Understanding the Rules to Self-Directed IRA Investments
Now that you are aware of the option to invest in real estate using your self-directed IRA and can confidently identify a custodian and prospective investments, the last piece to consider is ensuring you clearly understand the limitations on IRA investment transactions established by the IRS and other applicable law. When selecting investments for your IRA, there are certain people and entities that you cannot do business with; since doing so could put the taxable status of your retirement funds in jeopardy.
Your IRA may not “self-deal”, meaning it cannot buy an investment from or sell an investment to a disqualified person. Additionally, investments made in your self-directed IRA must be at arm’s length. Put simply, the willing buyer and willing seller come together with no undue influence from outside sources.
What is a Disqualified Person According to the IRS?
Disqualified persons are individuals or entities between whom or which an IRA is prohibited (absent a special exception) from engaging in any direct or indirect sale, exchange or leasing of any property, lending of money or other extension of credit, furnishing goods/services/facilities or transferring to or permitting the use of IRA income or assets. Parties involved in your IRA transaction must engage in business without any conflicting interest. The IRS prohibits your IRA from engaging in transactions with fiduciaries, including:
- Yourself as the owner of the IRA
- Your parents
- Your spouse
- Your children and their spouses
- Grandchildren, great-grandchildren and their spouses
What is a Prohibited Investment in a Self-Directed IRA?
While self-directed IRAs give you more freedom to invest in alternative investments, there are certain IRS-prohibited transactions to be aware of in order to protect the tax-deferred or even tax-free status of your retirement account. The IRA defines a prohibited transaction as the improper use of your government-sponsored retirement plan by yourself, your beneficiaries or other disqualified persons. Prohibited transactions include:
- Borrowing money from your IRA
- Selling property to your IRA
- Receiving unreasonable compensation for managing your IRA
- Using your IRA as a security for a loan
- Buying property for personal use (present or future) with your IRA
Generally, the consequences for breaking these rules are substantial. In any tax year that an investor engages in one of these prohibited transactions, the account stops being considered an IRA. This could result in hefty tax penalties, full distributions of IRA assets to your beneficiaries with assets taxed at fair value, or a portion of your IRA pledged as loan collateral to be taxed as a distribution including all early distribution penalties. More investors aren’t willing to risk the tax-advantages, as many times, it’s the driving factor behind setting up and investing in a self-directed IRA. Consult your tax, legal and accounting advisors before engaging in any transactions regarding your IRA.