If you don’t follow the rules set forth for self directed IRAs, you can risk the tax-deferred status of your account. This could lead to the disqualification of the IRA and severe tax consequences.
Official Documents Regarding IRS Rules…
Prohibited Transactions Under the Provisions of ERISA
A prohibited transaction, including prohibited real estate IRA investments, can bring into question the tax-deferred status of your account, potentially resulting in the disqualification of your IRA and severe tax consequences.
The following is the definition of a prohibited transaction that comes from IRS Publication 590 and speaks of those acts that you should avoid so as not to incur additional taxes and other costs, including loss of IRA status.
Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.
Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
The following are examples of prohibited transactions with a traditional IRA:
- Borrowing money from it.
- Selling property to it.
- Receiving unreasonable compensation for managing it.
- Using it as security for a loan.
- Buying property for personal use (present or future) with IRA funds.
-Source IRS PUBLICATION 590
Self Dealing Rule
Your IRA may not buy an investment from or sell an investment to a disqualified person as defined by Internal Revenue Code Section 4975. To do so is known as “self dealing.”
Additionally investments made with self directed IRAs must be at arms length, which is most often defined as a willing buyer and willing seller coming together with no undue influence from outside sources.
Disqualified Persons defined
Disqualified Persons are individuals or entities between whom or which an IRA is prohibited (absent a special exception) from engaging in any direct or indirect sale or exchange or leasing of any property; lending of money or other extension of credit; furnishing goods, services or facilities; or transferring to or permitting the use of IRA income or assets.
- Fiduciaries (which in the case of a self-directed IRA includes you, as the IRA owner);
- The following family members of the IRA owner:
- Grandparents and Great-Grandparents;
- Children (and their spouses);
- Grandchildren and Great-Grandchildren (and their spouses);
[NOTE: The term “disqualified person” under the Internal Revenue Code does not include siblings (brothers and sisters) or aunts, uncles and cousins of the IRA owner.]
- Service providers of the IRA (e.g., IRA custodian, CPA, financial planner);
- An entity (such as a corporation, partnership, limited liability company, trust or estate) of which 50% or more is owned directly or indirectly or held by a fiduciary or service provider; also a 10% or more partner or joint venturer of such entity;
- Additionally, in the case of a SEP or SIMPLE IRA:
- The Employer;
- 50% or more owner of the Employer;
- Officers, directors, 10% or more shareholders, and highly compensated employees of the Employer;
- An entity 50% or more owned by the Employer;
- 10% or more partner or joint venturer of the Employer.
Indirect Benefits Rule
The purpose of the IRA is to provide for your retirement in the future. It’s not intended to benefit you now. It’s considered an “indirect benefit” if your IRA is engaged in transactions that, in some way, can benefit you personally—and this is NOT allowed.
Indirect Benefit Examples:
The following are just a few types of indirect benefit transactions that are NOT allowed in an IRA:
- Personally using IRA property —such as using real estate purchased through your IRA— as an office, personal residence, vacation home, retirement home, or office space.
- Receiving personal benefits from your IRA —such as lending yourself money from your IRA or paying yourself, or a company that you own, to do work on a home purchased by your IRA
- Using your IRA funds to buy a vacation home that you or your family will use
Note that you, as owner of the account, are a disqualified individual. In the eyes of the IRS, you and your IRA are not one and the same. Although the IRA is established to benefit you and your beneficiaries, it is truly a separate “trust.”
An IRA CANNOT buy or sell investments from the IRA Owner.
Some examples of “Self Dealing”
- Having your IRA purchase real estate that you own presently.
- Having your IRA purchase real estate that is owned by a family member of lineal descent, such as your father.
- Issuing a mortgage on a relative’s new residence purchased by a family member who is a disqualified person as listed above.
- Granting a child a second mortgage for the down payment on his or her first home.
- Buying stock from the IRA owner (any transaction involving IRA funds and a “disqualified person” is prohibited).
- Purchasing stock in a closely held corporation in which the IRA owner has a controlling equity position or, if such corporation is the IRA owner’s employer, in which the IRA owner is an officer if the IRA is established pursuant to the employer’s SEP or SIMPLE program
- Purchasing restricted stock from a family member who is a disqualified person listed above.
UBIT (Unrelated Business Income Tax)
If your IRA owns an asset or interest that produces unrelated business taxable income (UBTI), your IRA may be subject to an unrelated business income tax (UBIT) pursuant to Section 511 of the Internal Revenue Code.
Is My IRA Responsible for UBIT?
UBIT applies if ALL of the following are true:
- Income is derived from “”trade or business”” activity (i.e., sale of goods and services).
- Business activity is not substantially related to exempt status.
- Business is regularly carried on by organization.
Generally, IRA investments that can generate UBTI include limited partnerships, limited liability companies, and any investment that incurs debt financing and/or is involved in an unrelated business.
Most passive investment income—including dividends, royalties, and rent—is exempt from UBIT. However, an investment that generates income with debt financing (e.g., purchasing real estate with a non-recourse loan in an IRA) is responsible for UBIT in direct proportion to the gain/income that’s debt financed.
Payment of UBIT
In most cases, IRAs that receive more than the current $1,000 UBTI exclusion must file Form 990T with the Internal Revenue Service on or before the April 15th deadline. Form 990T payments must be made from the IRA’s assets, and Equity Trust must receive direction to pay these taxes at least 10 days before the due date (plus any extensions).
IRAs that generate less than $1,000 of UBTI are not required to file Form 990T.
In most instances, UBTI is reported on Schedule K-1, which is prepared by the investment sponsor.