed to him on January 1, 2011 (plus penalties and interest);
- 10% early withdrawal penalty on the $2,000,000+ deemed distributed;
- 20% accuracy related penalty in 2011;
- Tax on the 2011, 2012, and 2013 rental income (plus penalties and interest)
- Tax on any interest, dividends, and capital gains from securities in 2011, 2012, and 2013 (plus penalties and interest);
- Tax on the capital gains from the sale of the rental property in 2013 (plus penalties and interest); and
- 20% accuracy related penalty in 2013.
It is not my intent to discourage anyone from using self-directed IRAs as investment vehicles. However, it is very important to understand that it can be very easy for someone to engage in a prohibited transaction and incur very severe penalties as a result. Therefore, if you are thinking about utilizing a self-directed IRA, talk to a tax professional to ensure that everything is done properly.