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Self-Dealing And The Rarely Discussed Prohibited IRA Step Transaction

The IRA Rules of Investment Don’t Allow You To Unfairly Benefit

If you do any amount of research about self-directed IRAs on the Internet, you’ll come across the term self-dealing quite a bit. Self-dealing is simply a prohibited transaction between yourself and your IRA. This could include buying something personally from your IRA or selling something that you already own to your IRA. The IRS created prohibited transaction IRA rules to prevent you from unfairly benefiting yourself or your IRA by giving overly generous “deals” to one or the other. Another rule is that you may only make cash contributions to your IRA; this eliminates the idea of assigning something to your IRA and considering it a contribution.

DO NOT use things owned by your IRA for personal use!

The other day I was speaking to a client who had purchased some real estate through his IRA. He told me that his IRA had been audited and one of his investments had been deemed a prohibited transaction. He was forced to take the entire property as a distribution and had to pay taxes and penalties on the entire value of the property.

It turns out that he and his family had stayed in the property, which was a beach condo for a total of nine days over the past few years. I didn’t get all the details on exactly how this was discovered during the audit, but somehow the IRS was able to determine that he had used the IRA owned property for his own personal use.

As I’ve talked about in previous blogs, you cannot use anything owned by your IRA for personal use, even if you pay at or above fair market price for its use. Please remember to keep these prohibited transaction rules in the forefront of your mind as you make your investments inside your self directed IRA. It’s not worth having something deemed a prohibited transaction even for a few days of a “free” place to stay. The IRS are very good at what they do and you will get caught.

Always Error on The Side of Caution

On another recent occasion, I received an interesting call from a lady who wanted to open a self-directed IRA and lend money to someone using a promissory note. So far, so good. There’s no problem with any of that. She then goes on to tell me that the person that she’s lending the money to is the man that she lives with. They are not married, but they’ve been living together for 35 years.

Here’s the possible dilemma:

We have already learned that your spouse is considered a disqualified party to your IRA. Would the same rule apply to someone that you have been living with for 35 years? Keep in mind that I am not a CPA or qualified to give tax or legal advice, but if this were my account, I would NOT do the transaction.

The rules are intended to keep you from benefiting yourself or your immediate family by using your IRA. Even though the person she was living with was not her spouse, the argument could be made that she is using her IRA to benefit the person she lives with, which may directly or indirectly benefit her, personally.

When doing things in your IRA, acting conservatively will always be the smarter approach. You would not want to risk losing your IRA due to a prohibited transaction. If you have any questions about whether a certain investment would be a prohibited transaction, be sure to speak with a CPA.

Avoid the Prohibited IRA Step Transaction

Inevitably, some unscrupulous people will vainly attempt to outsmart the IRS and say to themselves, “I’ll just sell the property to someone who is not a disqualified party to my IRA and then have them sell it to my IRA.” This is called a prohibited step IRA transaction. An IRA step transaction is any type of transaction that you do to circumvent or bypass prohibited IRA rules. The action is classified the same way as any other prohibited transaction is viewed.

If the IRS catches you doing a step transaction, you WILL be subject to the taxes and penalties for your actions. In short, there is no outsmarting the IRS. Just follow the self directed IRA guidelines outlined in the Internal Revenue Code and you should stay clear of the possible landmines.

If you have any questions about IRA prohibited transactions, please speak to a CPA or tax attorney.

Terry White

About Terry White

I started my business career after getting my degree in Accounting from the University of New Mexico in 1983. My first job was as a controller for a local title company, and in 1987 I started First Financial Escrow, Inc. Over the years I played a part in several startup companies including First Financial Equities, Inc., First Financial Trust, Inc., First Financial Marketing, Inc. and Asset Ventures, Inc. In 1997 First Financial Escrow, Inc. was able to purchase the escrow accounts from Sunwest Bank and changed its name to Sunwest Escrow. As the market changes, Sunwest has grown and changed along with it. Besides my wife, Sheila, we have three boys, two daughters-in-law, one grandson, another grandson on the way and a future daughter-in-law. Sunwest is my passion, and I enjoy coming to work every day to see what will happen next. I enjoy fly fishing, spending time in Colorado, biking and watching my boys play soccer.