Prohibited Transactions & Disqualified Persons
Understanding Prohibited Transactions & Disqualified Persons
A prohibited transaction is a transaction between a plan and a disqualified person that is prohibited by law, or improper use of the retirement account by any disqualified person. Prohibited transactions can cause penalties and can even result in the disqualification of your IRA.
Per IRC Section 4975, a prohibited transaction is defined as any direct or indirect:
- Sale or exchange, or leasing, of any property between a plan and a disqualified person;
- Lending of money or other extension of credit between a plan and a disqualified person;
- Furnishing of goods, services, or facilities between a plan and a disqualified person;
- Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- Act of a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
- Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Examples of Prohibited Transactions
- Selling property to yourself or having your IRA buy property that you currently own
- Using the investment property as a second home or as a vacation home
- Allowing your children to live in the home that the IRA owns
- Borrowing money from your IRA
- Doing your own repairs/maintenance or rehabbing the property yourself
- Using your IRA as security for a loan
When Jack’s son, John, was accepted by a college out of state, Jack decided to use some extra cash in his IRA to buy a duplex in the town John would be attending school. Jack allowed John to live on one side while renting out the other side to another tenant in order to help with college living expenses. As a result, this caused Jack’s entire IRA to become disqualified, leaving him responsible for paying taxes on the full value of the IRA.
What did Jack do wrong?
This is a prohibited transaction because Jack’s son John is a disqualified person gaining a benefit from the investment. Jack should not have allowed his son to live in a rental property held in his IRA and only allowed renters who do not fall under the category of a disqualified person.
Larry owns several rental houses within his IRA. After one of his tenants moved out, Larry discovered the carpet had been destroyed. Larry decided to replace the flooring himself in order to save money on installation costs. As a result, this caused Larry’s entire IRA to become disqualified, leaving him responsible for paying taxes on the full value of the IRA.
What did Larry do wrong?
This is a prohibited transaction because Larry is a disqualified person providing a service. Larry owns the IRA and therefore cannot contribute any value to the investment that comes from outside the IRA. By doing the work himself, he is adding value from outside the IRA. Larry should have hired someone to do the work and paid them from funds in the IRA in order to avoid a prohibited transaction.
Any person in the position to have substantial influence over the decisions of an entity, whether that influence is enacted or not, is considered to be a disqualified person. The IRS has very specific rules for identifying disqualified persons – the following are examples:
- IRA holder and their spouse
- Lineal family relationships
- Descendants: IRA holder’s children or grandchildren, and their spouses
- Ascendants: IRA holder’s parents and grandparents
- Exemptions: Brothers, sisters, aunts, uncles, cousins, and step-siblings
- Disqualified Persons Matrix
- Any corporation, partnership, trust, or estate in which disqualified persons have a 50% or greater interest
- Anyone that provides services to the IRA: Investment advisors, managers and fiduciaries (the IRS considers the owner of a self-directed IRA to be the fiduciary of his/her IRA)
- Any lineal family member of an individual described in 1-4
See IRS Rules for Identifying a Disqualified Person for a complete list of disqualified persons.