What is Not Allowed With a Self Directed IRA?
Self-directed IRAs must abide by numerous rules in order to avoid incurring penalties from the Internal Revenue Service (IRS).
One of the most critical rules relates to prohibited transactions. Any unwarranted dealings involving disqualified parties must be avoided at all costs, so always work with a custodian that specializes in alternative investments to keep yourself out of these illegal dealings.
Prohibited Transactions
There are certain financial transactions which cannot take place with a self-directed individual retirement account, known as prohibited transactions, typically those involving interactions between an IRA and what the Internal Revenue Service considers disqualified persons.
Engaging in prohibited transactions could result in their IRA losing its tax-exempt status and incurring taxes and penalties. For instance, using real estate owned by their IRA for personal gain prior to retirement would constitute a prohibited transaction since this would benefit both themselves and the IRA owner before retirement.
Also considered prohibited transactions are investments in life insurance contracts, most collectibles (except gold, silver and palladium bullion of specific purity), alcoholic beverages and tangible personal property. To prevent an illegal transaction from taking place it’s essential that all parties involved take appropriate steps prior to investing, complying with IRS rules and regulations while never directly transferring funds out of an IRA to yourself or anyone else.
Fiduciary Responsibility
IRAs are fiduciary investments, which means you, as account owner, have a fiduciary responsibility to act according to IRS regulations and avoid prohibited transactions. Self-directed IRAs offer more flexibility than traditional ones but come with their own set of risks; IRC 4975 from the IRS details these rules extensively so it is vitally important that before making decisions for your IRA you fully comprehend them.
An example of prohibited transactions between an IRA and disqualified persons would include selling or exchanging assets between these two. Disqualified parties include their fiduciaries, spouses, ancestors, lineal descendants or anyone related to these individuals. Furthermore, an IRA cannot extend loans or extend credit to its owner and/or certain family members even if the transaction meets DOL Plan Asset Rule exception.
Examples of prohibited transactions include purchasing or selling collectibles such as artwork, stamps, metals (with certain exceptions for specific kinds of bullion), alcohol beverages, coins (except certain U.S. minted coins) or tangible personal property. Be sure to independently verify information such as prices and values provided in your IRA account statement.
IRA owners should carefully consider which investments to make to avoid any prohibited transactions, such as owning property that can be used by their holder for personal reasons such as a vacation home, or paying themselves or disqualified people to manage said property – such transactions violate the exclusive benefit rule and could result in self-dealing which results in taxable income for their IRAs.
Another example would be when an IRA invests in an operating business that generates non-passive income; such as a shoe factory, gas station, technology company or similar enterprise that generates non-passive profits and generates non-passive profits taxable as Unrelated Business Income Tax or UBIT.
UBTI is taxed at trust tax rates of 37%, so IRAs must file IRS Form 990-T in order to report this type of income. In order to minimize UBTI taxes, an IRA should focus its investments only in passive operating businesses and carefully review financial statements of any businesses with which it invests to assess whether their activities qualify as UBTI income sources.
Personal Guarantees
Self-directed IRAs provide investors with a diverse set of investment choices; however, certain transactions that involve disqualified persons (you and/or close family members, as well as those owning 50%+ of an entity which your IRA invests in) are prohibited and therefore an IRA should not engage in these types of dealings.
One prohibited transaction would include lending money directly or indirectly to yourself or an organization you control; this is known as indirect self-dealing and constitutes a violation of IRS regulations.
An additional prohibited transaction involves buying property for personal use with your IRA funds, in violation of IRS regulations. An IRA cannot own real estate that serves its own benefit prior to retirement – rather, it should act solely as a passive investor in such properties.
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