Self-Directed IRA Prohibited Transaction Rules

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In this episode, Mat Sorensen and Mark J. Kohler break down one of the most important rules in self-directed investing: prohibited transactions.

Self-directed IRAs provide significant investment flexibility, but that flexibility comes with responsibility. Understanding and adhering to these rules is essential to protecting your retirement account from disqualification, avoiding unnecessary taxes and penalties, and properly executing alternative investment strategies.

If you’re investing your retirement account into real estate, private deals, or other alternative assets, this is a foundational episode you should not overlook.

For educational purposes only. Consult your own legal, tax, or financial advisors regarding your specific situation.

For questions or to learn more about this episode's topic, book a call with an IRA specialist here: https://directedira.com/appointment/

Other:

Mat Sorensen: https://matsorensen.com

Mark J. Kohler: https://markjkohler.com/ 

KKOS: https://kkoslawyers.com

Main Street Business https://mainstreetbusiness.com

Transcript

Welcome And Why Rules Matter

SPEAKER_01 0:06

Welcome everyone to the Directed IRA podcast. This is Matt Sorensen joined by the amazing the Dapper Mark J. Kohler. And we are here to talk about something very important for your self-directed IRA, something you do not want to screw up. The prohibited transaction rules. This is the number one rule you gotta know.

SPEAKER_00 0:24

Yeah, absolutely critical. I appreciate the comment about Dapper. I did my hair today. So Matt's just trying to use the phone. I'm just in a quarter zip.

SPEAKER_01 0:32

Yeah, I'm in a quarter zip, and Mark's got a jacket on. He's kind of, you know, flexing on me here.

SPEAKER_00 0:38

So I'm I think Matt's just trying to encourage the more of the same. So I I'll I'll I get the message. I look like crap last year.

SPEAKER_01 0:45

I like I like a co-host I got to keep up with, you know? I need someone pushing me to be better.

The Kite String Rule Analogy

SPEAKER_00 0:50

Well, as many of you can already see, we want to keep this as enjoyable, lighthearted, and fun as possible because talking about the rules can sometimes seem um a little daunting or frustrating or Debbie Downer. But let me tell you an example. This is a story that's super super powerful, maybe in the Christian world or whatever. Is there was a uh kid that was flying a kite with his dad, and he said, Hey, I hate this string. It holds the kite down. The string does why do we have to hold the string? Just let the kite fly. And the dad's like, Well, the kite is the string is what helps the kite stay in the air. If we didn't have the string, the kite couldn't fly. He's like, didn't get it. So the dad cuts the string, the kite falls to the ground. And come to find out, we realize that these prohibited transactions, these strings, actually help your retirement account soar. You've got to have these rules in place so that your account can do what it can do. Invest in what you know best. But these rules actually are not there to hold you back, they're there to set you free.

SPEAKER_01 1:57

Yes, I love that. And it is the IRS. Dude, that was I love that. I love that. Um, let's take it a step further here. It is the IRS that I guess will be the lack of wind or what is that pressure. I don't know. There's some engineering or physics term for it here. Um that if you screw this up, they're the ones that's gonna send that kite to the ground because there's no longer any pressure on it. And so we want to make sure you know these rules. So when your self-directed IRA is out there investing, you're doing real estate deals, you're investing in a private company, in a small business, you're partnering in on deals individually, or you're doing creative structures. We want to make sure you don't blow it up and make a mistake. Because if you commit something called a prohibited transaction with your IRA, your entire IRA account is distributed. It's subject to tax and penalty, and all the investments in it now are going on your 1040. They're not in this tax-free or tax-deferred bucket with your traditional or Roth IRA. So it's really important that you know these rules. They're not complicated. This is not rocket science. This is like learning a board game, is like what we say. You can learn these rules. Once you get the lay of the land, it's the same stuff over and over. So we're gonna break them down for you fast and quick here so you know what to look out for and make sure making sure that you're conducting transactions properly, and it's pretty easy.

SPEAKER_00 3:18

Yeah. Well, I I was gonna go with my number one, and uh I just realized I'm here on the show with the best-selling author on this topic in the country, Mr. Matt Sorensen. And so I will be colored commentary. You know, I'll add a nice little story about a kite or you know, some something. If you tell us what the what number you like, if you want to lay these out, then I'll help break them down and make it real.

Per Se Violations And Disqualified People

SPEAKER_01 3:45

Love it. Okay, all right. The first rule here this is something called a per se prohibited transaction. Now, this happens whenever your IRA does a transaction with someone who's called a disqualified person. Basically, what the IRS is saying is hey, these IRAs are our tax favorable accounts. When you're investing with them, we don't charge you any taxes. And and and we want you to do that, but we don't want you to manipulate deals. We want you to do real deals. And so they create this primitive transaction rule to prevent you from manipulating deals. Okay.

SPEAKER_00 4:19

Well, how would I manipulate a deal? All right, you're ready for an example now? Yeah. Some of you that have listened to the show know that I own a cattle business inside uh mine and Patty's health savings account, and LLC set up for this. And if you watch the last season of Yellowstone, you know Casey goes out and starts bidding on cows. He's gonna build up his own herd now that dad's died. Spoiler alert. So now we're out there this spring buying cows inside our. We made new contributions to our HSA. Our IRA slash HSA is out buying cows. Can I buy a cow from my mom, my dad, my kids, my spouse? No, those are prohibited parties. The IRS already knows they would give my IRA a killer deal, and I would end up screwing over the American people with a prohibited transaction, taking advantage of the tax law because a family member sold me a cow. So I have to go to the auction and bid on a cow just like Casey Dutton, just like everyone else, and buy that cow from a third party so I don't violate this per se transaction. I cannot benefit myself or my family member by transacting with these prohibited parties. Was that a good example?

SPEAKER_01 5:33

Yeah, I like, I like it. I mean, you know, where's the beef? You know, that's what I want to know. The IRS has beef if you were buying, you know, from your cattle from yourself. Um so but but that is what Mark said called a prohibitive person. It's also called a disqualified person. So if his HSA is obviously transacting, you got to transact to buy or sell something to make money with your retirement account. But it's who is it with is really the key there. Anyone who is a disqualified person, and Mark rattled off the short list there, you yourself are a disqualified person. That means if you own real estate personally or you own crypto personally, we get that question all the time. Oh, it's gone up in value, so big. Can I just transfer it to my IRA or sell it to my IRA at low cost or what I bought it for? And then I'll sell it out of my Roth IRA and I'll take all the gains and pay no tax. No, no, no, no. The IRS thought of that. They knew you would do that. They knew Mark and Matt would tell you to do that if we didn't have this rule. Okay. So they created this rule to make sure that we weren't manipulating transaction shares. So you're on that list, um, your parents are on that list, your kids are on that list, your spouse is on that list. For those of you in Utah, all your spouses are on the list there too. So those are all the disqualified persons. Also, any company you or your disqualified family we listed there that owns 50% or more, that company is disqualified. So if let's say I own a company, um uh 30%, my spouse owns a third, and let's say Mark owns a third, or let's say some third party owns a third. Okay. Well, now me and my spouse are disqualified to my IRA. And so my IRA cannot transact with that LLC because we're already over 50%. All right, so that's how it works for an when a company, an LLC or corporation is becomes disqualified to your IRA.

SPEAKER_00 7:22

All right. Is this the point where I tell another quick example? This is Goldie Hahn, Kurt Russell example. I was just watching Overboard the other night. Classic. Love that show. Goldie Hahn and Kurt Russell are not married. They have never wanted to get married, and they are the cutest, most beautiful couple, last 30, 40 years. So, are they a prohibited party from one another? No, they are not. In fact, I may guess that they have not wanted to get married so they could transact with their IRAs together. I bet you that's the real reason. Probably not. But anyway, if you only have a fiance, that is not a prohibited party. Goldie Hahn could sell her real estate to Kurt Russell and give him a killer deal, and his IRA could buy it if she wanted to do that. Because what the IRS is saying is we're gonna let third parties kind of do what they would normally do. They would never give another person that's such a good deal. Only family would do that. But who knows? Anyway, that's the Goldie Hahn Kurt Russell example.

SPEAKER_01 8:25

There you go. And I was just looking up um Kate Hudson.

SPEAKER_00 8:28

Because you know if I love Kate.

SPEAKER_01 8:30

Yeah, because if Goldie Hahn was using her IRA, or let's say that Goldie Hahn owns some real estate personally and Kate Hudson's IRA wanted to buy it. Well, now we would have a prohibited transaction because that's Kate Hudson buying it from her mom, which is Goldie Hahn. But if her IRA was buying the property from Kurt Russell, that would not be disqualified. Why? Kurt Russell is actually not her father, even though he's the one that raised her and has been her father figure and she refers to him as her father. But according to Google, her real father is not Kurt Russell.

SPEAKER_00 9:03

Okay. So hence this show is now just cross the bounds into TMZ. Yeah. So uh hope you all enjoy that.

SPEAKER_01 9:12

But you know, we got to keep this fun and light because we're talking about did you want us to talk about section 4975 of the tax code, subpart B? I mean, we're trying to break this down and make it digestible for you guys.

SPEAKER_00 9:24

I love it. Okay, so what is the next prohibited transaction rule we need to know besides the per se and who disqualified parties are?

Self Dealing And Personal Benefit Traps

SPEAKER_01 9:32

All right. The next one would be a self-dealing prohibited transaction. All right. One version of this, and this is a self-dealing prohibited transaction, occurs when a disqualified person, remember all those people, you for your own IRA, your spouse, your parents, your kids, whenever a disqualified person financially benefits from an IRA's investment. For example, you are a real estate agent and you go to buy a rental property for your IRA. So your IRA is buying the rental property, but you're the buyer's agent. The seller's offering a 3% commission. Let's say you're buying a rental for$300,000, and you're like, well, I'll take that$9,000 commission personally, because I'm an agent and I'll represent my IRA buying it. Well, your IRA is actually not paying that to you. So it's not a per se primitive transaction, but because your IRA bought it, the seller is willing to pay you$3,000 is the, or sorry, 3%, 9 grand in the example here, and you're financially benefiting because your IRA invested, that would cause a self-dealing primitive transaction.

SPEAKER_00 10:30

Right. Now, for this example, you were we are going to refer to the Bluth family, the Bluth company in Orange County, California. Now, if you remember the Bluth construction. If for those of you following, rest of development. Yeah, arrested development. They owned a model home. Now, if their IRA, their IRA LLC, was going to do this development, which we have many clients that do developments and real estate deals with their IRAs, and they build a model home. Could Michael and Lindsay and Tobias all live in the home? No. They would be self-dealing because their IRAs are part of this LLC. The family's IRA owns the company. It could have been dad in prison with the IRA. But they're all prohibited parties. And so to stay in the house is a form of self-dealing. And Michael couldn't even run the company, by the way, too. That would be another example. But that is called self-dealing when you benefit from the asset owned by the LLC.

SPEAKER_01 11:30

Yeah, and and I love that. We can make some rest development jokes all the time. I love rest development. Great show. Um I I'll just give one. Okay. You got Michael and his son, George Michael, you know, and they have this very intimate father-son conversation. And and Michael asks his son, George Michael, what's the most important thing? What's the most important thing in life? And George Michael responds, breakfast. You have to know the show to understand why that's funny, but it's like that's great. All the money's in the banana stand. I'll just say that. Yeah, that's where all the money's at. So but here's another example. Because I get this question all the time. Matt, my IRA owns a Airbnb. And no one's staying there this week because your IRA could own a short-term rental. You're leasing it out to other third parties. They're paying your IRA. It's making all the money. It's covering the expenses. It's getting the cash flow. It's getting the appreciation of the property. And um but they're like, well, no one's staying there this week. Can I just stay there? Or can't my kids just stay there? We're not going to pay the IRA, because that'd be per se, because now we'd be transacting. We can't pay the lease, but we'll just stay there and use it. No, now you're benefiting personally or disqualified benefiting from the IRA's investment. So avoid any personal use. I'd say the other variation of this is physical improvements to real estate. If your IRA owns a rental property or investment property, you can't physically go work on the property, put on the tool belt, and fix it up.

SPEAKER_00 13:02

And I I want to digress here and make one important point. Some of you, I was just on another podcast this last week with a real estate group, and they were fighting the rhetoric, if you will, that I shouldn't buy real estate in my IRA because I can't work on it. And that's the big trick with real estate is that I'm gonna put in sweat equity, I'm gonna work on it, yada yada. And I had to um break that down and peel away the onion and remind everybody. There are two types of real estate deals. One where you are gonna carry the tool belt and the toolbox and you're gonna go work on it and create some sweat equity. Sure. Is your ROI gonna maybe be 40% or more because you were able to cut out a lot of middlemen on that and manage the project yourself? You bet. But that doesn't mean your IRA can't do a deal and pay a handyman or a subcontractor or contractor to lead the project, and you just drive by and write checks and look at it and manage it, that's fine. You're not gonna work on the property. And maybe your ROI is 24%, 25%, because you had to pay a few people involved. Does that mean you don't do the deal? No, it does not mean you don't do the deal. You compare apples to apples. You say, if I took my IRA and bought an ETF and made 11% at best, or should I go do this real estate deal and yeah, suck it up and pay a contractor, but still make over 20% or more? I like the 20% or more option. Compare what your best alternative is to your IRA, not what you could do. That's an apple to orange comparison. I want you to compare apples to apples. So don't get dismayed by these rules again. It still means your IRA can have an incredible rate of return. Just don't compare it to what you could do, because that's not a fair comparison.

SPEAKER_01 14:56

Yeah, absolutely. Such a good point. And also on the sweat equity part, and many investors have realized this, their time isn't worth that additional 14% return in the difference on that example. If they put that time back into their business or other investments or just enjoyed their life rather than putting on the tool belt, that would be me. Mark actually enjoys putting on the tool belt. So the value proposition here is different for everybody. But where can I other otherwise spend that time, whether it's making more money or in something else where I can put my time? Because I'm actually not a plumber or an electrician or a painter or a handyman. Okay. Obviously, if you've seen me work on anything, you would know that. Um so enough, that's just another perspective on it, too. So, but we love the idea of your IRA being able to buy a property, rehab it, whether you are going to hold it short-term, long-term rental, you're gonna flip it, whatever your strategy is, very common for self-directed IRAs. And and and these primitive transactionals, I'll say, really apply mostly for real estate deals or where you're doing creative deals. When your IRA is investing in a private fund, it's pretty simple. When your IRA is buying crypto, especially on an exchange or in a marketplace, pretty simple. It's where you personally are trying to get in on the deal or make some money personally or have use of the asset or physically improve it. These are the categories where you can screw it up.

SPEAKER_00 16:16

Well, is there any more prohibited transactions you want to do? One left.

Extension Of Credit And Non Recourse Loans

SPEAKER_01 16:21

There's one left. One more. Then we can call it, then we can call it a heck of a good show. Um, that last one is called the extension of credit prohibited transaction. And what this is, is a prohibited transaction if you extend credit or you or any disqualified person for your IRA. So, for example, let's say that my IRA is buying real estate and it's a$300,000 property. I want to put$100,000 down for my IRA and I'm gonna get a mortgage for the other$200,000. You can actually do that. There's banks that lend to IRAs buying real estate. We have a whole list of them. And they like to lend on those types of deals that I just explained right there. But they're gonna do what's called a non-recourse loan because they know the IRA rules. If you do this wrong and you basically get a loan where your IRA's buying a property and you personally guarantee the debt for your IRA, which is what a lot of banks will do if they're not following the rules and don't understand these types of mortgages for IRAs. But if you extend credit and are guaranteeing the debt for your IRA, you've just engaged in a extension of credit prohibited transaction. So your IRA can get debt, it can get a mortgage to acquire real estate as an example here, but it needs to be non-recoursed, meaning you personally are not on the hook, haven't guaranteed or provided your credit. What happens on a non-recourse loan is if you get one of those, which those comply with IRA rules, if there's the IRA doesn't make the payments, the bank can foreclose and take the property back, but they can't come after the IRA and they're not coming after you personally.

SPEAKER_00 17:52

Well, I wish I had, you know, a Sopranos episode of, you know, having to go collect bad debt and someone with a baseball bat, but I don't have a quick response to that one except don't do it. Yeah. Yeah. And uh don't lend or borrow from your IRA, period. And there's places out there that you you can bring in third parties. In fact, one of the strategies I like is when you partner with someone, you oftentimes have to give them a bigger chunk of the profit because they're taking the risk that you may not even make any money at all. So you have to give them a bigger piece of the action. However, there's a lot of people out there that say, hey, I'd rather just have 10 or 12% uh hard money loan or 8 to 10% or whatever, some points, and say, I'd rather loan on this project. Can the IRA give them a secured interest in the project? For sure. Could a lender come in and now you lock down a cost for the project that's lower than bringing on an actual partner? Nothing wrong with that. It just can't be you or disqualified project.

A Real IRS Case That Lost

SPEAKER_01 18:58

Yeah, yeah. And you can't be doing, and yeah, and you if your IRA is the one that owns the project, you personally are not guaranteeing any type of loans where where your IRA is the borrower. Um and just one last example here, which is there's a case called Peak and Fleck versus Commissioner. This is in my book, the self-directed IRA Handbook. I got a hundred plus citations, by the way, in my book. Third edition coming out here in April.

unknown 19:21

Wow.

SPEAKER_01 19:23

Wow. Okay. Pretty exciting. Where do you find it? You're on the lookout for some.

SPEAKER_00 19:27

Where do you find the fine?

SPEAKER_01 19:28

Yeah, I know. So um, but Peak and Fleck versus Commissioner, this is two guys who had Roth IRAs. They put those two IRAs 50-50 into an entity and it's actually a corporation instead of an LLC. And then that entity went and bought a small business, an existing small business. But when they bought the small business, they negotiated with the seller of that business for a seller finance note. The seller sold the business for like$3 million. They gave them them a million from their Roth IRAs, and the seller financed the other$2 million and said, hey, pay me back this$2 million over time. Well, problem that they did is in that seller finance note, they personally guaranteed the debt on behalf of their IRAs and they got audited. Now, the bummer of this is that business grew and they sold that business, and each of them made over a million dollar profit in their Roth IRAs, but they lost on audit because the IRS said you conducted an extension of credit prohibited transaction because you guys personally guaranteed this loan to buy the business from the seller of the business. It's called Peak and Fleck versus Commissioner's more details in my book. But so these cases do come out. And I know we're joking about movies and stuff here, but there's actually real cases on this. Yeah. And we are tax lawyers who are steering in the right direction on these rules.

SPEAKER_00 20:44

Yeah. And some of you might be like, well, that's so dumb, or that's not fair, or have like some argument like why would the IRS do that? Well, think about this. Without that personal guarantee, would have the Roth IRAs gotten that deal? Would have the deal been structured a little differently if they didn't offer that personal guarantee? The answer is probably yes. And maybe they would have made$950,000 each, not a million. But they could have done the whole deal still with just maybe modifying the terms to make that seller comfortable with the note without providing the personal guarantees. And then you'd say, well, what's wrong with that? Well, the the wrong thing is, is you all know listening here, how much can you put in a Roth IRA this year?$7,500. Maybe more if you're over age 50. Okay, cool. Well, by extending credit, didn't they put more money in their IRA? Right? It was kind of a workaround. Rather than writing a check and contributing to the IRA, by extending credit, they added value to the IRA. Well, can other people do that? No, it's not allowed. So this is why this rule applies, is because it's like you're supercharging. Your IRA with a backdoor method, and they're like, no, go out and play, go have fun. Just you can't supercharge it this way.

Quick Recap And Getting Help

SPEAKER_01 22:08

Yeah. So that's it. We've got per se primitive transactions, your IRA transacting with the disqualified person. Remember, that's you, your spouse, your kids, your parents. Your uh self-dealing primitive transaction, that's where a disqualified person, this is you again for your own IRA and these other family members, where a disqualified person benefits from the IRA's investment or asset. And then third extension of credit when a disqualified person extends credit or guarantees debt for your IRA when it's making investments. If you have one of those three, you've got a primitive transaction. So just make sure you steer clear of those. Remember, our team at Directed IRA is here to help you. We do a ton of education. You can book a call with our team to get started on your self-directed account. And if you're someone trying to do a really creative deal and you're like, well, I want to be involved in this deal personally, or this is an LLC that I'm going to be in it, or I got family members, other disqualified people, that's where you want to book a call with our law firm, KKOS Lawyers. We've been advising clients for 20 years on how to use their IRAs to invest in alternative assets. So we can certainly help guide you and actually give you tax and legal advice at the law firm and structure those deals as may as you may need it. Now, not for everybody, but again, when you get in those hairy situations and you're dealing with disqualified people, you're going to need some tax advice.

Ratings Request And Legal Disclaimer

SPEAKER_00 23:20

Yeah. Well, if you can follow these rules, your kite will stay in the air and fly to heights you never imagined. So hang on to that string, follow the rules, and you'll better live that American dream. Thanks everybody for listening, watching, whatever your format is. We're grateful to have you. Please give us five stars, three, two thumbs up, three, three watch. Three thumbs up. Two thumbs up, three thumbs up, whatever. And uh share this episode with a friend or family member if you found it compelling and helpful. Thank you so much, and we'll see you next week for another episode of the Directed IRA podcast. See you then. 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_01 24:16

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.