The IRS goes to great lengths to explain the prohibited transaction of your IRA dealing with disqualified persons. Prohibited transactions in your IRA can incur penalty, taxation, and even the loss of the tax-sheltered status of your account. However, there’s one tactic IRS regulations do allow that may surprise you: you can partner IRA funds with a disqualified person to invest.
How Can You Partner IRA Funds with a Disqualified Person?
Partnering IRA funds with other investors is a strategy individuals use to leverage buying power while at the same time decreasing liability. Partnerships with self-directed IRAs and other investors earn income and divvy expense costs based on the investment ownership percentage of each partner.
Because the IRS prohibits your IRA from dealings with disqualified persons, you may not know that you can partner funds with a disqualified person to invest.
But this permission is commonly misunderstood, which is why lots of people don’t think it’s possible. IRC 4975 clearly lays down the laws that prohibit your IRA dealing with disqualified persons.
For instance, your self-directed IRA is prohibited from selling property to or buying property from a disqualified person. (These people include your lineal descendants, ascendants, and their spouses, and others as outlined in the next section.) So, of course, you naturally think this rule applies to partnering your IRA’s funds with a disqualified person’s funds. Thankfully, it does not.
Partnering funds with disqualified persons gives you the opportunity of transacting with people you know and trust. You have the added benefit of discerning whether or not they can maintain their stake in the venture since you (hopefully) have some first-hand knowledge of their financial situation. That makes the partnership vetting process a whole lot easier than forging a partnership with strangers.
Imagine pooling your IRA’s funds with family members and friends who have the same interests and skills as you do.
You can even partner your IRA funds with your personal funds to invest, and IRAs can partner with other IRAs, as long as you do so in compliance with IRS rules.
Who Are Disqualified Persons?
Disqualified persons include yourself and your spouse, your lineal ascendants (parents, grandparents, their spouses) and lineal descendants (children, grandchildren, and their spouses).
The disqualified list also includes any other person or entity that is connected to your self-directed IRA such as fiduciaries, managers, advisors, or anyone providing service to the account.
Additionally, any corporation, partnership, trust, or estate in which disqualified persons have a 50 percent or greater interest is not allowed to transact with your IRA.
Why Does the IRS Allow IRAs to Partner Funds with Disqualified Persons?
The reason you’re able to partner funds with a disqualified person is simple once you understand this:
Your IRA is meant to benefit you only upon retirement and not before. So, if you have real estate in your IRA, such as a vacation rental, you and any disqualified person are not permitted to enjoy a relaxing week—or even one night—in that property. That is considered a current benefit, which is a prohibited transaction.
But partnering funds to invest is a bit different. Your IRA and its partner are purchasing an asset together. Ownership of that asset belongs to your account and the person or entity your IRA partners with. The partner does not benefit from your IRA’s portion of the investment, and neither do you. The same is true if you partner your IRA funds with your personal funds to invest.
Ownership is assigned according to the buy-in of each party. Income and expenses are distributed accordingly. For example, if your IRA purchases 60 percent of the asset and the partner purchases 40 percent, your IRA would receive 60 percent of the income and be responsible for the same share of expenses.
Benefits of Partnering IRA Funds
The greatest benefits are that you can increase your buying power and decrease your liability.
You’re able to leverage your IRA funds with others to participate in acquisitions on a larger scale. Maybe that’s a commercial property your IRA couldn’t buy alone. Or it could be raw land that’s ripe for development that costs more than your IRA can afford.
Additionally, liability exposure is lessened if your IRA only owns a portion of the property. Instead of putting up the entire cost of a project, you could use just a portion of your IRA to invest as a partial owner. Therefore, your entire IRA is not at risk with one particular investment.
Your IRA Still Cannot Participate in Prohibited Transactions with Disqualified Persons
Even when those disqualified persons have partnered with your IRA, you must follow the IRS guidelines for compliance. Your IRA and its partners who are disqualified persons are not allowed to sell property to each other. You cannot participate in loaning funds to a disqualified person. The disqualified person you partner with to invest in vacation in homes cannot stay in that property. Find the details by reading IRC 4975 and make sure your partners understand this, too. You don’t want to cross a line and get yourselves in the crosshairs of the IRS. When in doubt, consult a professional for guidance. We can point you in the direction of a competent or attorney or CPA to help with this aspect.
Partnering IRA funds with a disqualified person can involve intricate planning and knowledge. Contact Advanta IRA if you have questions on this subject. Our team is always ready to assist you in your self-directed investing endeavors.
Additional reading about partnering funds with disqualified persons:
This article was initially published on April 3, 2018 and has been updated for accuracy.