5 Examples of Prohibited Transactions in a Self-Directed IRA

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You’ve got a lot of freedom with a self-directed IRA, but you do have a few rules you need to follow. Investing in real estate with your self-directed IRA is a lot like investing in real estate outside of your IRA— except the IRS prohibits a few things (per IRC Section 4975). These investment rules are really the biggest differences between IRA investing and the traditional real estate purchase— aside from the incredible tax benefits.

Prohibited Transactions

Specifically, there are a few types of investments, transactions, and situations prohibited by the IRS, known as prohibited transactions.

They exist to prevent you and your IRA from having an unfair advantage over other investors and keep you (or you through your family) from benefiting directly from the IRA— at least until you’ve retired.

 

Prohibited Investment Types

The IRS doesn’t have a list of “approved investments” for self-directed IRAs, but what the IRS does have is a list of prohibited investment types, transactions, and situations it does not want your IRA to engage in.

Self-directed IRAs can’t invest in:

  • Collectibles - like art, antiques, gems, coins, alcoholic beverages, and certain precious metals (See IRC Section 590)
  • S-Corporations – defines allowable shareholders in Subchapter S corporations, which does not include IRAs (see 26 USC 1361)
  • Life Insurance - (See IRC Section 408(a)(3))

Disqualified Persons

There are specific individuals (known as disqualified persons) that the IRS forbids your IRA from engaging in transactions. Any transaction with these individuals is a prohibited transaction (with one exception— when partnering on a new transaction. 

Disqualified Persons:

  • You
  • Your spouse
  • Any of your lineal ascendants or descendants (parents, children, grandchildren, and the spouses of children, grandchildren, — including legally adopted children)
  • Any investment providers or fiduciaries of the IRA
  • Any entity (like a corporation, LLC, or trust) where a disqualified person owns more than 50%
  • Any entity (like previously listed) where the IRA account-holder is an officer, director, a 10% or more shareholder, or a highly compensated employee

Your IRA can’t engage in any transactions with these individuals (with a few exceptions, like when your IRA partners on a new transaction) or you can lose the tax-status of your account.

Otherwise, if you don’t follow these rules, you’re putting your account at risk.

Self-Dealing

One of the most common prohibited transactions is known as self- dealing, which is when the IRA owner attempts to do business with themselves. This isn’t allowed. You can’t buy or sell property to yourself, you can’t lend money to you from the IRA, and you can’t pay any IRA expenses or take any IRA income personally. You can’t use any IRA asset for personal benefit in any way— this is a prohibited transaction.

 

Sweat Equity

You can’t do any work at all on the property— this is not something allowed with a self-directed IRA. No matter your expertise, no matter the size of the job.

Any work you perform on or for the asset is prohibited. Often called sweat equity, it refers to any work you personally do on a property (the “sweat” referring to effort spent to improve the investment, instead of paying an outside provider). So if you’re a contractor, you can’t fix a clogged toilet or leaky sink— that’s prohibited.

With a self-directed IRA, you (or a disqualified person) are not allowed to personally do any work on the property, no matter how big or small. Any repair, improvement, or maintenance must be performed by a paid, non-disqualified person to avoid any unfair advantage to your IRA investments. The IRS sees this money you saved by doing the work yourself as an indirect benefit, so you need to steer clear.

This is an excerpt from IRAR's eBook, "Yes! You CAN Invest in Real Estate With Your IRA!"

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5 Examples of Prohibited Transactions in a Real Estate IRA

1 - Buying or Selling a Property to or From Your Self-Directed IRA 

Q:  May I move the properties I already own to my self-directed IRA?

A:  Anything already owned by you can’t be moved into your IRA.

Q:  What if my company owns the property?

A:  The same rules apply, if your company owns it, it is prohibited.

Q:  “But what if it’s an investment property?”

A:  It doesn’t matter what the purpose is, if you own it already, the transaction is prohibited.

Q:  Can I get paid a commission for listing a property my IRA is trying to buy or sell?

A:  You can list the property yourself, but you cannot receive any compensation for doing so.

Why are these considered prohibited transactions?  The IRS specifically prohibits “self-dealing”, meaning any transaction between yourself and the IRA. If you already own the property you wish to buy with your IRA, that transaction is prohibited.

 

2 - Combining IRA and Personal Funds Or Property 

Q:   Can I use funds from your IRA LLC (that I’ll pay back) to pay a non-IRA expense?

A:  As mentioned above, you’re considered a disqualified person to your IRA, so this is prohibited. This isn’t allowed— personal and IRA funds must stay strictly separate.

Q:  Can I deposit my IRA’s rental check into a personal bank account so I can pay a contractor ASAP?

A:  It doesn’t matter if the funds are on their way or if you need them ASAP, combining personal and IRA funds is not allowed. This would be considered a prohibited transaction.

Q: Can I use my IRA-owned property as collateral on a personal loan?

A:  This isn’t allowed. Your IRA is a distinct, separate entity from your personal assets and investments. This would be prohibited.

 

3 - Personally Living, Using, Or Working on the Property 

Q:  May I buy commercial real estate, rent the building out and use one office myself?

A:  If you’re planning on using the property even once, that’s prohibited.

Q:  May I buy a vacation property with my IRA?

A:  Yes, but you can’t stay in the property your IRA owns, even for one night, so you wouldn't be able to vacation in the property.

Q:  May I renovate the IRA property myself?

A:  No. You’re saving money by doing this work yourself instead of paying someone, so it isn’t allowed.

Q:  May I be the handyman for my rental property?

A:  You’re benefiting from your personal labor by saving money on upkeep, so this is prohibited.

Q:  May I buy vacant land and build on it myself?

A:  You can buy vacant land. However, you’ll have to hire a construction company, because you’d benefit from doing this work yourself.

Q:  May I buy vacant land to personally farm or work?

A:  Unfortunately, you can’t do this. Any work, be it one-time or ongoing, can’t be done by the account-holder. If you’d like to hire a non-disqualified-person to do this work, you may.

Why are these considered prohibited transactions? The IRS prohibits the IRA-holder from putting “sweat equity” into their investments, except in certain circumstances. Sweat equity refers to work done on or for the property that, if not for your efforts, would have to be paid by the IRA. The IRS sees the money you saved as an indirect benefit and is not allowed within your self-directed IRA.

 

4 - Buying or Selling a Property to Or From A Disqualified Person 

Q:  What if I want to buy my parents’ house with my IRA?

A:  The IRS doesn’t allow this, since your parents are both disqualified persons.

Q:  What about selling a property I own in my IRA to my daughter?

A:  Your daughter is a disqualified person, so this is prohibited.

Q:  Can my IRA buy property owned by my wife’s IRA?

A:  Unfortunately, no, your wife is a disqualified person.

Why are these considered prohibited transactions? The IRS is looking to prevent any personal benefit, tangible or intangible, that could arise from a transaction with your IRA. This is related to the “arm’s length” requirement for self-directed IRAs, where all transactions must be completed at arm’s length from the account holder to assure there is no personal benefit from the investments.

 

5 - Disqualified Persons Living, Using, Or Working on the Property

Q:  May I buy a house for my daughter to live in during college and then rent out?

A:  Your daughter is a disqualified person, so this is not allowed. You could buy a property and rent it out, but your daughter can’t live there, not even for a few years.

Q:  May I let my parents, my children, or my financial advisor stay in the property, even for one night?

A:  You and any disqualified persons cannot stay in the property at all. Not to live, not to vacation, not even for one night.

Q:  May I have my son’s construction company to do work on my IRA-owned property?

A:  No, your son is a disqualified person, so any company he has a controlling ownership in would be considered disqualified.

Why are these considered prohibited transactions? The IRS assumes that any benefit given to a disqualified person, either directly or indirectly, could benefit you, so just like self-dealing and sweat equity, the same rules apply to disqualified persons. Disqualified persons cannot use or perform work on the property, even if they are being paid for it. The goal is to avoid benefits gained through avoidance of taxes, an unwritten quid-pro-quo agreement, or any other possible arrangement.

 

In a Nutshell

Prohibited transactions are the most important things to keep in mind when investing with a self-directed IRA— make the wrong move and you can put your retirement account in jeopardy. Our ebook can help you to avoid major pitfalls. Get the download below.

 

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