self directed iras and prohibited transactions

In short

A friend of mine once bought a rental house with money from his IRA and then spent a weekend painting it himself. He thought he was saving the account a few dollars. He was actually handing himself a problem. If you are holding a self directed IRA, or thinking about one, you have probably wondered where the lines are. The account has to stay at arm's length from the owner and close family. Money and property inside it can only serve the account, never your own pocket today. The IRS names the people and deals that cross the line, and the penalties can be steep. A tax professional can read the rules against a person's own case before anything is signed.

The whole of it

What it is

I once watched a neighbor sort his tools into two toolboxes, one for the farm and one for the house, and he never let them mix. A self directed IRA works much the same way. It is an individual retirement account that lets the owner hold things beyond the usual stocks and funds, such as real estate or a private business interest, if the account paperwork and the custodian allow it. The custodian is the bank or trust company that holds the account and does the filing. It does not give advice, and it does not check whether a deal is wise.

A prohibited transaction is a dealing between the IRA and a certain group of people that the tax law forbids. The law is in section 4975 of the Internal Revenue Code. That group is called disqualified persons. It includes the account owner, the owner's spouse, parents, grandparents, children, grandchildren, and the spouses of those children and grandchildren. It also includes a business those people control. Siblings are not on the list. Still, the rule is easy to trip over, so folks should read the full definition before assuming a relative is safe.

The idea behind all this is simple. An IRA gets a tax break so that the money can grow for retirement. Congress did not want the account used as a way to trade favors with the owner's own family or firm.

How it works

You have probably worked hard for what is in your account, so it helps to see how the rule bites. The tax law bars a few kinds of dealings between the IRA and a disqualified person. The IRA cannot sell or lease property to such a person. It cannot lend money to one, or borrow from one. It cannot pay one for services. And a disqualified person cannot use the account's assets for personal gain. That means no living in the IRA's vacation cabin, even for a week.

Here is where the sweat equity trap comes in. If the owner fixes up an IRA owned rental by hand, the owner is giving services to the account. That counts as a prohibited dealing, even though no cash changes hands. Repairs are meant to be done by a hired contractor, with the IRA paying the bill.

The penalty is the hard part. If the owner takes part in a prohibited transaction, the IRS treats the whole account as if it ended on January 1 of that year. The full value is then counted as a distribution. That means it is added to taxable income, and if the owner is under age the current figure, which the official source publishes each year, an extra the current figure, which the official source publishes each year percent early withdrawal tax may apply. One slip can undo years of tax deferral. The rules differ when someone other than the owner, such as a related business, takes part. Then a separate tax on the disqualified person may apply.

The numbers, and where to find yours

A friend of mine keeps a worn notebook of numbers that change, and the figures here work the same way. Each one is set by law and can change, so the site fills them in with the date and source. The yearly limit on what an owner can put into an IRA is the current figure, which the official source publishes each year. The age for the early withdrawal tax is the current figure, which the official source publishes each year, and that tax is the current figure, which the official source publishes each year percent. The first tax on a prohibited transaction under section 4975 is the current figure, which the official source publishes each year percent a year of the amount involved, and a second tax applies if the problem is not corrected.

If you are wondering where to find your own numbers, the account statement from the custodian is the place to begin. It shows what the account holds and what it is worth. Your yearly Form 5498 reports contributions and the account's fair market value. IRS Publication 590-A covers contributions, and Publication 590-B covers distributions. Section 4975 of the Internal Revenue Code lists the disqualified persons. Those are primary sources, and they are free.

A worked example

I once knew a man I will call Daniel. He is 48, and he has $80,000 in a self directed IRA. His custodian lets him hold real estate. In March, Daniel has the account buy a small duplex for $70,000 in cash. The IRA has $10,000 left over.

Daniel is proud of the deal, and he should be, because buying through the IRA is allowed. The trouble starts in June. The roof leaks. Daniel is handy, so he spends two weekends replacing it himself. He saves the account about $4,000 in labor. He feels good about it.

But Daniel has just given services to his IRA. A disqualified person, himself, worked on an account asset. That is a prohibited transaction under section 4975. The tax law now treats the whole account as paid out to him on January 1. The account held $70,000 in the duplex plus $10,000 in cash, which is $80,000. That $80,000 is added to his income for the year.

Say Daniel earns $60,000 at his job. Add $80,000 and his income for the year looks like $140,000, since $60,000 plus $80,000 is $140,000. Because he is under age the current figure, which the official source publishes each year, the early withdrawal tax of the current figure, which the official source publishes each year percent may also apply. On $80,000, if the rate were 10 percent, that would be $8,000, since $80,000 times 0.10 is $8,000. The exact figure depends on the rate the law sets that year. Plus, the duplex no longer sits in a tax sheltered account.

Daniel saved $4,000 in labor and risked a bill that could run to tens of thousands. That is a poor trade. A hired roofer, paid by the IRA, would have kept the account safe. Four words say it best. Let the account pay.

Where it goes wrong

A fellow I know once told me the trouble with a rule is that nobody reads it until it hurts. The common mistakes with these accounts are not wicked ones. They are small and easy to make. An owner pays an IRA owned property's tax bill from a personal checking account because it was handy. The money was meant as a favor, but it counts as a contribution that may exceed the limit, or as a mixing of funds. An owner uses the IRA to buy into a company that the owner or family runs, and then takes a salary from it. An owner lends the account money, or the account lends to a child. Each can cross the line.

Another trap is the personal guarantee. If the IRA borrows to buy property, a lender may ask the owner to sign for the loan. Many tax advisers steer owners away from signing personally for a loan made to the IRA. Section 4975 and the IRS guidance spell out how loans to an IRA are treated, and the lender's terms deserve a careful read. Loans inside an IRA also bring other tax questions that deserve a professional's eye.

A neighbor of mine assumed someone was checking his deals. The IRS does not rule on every deal in advance, and the custodian does not stop one either. Because the account is self directed, the owner carries the risk of getting it wrong. That is a heavy thing to carry alone, so it is worth paying a tax professional to look at a deal before the papers are signed.

You are not careless for finding this tricky. The rules are tangled, and good people stumble. A slow pace, plenty of questions, and two separate boxes for the account and the owner's own life make for a calmer road.

Questions to answer before you leave this page

Have you written down who counts as a disqualified person in your own family and your own business? Does any deal you are weighing put you, a relative, or a company you control on the other side of the table from your IRA? Who will do the work on an IRA owned property, and will the account pay them directly? Are you sure no personal funds will cover the account's bills, and that no one in the family will use an account asset? Has a tax professional read the deal papers and the account agreement? And have you checked the current limits and rates on the official IRS pages, so that the numbers you plan around are the ones the law sets today?