Directed IRA Podcast

Prohibited Transactions in a Self-Directed IRA (You Know It's a Prohibited Transaction When...)

• Mat Sorensen and Mark Kohler

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For more details on prohibited transactions download the Self-Directed IRA Handbook (look for chapters 4, 5, 6, and 7): https://directedira.com/the-self-directed-ira-handbook/

In this episode of the Directed IRA Podcast, Mat Sorensen and Mark J Kohler break down the single most important rule in the world of self-directed IRAs, the prohibited transaction rule. Before your IRA buys real estate, a private company, crypto, or any other alternative asset, you need to understand who your IRA can transact with and how to avoid accidental mistakes that can blow up your entire account.

Mat and Mark explain the three core varieties of prohibited transactions in a simple and memorable way, using real client examples along with their usual energy, humor, and clever comedy bits. You will learn why certain family members are off limits, what happens if you try to stay in your IRA owned Airbnb, how sweat equity can accidentally trigger a self dealing violation, and how to safely buy rentals or businesses in your retirement account with confidence.

The hosts also sprinkle in a series of fun “you know it is a prohibited transaction when” jokes that make the topic easy to remember and surprisingly entertaining. By the end, you will understand how to stay compliant, make smarter investment decisions, and unlock the real power of a self-directed IRA.

Perfect for real estate investors, business owners, and anyone using an IRA for alternative assets, this episode gives you the clarity you need to protect your account and maximize long term gains.

Chapters: 
0:06-  Welcome And Why This Matters
0:12 - Defining Prohibited Transactions
2:16 - What IRAs Can And Can’t Own
2:54 -It’s About Who And How, Not What
2:59 - Per Se Prohibited Transactions Explained
4:34 - Disqualified Persons And Family Traps
7:25 - After You Buy: Use And Benefit Rules
8:17 - Renting To Family And Self-Dealing
10:26 - Sweat Equity And Fixer Upper Pitfalls
12:49 - Managing Vs. Working: The 50 Percent Line
16:13 - Facts, Circumstances, And Case Law
17:49 - Practical Guardrails And Flexibility
19:36 - Resources, Book, And Professional Help
19:51 - Closing Remarks And Disclaimers

Directed IRA Homepage: https://directedira.com/

Directed IRA Explore (Linktree): https://linktr.ee/SelfDirectedIRA

Book a Call: https://directedira.com/appointment/


Other:
Mat Sorensen: https://matsorensen.com & https://linktr.ee/MatSorensen
KKOS: https://kkoslawyers.com
Main Street Business https://mainstreetbusiness.com



SPEAKER_00:

Welcome everyone to the Directed IRA podcast. This is Matt Sorensen joined by the great and powerful Mark J. Kohler. We are two tax lawyers here to teach you what is a prohibited transaction when you're using a self-directed IRA. These are IRAs that can own in real estate, private companies, you can invest crypto. All these private assets you can actually own with your IRA. But there's one critical rule, the most important rule I should say, that you need to know.

SPEAKER_01:

Is you're gonna have fun during this podcast. That's why I'm here. Yes, yeah. Can we do that?

SPEAKER_00:

Yeah, I'm gonna obviously lobbying for comic relief on the podcast today. I'm like, we need to be serious.

SPEAKER_01:

I know, he's like plowing through. I'm like, I gotta get a word in here, you know, to make sure you guys are gonna have a great time. But apparently you're saying there's a number one rule.

SPEAKER_00:

And it's the prohibitive transaction rule. And it's really once you know it, you can be super powerful and unstoppable with your self-directed IRA.

SPEAKER_01:

I love it. And I was like, I love this time because I love Jeff Foxworthy. We have some younger people here who have never heard of this guy who said, you know, you're a redneck when. Anybody remember that joke? Well, we're here to tell you today. We're gonna spatter or sprinkle in some of these great jokes of you know it's prohibited transaction when. So stay tuned. It's gonna be good.

SPEAKER_00:

Are you gonna give us one on the day?

SPEAKER_01:

I'm gonna lead out of one. Okay, I'm gonna lead with one. Okay, so everybody, you're you're gonna, you're never gonna forget. See, this the beauty of this podcast today, you're never gonna forget what a prohibited transaction is again, and you're gonna make so much freaking money in your IRA because we're gonna make this fun to learn. Okay, so I okay, you want one of my? I'm gonna go with a holiday one. You know it's a prohibited transaction when your IRA owns a vacation home and somehow your whole family accidentally spent Christmas there.

SPEAKER_00:

If you're not laughing right now, that's because you thought that was great. Yeah, that's because you know, sometimes delivery matters, you know. Um, you know, comedy's all about timing. Okay. And also, you probably don't know what a primitive transaction is. Because if you did know, you would be laughing. Okay. Because that was funny.

SPEAKER_01:

So we know you get it, your whole family accidentally. Yeah. Yeah. Whatever.

SPEAKER_00:

Because they can't stay there. So, all right, let's unpack what is a primitive transaction.

SPEAKER_01:

I like it. Okay. Okay.

SPEAKER_00:

Let me say one thing on at the outset here. Your IRA can really own any asset allowed by law. It just can't own life insurance, collectibles, or S corporation stock. Everything else is fair game. It can own the duplex down the street, it can own an Airbnb, it can own a vacation rental, but your family can't stay there. And this is because of the prohibited transaction rule.

SPEAKER_01:

And I want to add to this too. A lot of people hear prohibited transaction rule, and they think it's all about stuff you can't buy. It's not that. You got world is your oyster. The prohibited transaction rule is what you do with it after you buy it or who you buy it from. That's what the prohibited transaction rule is about. It's not about what you're buying, it's how you're buying.

SPEAKER_00:

Yeah, and there's really three varieties of this. We're gonna teach them here, we'll get through it. It's not, it's pretty simple. Okay. The first is what's called a per se prohibited transaction. And like Mark said, this is about who is your IRA, once you have money in your self-directed IRA, who is it transacting with? If my IRA is buying the duplex down the street as a rental property, who's selling that? Who's selling that property to my IRA? So I have a primitive transaction. If I have an IRA, transact with the disqualified person. Well, the whole point of having a retirement account is to have one. So I got one and I gotta make money, so I gotta transact it. But who is on the other side of the transaction?

SPEAKER_01:

And this is where people start to play games and want to benefit themselves and their IRA at the same time. And themselves means your mom, your dad, your kids, your spouse, you're trying to benefit your family somehow and have your IRA provide some cool asset or payment or use of property to your family. That's where, and this is the crazy part. Just this principle alone, your IRA can make so much more money than a Wall Street structured product. That's the beauty of it. But then some people push the envelope even farther and say, ooh, ooh, that's great. Now I'm gonna use that rental property. No, just just enjoy the incredible ROI. Don't screw it up by trying to use it. So so I'd like so first example is I like your point. Prohibited transact transaction number one is I am doing a deal with a person that I shouldn't.

SPEAKER_00:

I'm either buying a property from them or selling it, I'm leasing it. So let's just go through the clear example here. My IRA is buying the duplex down the street, and the seller is my father. Okay. Well, my father's on this list of who is a disqualified person. It's what it's called in the tax code. This is section 4975. I did tip warn you, we're tax lawyers, okay? All right, you might think we're comedians or some, you know, well, I don't know. I know I don't know what you're thinking right now. Okay, I don't really don't know. Okay, but you're still listening and watching. Okay. So um, but your father's prohibited. Now, you're prohibited. So this is what we get a lot of times, too, is they're like, hey Matt, I own this stock or I got some options in this company I work at, and they've gone up in value. And if I sell them, I'm gonna pay all this tax. Can I just sell them to my Roth IRA? Well, now let's look at that again. This is your IRA buying stock, a transaction or options here from yourself. You're disqualified. So this would cause a prohibited transaction as well. Now let me change one fact here, and then I'll let it let you take it from me. I will defer to you, I will, you know, yield, I will yield the balance of my time. All right. Okay. Is let's say you're like, okay, let's go back to this real estate example. Now let's say that your IRA is buying the duplex down the street, but the seller's your sister. Your sister's not on the list of disqualified people. And I know you're thinking, but Matt, I thought family was prohibited. It depends on who they are in the family. Your brother or sister are actually fine. Okay, your aunt, uncle, cousin, obviously third parties, some seller you don't even know, that's totally fine. The real issue here is these certain family members that are disqualified, do not transact with them. It'll blow up your IRA. You have a distribution of your IRA, it no longer exists. If you're not yet 59 and a half, you have an early withdrawal penalty. So those are some easy examples here, I think, to get the juices flowing about what we're talking about.

SPEAKER_01:

And to give you kind of like why the practical reason why is the IRS knows you would not screw over your mom or dad in a transaction, but you'd screw over your sister. And that's okay. They're like, that's fine, you know?

SPEAKER_00:

Yeah. But so or they thought, or they thought, you know, your mom or dad wouldn't collude in a transaction with you to avoid taxes, but your brother and sister I don't know what they're thinking. Actually, let's let's not even worry about this. This try to think what Congress was intending when they were. Yeah, that's almost impossible. That's a disaster.

SPEAKER_01:

Yeah. No, I actually think I'd like your example because I do want to say it. The IRS actually thinks your mom and dad would collude with you to increase the value of your IRA and screw over the IRS, but your sister would be like, hell no, just buy my house. You know, you jerk. And so that's kind of what's going on there. Um, okay, now that's the acquisition transaction issue. Okay, so everybody, let's let's knock these out. So when you're using your IRA to buy assets, you can't buy something from yourself, your parents, your kids.

SPEAKER_00:

Uh, you know, the spouse and all the spouses for the NBU in Utah.

SPEAKER_01:

Kind of yeah, there you go. Now, the next rule that you want to be aware of is kind of this use and kind of transaction stuff. Like, once I buy the property, so I buy it from a third party, it's all good. But now you want to go stay there. Say it's a short-term rental, or it's a long-term rental and you want your kids to go live in it while they go to college, or um you want you buy this business and you want the business to hire you or hire your kids. Um, but your IRA owns it, and we know that the IRA could very well make more money because you're gonna play games with this, or benefit your family with money that's stuck in your IRA, and it could go both ways. Some people want their IRA to own the business so that it can suck money out faster. Other people want the IRA to own it so you can work in it for free and make it go up faster. You never know. So the IRS says, with all that crap going on, no, you can't do it with these prohibited parties. Once you buy something, leave it alone. Go make some money, but don't transact with it.

SPEAKER_00:

Yeah. So now my IRA owns that duplex that I bought from my sister, not a disqualified person, right? I can go rent it. I can have any tenant that I want to rent that property, but it's not me, not my spouse, not my parents, not my kids, anyone on this disqualified person list. All right. And also, you can't stay there for free. Okay. So whether you you're having a disqualified person rent from there, that's a problem. They're they're transacting because they're paying rent to your IRA, or you're staying there for free and getting some unfair benefit, this causes what's called a self-dealing transaction prohibited transaction. So the bottom line is once your IRE owns an asset, don't have use or benefit of it yourself or any of these people that are disqualified on the list. Now, for 99.99%, well, I say for 99.98% of you, all right, let's be precise here. Um, this doesn't matter. But we know we run across the people that are like, they're trying to manipulate and use the IRA some way unfairly to benefit them or their kids or their spouse, or they think that the self-directed IRA gives them this freedom to use it in these ways that benefits them. No, that's not what we're talking about here. You are investing in that duplex because you think it's going to appreciate in value and cash flow rent better than the mutual fund that your IRA owned before. That's why we're buying these assets, not to have some weird use or benefit from them or to do some crazy transactions to screw over the IRS. And so that's what this primitive transaction rule is really all about at the end of the day.

SPEAKER_01:

I love it. And you know, and the reality is some of you are like, well, that's that's not that complicated. That makes sense. And it actually is quite easy to absorb and understand and then put into practice. So I think we're ready for another, you know it's a prohibited transaction when. All right.

SPEAKER_00:

May I? Yeah.

SPEAKER_01:

Okay. You know it's a prohibited transaction when your IRA buys a rental and your mom is the tenant and she pays rent in cookies. I love that one. Because your mom would do that, you know? Yeah. Like, do I have to really pay rent? Can I just bring you a plate of cookies? Yeah. Um, mom, that is a prohibited transaction transaction. You shouldn't even be there. Get out. I'm gonna go to trip go to jail.

SPEAKER_00:

So yeah. A couple more points there. Fixer uppers. Okay, yeah. Fixer uppers. We a lot of clients are investing in real estate that needs to be fixed up, or they're buying businesses, frankly, that need someone to get in there and run it and turn it around, maybe. All right. Now, whether you're buying real estate or you're buying a business, a lot of our clients that are business owners, real estate investors, they're like, I'm going in, I'm going in, put me in, coach. You know, I'm putting on the tool belt to go remodel the kitchen. The IRS is like, no, you're not. All right, okay. That is self-dealing because you're adding value to the asset past doing administrative and management oversight. So once your IRA owns real estate, let's just stick with that one here for a second, keep it simple. We can have the kitchen remodeled, but your IRA is gonna pay someone to come do it. It's not gonna pay your kid or your or your parents or yourself. It can pay some contractor, of course, unrelated, to come in and remodel and improve the kitchen. And that's presumably gonna increase value or get you better cash flow.

SPEAKER_01:

And by the way, can I just say this is okay? Now I know some of you listening are like, well, I'm not gonna have my IRA do that because I'm a fix and flip expert and I make half my money when I start going in to make them better.

SPEAKER_00:

If you were a fix and flip expert, you actually don't work on your properties.

SPEAKER_01:

Fair enough. Okay, that's a good point. And also I used a key word there. I said, I make half my money by adding value through my sweat equity. Well, what was the key word in there? Half the value. Just just don't, you don't need that extra half because remember, your IRA can sell this property tax-free. So you just don't, just you don't have to have all the cake and eat it too. Say, all right, I'll hire a contractor for this sweat equity stuff. My IRA is still gonna make a great return, not as much as if you did it yourself. Granted, we get that. But don't create a prohibited transaction by going and working on the property. If you were audited, you'd have to show receipts of actually paying third parties to improve the property. You're still gonna make a great ROI and you don't pay tax on the deal. Just enjoy that. You don't have to have it all. Don't get greedy. So that is that sweat sweat equity rule of adding something to your business or adding something to that rental property that you normally would. Go do that with your own LLC. Just don't do it with the LLC that your IRA owns.

SPEAKER_00:

Yeah, absolutely. And so um But you can be the manager of the LLC. Yeah, you can. So the IRS says, like, hey, look over things. You can even go to the property, you can oversee the make sure the work was done properly. All this administrative oversight management, totally fine. Your IRA can even own an LLC 100%, and the LLC can own the property and you can be manager of the LLC. This is called an IRA LC checkbook IRA. We've got a lot of other content on that if you want to read up on that. Very popular, of course, for real estate investors. Now let's go over to the business too. Your IRA buys a business. Go hire, the IRA is going to pay for a manager, or the cash flow from the business is gonna pay for a manager. You're not gonna be the one working in the business, particularly when your IRA owns 50% or more of that company.

SPEAKER_01:

And uh just to give you, you may say, well, that sucks or whatever. Just know there's some guardrails. For example, if your IRA owns a minority interest, you might be able to work in the business. Now, when you do a consult with one of our tax lawyers, they'll tell you where that line is because it's a it's a subjective line. The case IRS case law says 50% hell no. If you own 50% or more of this business in your IRA, you are not working for it. That's prohibited. But somewhere between 49% and 2%, there might be flexibility. It depends on who owns the other 50% plus, the majority. Just know there are some options there, but you and family cannot, and your IRA cannot own a majority of this company and you work for it. So you'll get to know those rules. And maybe like if Matt's IRA or someone uh owned an IRA and he wanted to hire someone to work for it, that's great if they're not family. It it's it really looks at who has majority control of the company and would they normally pay someone to do this and how much. That's their iris is really letting people just kind of self-regulate.

SPEAKER_00:

Yeah, and once we're below 50%, it gets into this self-dealing issue and it's all facts and circumstances. Did your IRA own 5% or 49%? If it frankly owned five, we're not gonna really care. If you're at 49%, it's gonna be super aggressive. Then also it's gonna look at what was the compensation you were receiving. Did you actually show up for work every day and do this as a job, you know? So it's gonna kind of get into facts and circumstances. Now, there are a lot of cases on this actually, and they're in my book. I have a whole chapter on self-dealing primitive transactions, probably 10 to 15 uh opinion letters, revenue rulings, cases out there on this self-dealing primitive transaction issue. So if you want to geek out on it or you want to test, know where the limits are, this is where it's not as cut and dry as we've been talking up to here so far. But our lawyers at Kick Yoast Lawyers can help.

SPEAKER_01:

Okay, you ready for another one? Yeah. Okay. This is a good one. We're gonna do the joke. Yeah, I'm gonna I'm gonna tell you, okay, you know it's a prohibited transaction when you use your IRA to buy a fixer upper, and the IRS shows up because your sweat equity is literally sweating. Get it? You're you're sweating, working on it. I get it for sure.

SPEAKER_00:

Okay, first of all, no good comedian finishes his joke and says, get it, get it, because this well, you know, I mean some of us have a little more humor.

SPEAKER_01:

Well, you know, I'm just trying to bring it out of you. When a joke lands, it just lands. Okay. All right, you try one here. Okay. You go with that with that solo 401k. Okay. Okay.

SPEAKER_00:

All right. So you know it's a prohibited transaction when your solo 401k buys a business and your business card says president, treasure, and guy who definitely pretends this isn't self-dealing.

SPEAKER_01:

Yeah, we're we're nerds. We pen drop, we don't mic drop. Okay, I got I'll see.

SPEAKER_00:

We got Mark Kohler in this one here.

SPEAKER_01:

Oh, okay. You know it's a prohibited transaction when you tell Mark Kohler, don't worry, I only used my IR, my IRA credit card for one tank of gas, and he passes out like a fainting goat. Oh, I don't know about that one. Okay, you want to just we're just going with these. Okay, you read that you go with that one. Yeah, that one sucks. All right, then let's try this one. You know it's a prohibited transaction when your IRA LLC writes you a check and you call it a management fee, and Matt Sorensen suddenly appears behind you, like, nope, try again.

SPEAKER_00:

You know it's a prohibited transaction when you refer to your IRA owned rental property as our little getaway place. And Mark Kohler says, Who's R? Yeah, who is R in that equation?

SPEAKER_01:

Okay, I'd love it. Okay. Um, let's do one more and let's team. You know, team team play the I'm gonna try and set you up.

SPEAKER_00:

Okay. I'm gonna throw the alley oop and you're gonna throw it down. Okay. Okay. All right, all right. All right.

SPEAKER_01:

So you know it's a priveted transaction when your IRA owns an Airbnb and has a glowing five-stair review from aka definitely not the owner. Uh which means you cannot stay in your own Airbnb that's owned by your IRA. I should say you cannot stay in an Airbnb that's owned by your IRA. Yeah. Anyway, I I hope that was fun and a few of those, but you're getting the the gist here that we actually have a lot of these questions come through to us. And we should probably do that, take more of those. But um, this is something that you shouldn't be afraid of. It's easy to understand this rule, and it's so easy to make more money in your IRA just playing in the right in in the right lanes. You don't have to get a go off-roading and start taking risks to be successful at this and and just rapidly increase the value of your IRA.

SPEAKER_00:

So yeah, and we got tons of resources here. You can book a call with our team, they can help you go over the resources, understand and educate you on this. And if you have crazy complicated questions, you're like, but I want to do a deal with myself or anybody who's a disqualified person or this LLC that I'm a part of, that's where you want to talk to your tax lawyer or CPA, our firm of KQS Lawyers can help you with that. Also, my book, the self-directed IRA handbook. I hate to plug it, but you should. You know, yeah, it is the number one book in the field. Government regulators, literally, buy my book. Other competitors in the industry.

SPEAKER_01:

I normally wouldn't brag about that, but he does.

SPEAKER_00:

I'm just saying that, you know, if they're trying to learn this, where do they go?

SPEAKER_01:

Yeah.

SPEAKER_00:

Just saying.

SPEAKER_01:

Really, they're stalking him. It's you know, you're looking at just glass half full. I like that. But you know, they loved it. Yeah, yeah. I mean, if the feds have a wiretap on you, it's you know, probably a good thing. They're trying to learn from you.

SPEAKER_00:

Man, you really spun that the wrong way.

unknown:

Jeez.

SPEAKER_01:

No, it's no, I love it. It is the best-selling book, and I love it. I have a copy of it on my desk. You guys should as well. Uh, don't give up. Keep investing. Know that you control your retirement, no one else, and you're gonna be the best person to determine what really investment is gonna work best for you and get you the greatest return. So keep listening, please. Uh, we're gonna be here every week trying to help you on your American dream and building your retirement account. If you enjoyed this, please give us a five-star, two thumbs up, double high five, whatever. And uh, we'll see you next week for another episode of the Directed IRA podcast. And thank you everyone for listening. A quick disclaimer and reminder: this presentation does not constitute an attorney or CPA client relationship, and it is always in your best interest to consult competent legal and tax professionals when conducting your own personal transactions.

SPEAKER_00:

We also want to make sure you know this is not investment advice or financial advice. We're just trying to give you education, ideas, and strategies you can take to your professionals or conduct your own research on. We'll see you next time.