Self-Directed IRAs (SDIRAs) offer investors the flexibility to diversify their retirement portfolios with alternative assets like real estate, private equity, and digital currency. However, with greater control comes greater responsibility. There are specific rules and restrictions to be aware of, as certain transactions can result in penalties or even disqualification of your IRA. You’ve worked hard to build your retirement savings, don’t let prohibited transactions jeopardize that. In this article, we’ll explore what you need to know about prohibited transactions in a self-directed IRA and how to avoid them.
Let’s take a look at five of the most common prohibited transactions in self-directed IRAs and how you can steer clear of them. Each example will be supported by the Internal Revenue Code (IRC) (26 U.S. Code § 4975 - Tax on prohibited transactions | U.S. Code | US Law | LII / Legal Information Institute) to ensure you have a clear understanding of the rules.
This is one of the most common prohibited transactions. For example, let's say you use your SDIRA to invest in a rental property, such as a condo in Miami, and then decide to take a vacation to Miami, using the rental property as your own personal Airbnb. Can you do that? The answer is no; this is strictly prohibited. You cannot use any property owned by your IRA for personal benefit. The best way to avoid this is to keep a clear boundary between your IRA investments and your personal use.
This prohibits selling, leasing, lending, or exchanging goods or services between your IRA and a disqualified person. The IRS classifies a disqualified person as follows:
This is similar to self-dealing, but it specifically prohibits transactions that provide an unfair advantage to disqualified persons. Commonly referred to as "sweetheart deals," an example would be if your IRA purchases a rental property from your brother below market value. This not only violates the rule against transacting with disqualified persons but also provides your brother an indirect benefit since the deal was below market value. To avoid this, ensure all transactions are conducted "at arm's length," meaning both parties act independently of one another, and neither influences the other.
This rule prohibits using IRA assets as security for a personal loan. You should never use your IRA investments, such as real estate property, as collateral for any personal or business loans. This one is straightforward: simply avoid using your IRA funds to secure a loan for personal or business purposes.
Not all assets can be invested in through an SDIRA. Certain items, such as life insurance, collectibles (art, antiques, gems, etc.), some metals (unless IRS-approved like gold), and alcohol, are prohibited. These assets are not allowed because they either already have their own tax advantages or the IRS is unable to reliably calculate their value, making them unsuitable for inclusion in a retirement account. To learn more about these prohibited assets, as well as what you can invest in through an SDIRA, listen to a podcast episode from Preferred Trust titled "Can You Really Buy That?". This episode covers both prohibited transactions and eligible investment options in more detail.
How to Avoid IRA Prohibited Transactions
Here are some helpful reminders when utilizing your IRA. First, work with an experienced SDIRA custodian who is well-versed in IRS rules and regulations. A reputable custodian will not only help ensure you’re compliant but will also notify you if you’re at risk of participating in a prohibited transaction. If you do accidentally engage in a prohibited transaction, they should be able to help rectify it without creating additional problems, provided it’s within their capacity to do so.
It is essential to consult with a tax professional before making any investments. Reach out to a CPA or tax attorney to help ensure you stay on the right track and avoid prohibited transaction territory.
Finally, maintain organized records of all your transactions. Keeping accurate documentation will not only help you stay organized, but it will also give you peace of mind, knowing that you have everything in order if needed.
Keep Your Savings, Stay Away from Prohibited Transactions
Self-directed IRAs offer unique investment opportunities, allowing you to diversify your retirement portfolio with alternative assets. However, they also come with strict IRS regulations that require careful attention. Understanding prohibited transactions is crucial to avoid costly penalties that can jeopardize your retirement savings. By working with an experienced SDIRA custodian, consulting with tax professionals, and conducting thorough due diligence, you can confidently navigate these rules. Protect your hard-earned savings, keep your investments on track, and ensure your money is working for your future.