What is a prohibited transaction in a self-directed IRA?

In its most general sense, a prohibited transaction is one where there is some sort of “self-dealing” taking place, either directly or indirectly. In certain cases, the self-dealing may not even involve the IRA owner. The chances of inadvertently engaging in a prohibited transaction are increased with a self-directed IRA that allows you to purchase alternative assets, such as real estate or privately held limited partnerships (LPs) or LLCs. Basic guidelines have been established by the Internal Revenue Service (IRS) regarding the types of transactions allowable within an IRA. (Note: The law and regulations governing prohibited transactions within qualified plans differ slightly from those summarized above regarding IRAs. Please review IRS Publication 560 and consult with your tax professional if purchases are to be made within a qualified plan, such as a 401(k) plan.) The IRS specifically prohibits “self-dealing,” where the transaction benefits (directly or indirectly) the account owner, certain close family members and a few other persons or entities who are deemed as “disqualified persons.” Transactions restricted by the IRS are referred to as prohibited IRA transactions and include, but are not limited to: * Borrowing money from an IRArn * Selling assets to an IRArn * Receiving unreasonable compensation for managing an IRArn * Using an IRA as security for a loanrn * Buying property for personal use with IRA funds The transactions above are prohibited within an IRA for any disqualified person. Disqualified persons include: * The account owner (which includes the beneficiary in the event of the account owner’s death) * Account owner’s family of lineal descent: * Children, grandchildren, etc. * Parents, grandparents, etc. * Spousern * Spouse’s children, grandchildren, etc. * Spouse’s parents, grandparents, etc. * A fiduciary who exercises any discretionary authority or discretionary control in managing the IRA, or has any authority or responsibility to provide investment advice to the IRArn * Any corporation, partnership, trust or estate in which the account owner has a 50 percent or greater interest In general, a prohibited transaction, as defined by Internal Revenue Code Section 4975, is a transaction between a plan (your self-directed IRA) and a disqualified person. Generally, if the IRS determines that a disqualified person has engaged in a prohibited IRA transaction, the account will no longer be deemed an IRA as of the first day of the year in which the prohibited transaction occurred, and may result in adverse tax consequences. If the IRS were to determine that an IRA is no longer deemed to be an IRA because a prohibited transaction has occurred; the IRA owner receives the entire value of his or her account as an IRA distribution and is required to claim the distribution value amount as income. If the IRA owner is not yet 59 and ½, he or she would also face an additional 10% early withdrawal penalty on the distributed amount. If you have any questions about the legality of a proposed transaction within your IRA, consult with your IRA custodian. If your IRA custodian is unable to fully address your inquiries, then it should be able to offer additional resources that can help guide you through the complexities of these types of transactions and the associated potential tax consequences. Standard assets such as publicly traded stocks and mutual funds are less likely to face prohibited transaction scenarios than alternative assets. Alternative assets frequently have fewer investors, which increases the possibility of self-dealing. To obtain more information pertaining to these rules, see IRS Publication 590 and Internal Revenue Code Section 4975. The IRS also has a useful Frequently Asked Questions about retirement plan investments at Retirement Plan Investments FAQ.