Self-Directed IRA IRS Rules | Asset Protection for Real Estate Investors : Royal Legal Solutions

Self-Directed IRA IRS Rules

For those who are researching the legalities of using their self-directed IRA  for different kinds of investments, you’ll be happy to know that there aren’t very many prohibited forms of investment. On the other hand, IRAs were designed as vehicles for passive earnings and more specifically, for retirement security. There is some wiggle room here, but you don’t want to cross the line with the IRS.

Passive earnings can include things like rent, interest, the appreciation in value of real estate, stocks, or bonds, dividends, monies being paid off on a debt, and so on. There are, however, key restrictions that will be discussed in further detail later. Bear in mind that the IRS expressly prohibits certain kinds of transactions from making their way into your IRA trust.

Why the IRS Prohibits Active Earnings from an IRA

An IRA is designed for the express purpose of being a retirement account, not necessarily a tax loophole. Consider what would happen if individuals put their homes or their businesses into their IRA. The government would never collect a dime in taxes. The IRS, therefore, prohibits IRA holders from using their IRA to claim tax-deferred or tax-free status on their own personal ventures.

Self-directed IRAs allow individuals to claim tax-deferred and tax-free status, but they saddle those same individuals with a handful of rather complicated guidelines that must be followed. Failure to follow these guidelines can enable the IRS to revoke the IRA’s tax-preferred status.

The remainder of this article, then, will inform you as to what, precisely, those restrictions are and how they can be avoided.

Investments Prohibited for Your Self-Directed IRA

There are generally two kinds of investments prohibited for IRAs. Those that fail the metric for passive income, and those in which you are conflicted out of tax-preferred status. We’ll take a look at them one by one here.

Life Insurance Policies

Life insurance policies, generally speaking, cannot be held in an IRA. This includes:

  • Whole life
  • Universal
  • Term and variable
  • SEP
  • SIMPLE

Since IRAs are meant to act as a retirement fund, this makes a certain kind of sense. There is, however, one exception known as the incidental benefit rule. There are some qualified plans that are allowed to purchase a small amount of death benefit insurance, but the payoff does not constitute any form of lucrative investment, so it’s not really worth investigating.

Collectibles

In order to enjoy tax-deferred status, the IRS mandates that you defer any form of use or enjoyment from the investments held in your IRA. Any collectibles, antiques, sports memorabilia, or fine art that you purchase or possess can, thus, not be held in your IRA.

You may be wondering if coins fit the definition of a collectible. The answer is mostly. There are certain kinds of coins that are issued by the government as precious metal investments. While you would be prohibited from investing in antique coinage, you are not prohibited from investing in precious metals. Therefore, coins that are minted for their value as a precious metal are excluded from the collectible restriction.

Real Estate that You or Your Family Personally Use

Despite what you may think, real estate has become a very popular investment vehicle for self-directed IRAs. The one major restriction is that you cannot directly benefit from the real estate. That is to say, neither you nor your family can personally reside on the real estate. This is considered a prohibited transaction and it conflicts you out of tax-preferred status.

How does this work?

You yourself cannot receive the benefits of the property. You personally cannot collect rent. The rent must be paid directly to the IRA trust. In order for that to work, it must be held in the trust’s name and not your own.
Furthermore, you can’t purchase your primary home or a vacation home using your IRA. Nor can you purchase or sell property to members of your family.

Nonetheless, real estate is becoming an attractive option due to recent booms in the market.

Derivative Trading

There are a number of other prohibited transactions to be aware of. Those (generally) include any kind of derivative trade that has undefined risk. Again, the function of an IRA is retirement security so, more often than not, speculation of this sort is prohibited.

Business Interests

You can invest in business interests. However, you cannot be engaged in the management or running of the business in any way. Some folks want to use their IRA to start their own small business or use their IRA as collateral for a loan to start their own business. This is a prohibited transaction.

What Happens if I Engage in a Prohibited Transaction Using My IRA?

Essentially, if you use your IRA to engage in a prohibited transaction, the IRS will treat your IRA as if it were distributed. In other words, they will say you’ve cashed out your IRA. They will then subject you to:

  • Income tax on the entire contents of the account
  • A 10% early withdrawal penalty
  • Capital gains tax on the increased value of your account

In other words, the penalties are severe and it’s not something you want to experience.

A Checklist for Acceptable Investments

In order to avoid the steep penalties for triggering a prohibited transaction and an IRS reprisal, you should ask yourself the following questions:

  • Is this an active or a passive investment?
  • Are holdings being held in my name or the IRA trust’s?
  • Am I directly benefiting from items held in the IRA?
  • Does holding this item in an IRA trust produce a conflict of interest?

While the Internal Revenue Code is not necessarily accessible to laypeople, there is plenty that an individual with solid common sense can take away from these general principles. For the most part, those who use their IRA as a retirement account or operate it within the acceptable parameters which govern its tax-preferred status aren’t going to have very much to worry about.
One last thing worth noting is that there is some wiggle room in terms of the language that provides exceptions for certain kinds of investments. These types of transactions, however, should not be executed without the oversight of a competent retirement planning professional.

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