What are prohibited transactions?
If you don’t know, and you’re the owner of a self-directed (or “Solo”) 401(k) or self-directed (Solo) Roth IRA, you could end up in serious legal trouble.
In short, a "disqualified" person is anyone who directly benefits from any activity that occurs inside of a self-directed retirement account.
The Self-Directed IRA and Self-Directed 401(k) have become popular instruments for buying real estate over the past decade, because they allow “alternative” investments. With this growing popularity, there is a growing risk that the IRS will increase its enforcement of “prohibited transactions.”
In order to help you avoid accidentally making a prohibited transaction, in this article, we’re going to define some key terms that you need to know in order to get a solid grasp on the concept, outline common prohibited transactions, go over the four different types of prohibited transactions, and give you some tips on how to better protect your assets.
If you want to see our library of articles about these two self-directed retirement plans (note: they are not simply for retirement... they're also great vehicles for tax-free investing), click the links below to get our content hubs:
Terms to Know: Solo 401(k)/IRA, Disqualified Person, Prohibited Transaction
We’ll need to define a few terms first. Prohibited transactions are exactly what they sound like: transactions that aren’t allowed by the IRS. But for our purposes, “prohibited transactions” occur in a very specific context, and to explain that context, we need to go over some common definitions:
- Solo 401(k) or Solo Roth IRA: essentially, this is a retirement account that grants you a little bit more freedom. Using a self-directed retirement account, you can invest in alternative assets like real estate, debt, vacant land, gold, silver, cryptocurrencies, and more. If you’re interested in setting up a Solo 401k, click the link to learn more.
- Disqualified person: a disqualified person is anyone who benefits from the self-directed account. The IRS doesn’t want investors to use Solo 401(k)s and Solo Roth IRAs to avoid paying taxes. Both of the accounts are heavily tax-advantaged, and it wouldn’t be fair for someone to open a self-directed account to buy a beach-front vacation home tax-free. Unless that vacation home is a rental that isn’t used by any of the disqualified persons, which include the account owner (you, if you opened the self-directed account), the owner’s family members and friends, the custodian/manager of the account, a business entity you own, and more.
- Prohibited Transactions: finally, prohibited transactions are any transactions that occur inside of the self-directed IRA that benefits disqualified persons. It’s very important to keep these funds separate from any personal funds. If you used a self-directed account to help you buy your nephew a new car, for example, you just engaged in a prohibited transaction. Sometimes they’re obvious; sometimes they’re not.
You might be thinking: If prohibited transactions include anything that directly benefits the account holder and his/her family, why would you ever open a self-directed account in the first place?
Well, just because you can’t buy assets that directly benefit you doesn’t mean that the assets never benefit you. You can still buy assets that make you a lot of money inside of the account.
It’s the difference between buying shares of a company and buying shares of your own company. Both can be wildly profitable, but only one benefits you directly.
Types of Prohibited Transactions
In general, there are four types of prohibited transactions. In this article, we already provided examples of a couple of them.
- Direct Prohibited Transactions: any sort of transaction that directly benefits a disqualified person. If Tom uses his self-directed account to purchase a classic car for his son, that’s a direct prohibited transaction.
- Indirect Prohibited Transactions: these are a bit trickier, but the gist of an indirect prohibited transaction is that the IRA or 401(k) owner takes multiple steps to avoid a direct prohibited transaction, while the outcome is largely the same as a direct prohibited transaction. For example, let’s imagine Tom from the above scenario really wants to get his son that classic car, so he loans funds to an acquaintance who ends up buying Tom’s son the car as a “gift.”
- Self-Dealing Prohibited Transactions: if you use your funds to buy yourself a vacation home or primary residence, you’re self-dealing.
- Conflict of Interest: this often coincides with self-dealing. If you loan money to a business entity that you own, this could be considered a conflict of interest.
What are Some of the Most Common Prohibited Transactions?
With that said, how do most people end up getting in trouble? It’s probably not how you might think.
You can’t be directly involved in the investments you make using a self-directed Roth IRA in any way, and that can lead to some confusing scenarios. Additionally, the money that you use to maintain the investment needs to come from inside the account.
That means the most common prohibited transactions are mistakes—not intentional fraud.
For example, if you buy a rental property with a self-directed account, you can’t go to that property to make repairs. You need to hire outside help to fix anything that may be broken, no matter how tempting it is to make the repairs yourself. And, when you’re paying for that outside help, you can’t use your personal savings. If you do, that’s a prohibited transaction.
Interested in learning more? Check out our related articles:
- Prohibited Transactions & Solo 401(k)s: What You NEED To Know
- IRA Prohibited Transactions: Rules You Need To Know
- Common Self-Directed IRA Prohibited Transactions: A Quick List
- Penalties For Prohibited Transaction With A Self-Directed IRA LLC or Roth IRA
- What Rules Affect Self-Directed 401(k) Plans?
How Can You Avoid Making a Prohibited Transaction?
In order to avoid making a prohibited transaction and incurring penalties and fines, ask yourself two simple questions:
- Outside of my account, do I personally benefit from making this investment?
- Do any of my family members, friends, associates, or business entities personally benefit?
If the answer is "yes", you’re likely making a prohibited transaction.
IRS rules are difficult, and it can be nearly impossible to get a grasp on all of them.
If you want to make sure your real estate investing business is protected, start with our investor quiz and we'll help you find ways to protect your assets.