Prohibited Transactions & Disqualified Persons
Self-directed IRAs provide a great deal of freedom, flexibility, and choice of alternative investments to help you take control of your retirement funds. They are also governed by a set of IRS rules pertaining to IRA prohibited transactions that you must be aware of and follow to avoid the losing the tax-deferred status of your account.
The IRS outlines and explains these IRA prohibited transactions in Internal Revenue Code (IRC) 4975.
Two Types of Prohibited Transactions
- Prohibited investments
- Transactions with disqualified persons
Below are some examples of investments your IRA is not allowed to hold and prohibited transactions your IRA must avoid. These sections are meant to provide general guidance and understanding of IRS rules. Seek advice from your CPA or other professional to help you navigate permissible investments and dealings your IRA may participate in with disqualified persons.
Prohibited Investments in an IRA
The IRS clearly outlines the investments that aren’t allowed in your IRA—and that list is short compared to the great number of alternative assets your IRA can hold.
Life insurance and collectibles are prohibited investments in IRAs. Specific examples from the IRS include:
- Works of art
- Alcoholic beverages
- Coins and other precious metals that do not meet IRS standards for precious metals investments as described in IRC Section 408(m)
Transactions with Disqualified Persons
Prohibited transactions are more complex. These involve dealings your IRA cannot participate in with disqualified people or entities, including yourself.
You and other disqualified persons are not allowed to:
- Borrow funds from your IRA, including private lending transactions where a disqualified person is the borrower
- Use your IRA as security for a loan
- Rent property your IRA owns
- Vacation in your IRA-owned property
- Receive personal income from rental property your IRA owns
- Perform work or other services including sweat equity for assets in your IRA
- Purchase assets from your IRA (like a house)
- Sell assets to your IRA
Note that these are just a few examples of prohibited dealings with disqualified persons. This list is in not all-inclusive as there are many ways you and/or your IRA might violate regulations if you are not vigilant in understanding the nuances of IRS rules for IRAs.
Your IRA Can Partner Funds with Disqualified Persons to Invest
There is a transaction your IRA can perform with a disqualified person: your IRA can partner funds with a disqualified person to invest. Your IRA can partner funds with your personal funds, with another person’s personal funds, and with other IRAs to invest.
The basis that makes this possible is that the ownership percentage is split between your IRA and its partner based on the buy-in of each. For example, if the buy-in was 50/50, your IRA would receive 50 percent of any investment income and it would be responsible for paying 50 percent of expenses the investment incurs. The partner receives and pays the same because it owns 50 percent of the asset. Now, your IRA’s partner may enjoy immediate, current benefits of the investment, but you and/or your IRA do not. All income is deposited directly into the IRA, where it grows on a tax-free or tax-deferred basis until you retire and begin taking distributions.
Consequences for Prohibited Transactions
The IRS has severe consequences for the owner of the plan and persons who participate in IRA prohibited transactions. The IRA owner is subject to potential income taxes, a 10 percent early withdrawal penalty, as well as potential fines and penalties for not reporting the transaction. The IRS is permitted to seize the entire value of your IRA to satisfy any taxes and penalties. Your IRA can also be disqualified, losing its tax-sheltered status. Be aware that these penalties are attributed to the year in which a prohibited transaction first takes place—so if your IRA goes for several years without “getting caught” those years are included in any taxation, penalty, or disqualification of your account.
The SECURE Act 2.0 clarified penalties for IRA prohibited transactions for multiple retirement plan owners. Section 322 of the Act states that only the IRA involved in the prohibited transaction will be disqualified and taxed. Other retirement plans will not be impacted. This law applies to tax years in which prohibited transactions occur after the date of the enactment of the Act.
Court Cases Involving Prohibited Transactions and Disqualified Persons
Here are a few court cases and an advisory opinion issued by the Department of Labor worth reading regarding self-directed IRAs participating in prohibited transactions:
Each of these cases illustrate the unique and complex ways you and your IRA could commit a prohibited transaction—knowingly or not. Either way, the IRS will not hesitate to levy taxes, penalties, and possibly other rulings that could have a significant, negative impact on your retirement plan.
If you have questions about IRA prohibited transactions and disqualified persons, please contact Advanta IRA. We can help you understand how important it is to act within strict compliance of IRS regulations and direct you to a CPA or other professional who can provide further help in these matters.