When it comes to owning real estate in an IRA, it may be tempting to use your account-held property. However, the IRS prohibits such use. Prohibited transactions can result in steep penalties and distribution of the account.
At NDTCO, we hear a lot of questions from investors about what they can and can’t do with an IRA property. Here are a few of those questions and some basics about how the IRS treats prohibited transactions within real estate IRAs.
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The Basics of Prohibited Transactions
IRS audits are extremely thorough, so it would behoove you to keep your financial affairs in order. Unlike within our judicial system, the accused is guilty until proven innocent. The burden of proving innocence falls on the accused taxpayer.
The IRA prohibited transaction rules can be found in Section 4975 of the IRS code. With respect to buying real estate within an IRA, you and other disqualified persons cannot use the IRA-owned asset. There is no way for you to use the property or benefit from the property in any capacity. Additionally, your IRA cannot conduct transactions with you or your direct lineal relatives. Likewise, if you own an asset personally, there is no way to move it into your tax-deferred IRA.
“How would the IRS know if I use the property?”
Self-directed IRA custodians can help account holders avoid prohibited transactions, but they’re not always apparent. The IRS is not likely to monitor an IRA holder’s investments, so the agency relies on custodians to report prohibited transactions. At New Direction Trust Company, we won’t knowingly process a prohibited transaction. However, because some of your investment activities take place outside our field of vision, the onus of following the IRS rules falls on you. If you’re audited by the IRS, any prohibited transactions you’ve carried out with your retirement plan are likely to be revealed.
“What if I sell my personally owned property to my friend and then buy it back with my IRA? How would the IRS ever know?”
Buying the property with your IRA from your friend is not directly a prohibited transaction. However, the arrangement of selling something you own to the friend and then buying back with the IRA is most definitely a prohibited transaction.
The IRS doesn’t just look at transactions on paper; they also look at the circumstances involved. The IRS has seen just about anything an investor could propose or scheme. They can recognize these prohibited structures and declare them as prohibited transactions with relative ease.
Other investors suggest using an LLC to get around the IRS rules. LLCs can sometimes be useful in structuring real estate investments. However, they are not magical entities that make all the rules disappear. If your IRA invests in an LLC, then the rules that apply to the IRA now apply to the LLC as well, but now it’s up to you to maintain proper bookkeeping for the account in case of an audit.
The penalties for prohibited transactions can be harsh. Each case is judged on a case-by-case basis. An IRA that committed a prohibited transaction will almost certainly lose its tax-deferred status (the IRA would be immediately distributed to the account holder). This can create an unexpected tax liability as well as penalties if the account holder is under the age of 59.5. On top of that, the IRS will most likely impose a 15% prohibited transaction penalty. There have been extreme cases when the prohibited transaction resulted in 100% loss of the IRA. Prohibited transactions are not to be taken lightly.
The Bottom Line on Prohibited Transactions
Your IRA receives special treatment from the IRS via the tax benefits afforded by the account. In order to maintain that treatment, it is important that the IRA investments are just that–investments. If you want to use the IRA funds or benefit from the IRA funds, you would need to take a distribution and then pay any applicable taxes. However, while they remain in the IRA you (and your direct lineal family members) should not benefit from what the IRA is doing.
Give us a call at 877-742-1270 or send us a message through the Client Portal if you have questions or concerns about prohibited transactions.