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:
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:
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.
In general, there are four types of prohibited transactions. In this article, we already provided examples of a couple of them.
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:
In order to avoid making a prohibited transaction and incurring penalties and fines, ask yourself two simple questions:
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.
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Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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