What is Not allowed With a Self Directed IRA?
With a self-directed IRA (SDIRA), you have the flexibility of investing in nontraditional assets such as real estate and private equity without incurring taxes and penalties that might reduce its tax-qualified status. But be wary when making nontraditional investments – strictly adhere to any applicable rules to avoid prohibited transactions that could void its tax-qualification status and incur tax and penalty implications.
Here are three fundamental rules you need to keep in mind.
Prohibited Transactions
Self-directed IRAs offer greater flexibility and potential returns, yet come with specific IRS regulations that must be observed to preserve its tax-deferred status and avoid potentially significant tax penalties for misbehaving.
One rule prohibiting transactions within your retirement account includes engaging in prohibited transactions that include self-dealing and conflicts of interests. Prohibited transactions involve investing in properties which provide direct personal benefits to either yourself or other disqualified parties who own an IRA account.
Example: Jack uses his IRA to purchase rental property that he then rents out to his son. This would constitute an illegal transaction as you, your son and their wife would all qualify as disqualified persons and would gain personal benefit from investing.
An investment that would violate IRA rules would involve investing in companies where its owner acts as fiduciary; for example, an IRA should not invest in real estate development companies where its owner holds more than 50% of assets owned by an IRA.
Self-Dealing
One of the main risks involved with investing in an IRA is self-dealing. Self-dealing occurs when someone with fiduciary duties towards an organization takes actions for their own benefit rather than that of the company they represent.
Example: An IRA owned company where one of the board members also works can engage in self-dealing by using company assets to cover personal vacation travel expenses – this constitutes breach of fiduciary duty and could lead to serious legal consequences for both themselves and the IRA owner.
Self-directed IRAs give you the flexibility to invest in any asset type imaginable, from private non-exchange traded assets to privately held ones. But those unfamiliar with the rules or who try to gain more benefits than is allowed may incur heavy taxes and penalties that jeopardize their retirement savings, necessitating strict adherence to any prohibited transactions rules that exist; it is essential that investors understand and abide by them as disqualified persons engaging in such prohibited transactions can face harsh hefty tax penalties from the IRS when disqualified persons engage in such prohibited transactions.
Disqualified Persons
The IRS defines disqualified persons as any individual that you or your IRA cannot conduct business with, including spouses, children, parents, siblings and grandparents – as well as fiduciaries like your custodian. Anytime that an IRA does business with any disqualified person they risk engaging in an unlawful transaction which would likely violate federal regulations.
An IRA cannot invest in real estate owned or rented to disqualified people; nor can it conduct work on said properties to reduce costs (sweat equity). You or disqualified individuals cannot perform work themselves to reduce costs (sweat equity), nor should you ever use your IRA funds for yourself (self-dealing is frowned upon by the IRS and can lead to its cancellation, leaving only tax bill and no future retirement benefits in its wake – therefore it is imperative that investors understand disqualified persons and prohibited transactions before investing using self-directed IRA.
Investment Options
Self-directed IRAs allow investors to invest in many asset classes not normally provided by traditional brokerages, including real estate, private debt (such as promissory notes and deeds of trust), limited partnerships, tax lien certificates and other alternative investments.
Although these investments can be extremely rewarding, they do carry risks that require extra caution and knowledge before investing. For instance, using your IRA to purchase rental property that then rents to someone related to you could constitute a prohibited transaction that incurs severe penalties.
Most self-directed IRA custodians will only permit investments that comply with IRS guidelines for self-directed IRAs, such as purchasing alternative assets such as real estate or cryptocurrencies via an exchange or private market, which typically involve buying alternative investments like real estate and cryptocurrencies. While these are considered lower risk investments, they still require more initiative and diligence on your part as account owner compared with investing directly in startups where no direct participation from the IRA owner may occur.
Categorised in: Blog