DON T RISK IT. By Scott Turransky. Disclaimer

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2 DON T RISK IT A guide fr self-directed retirement accunt investrs n aviding prhibited transactins per Publicatin 560 and 590 f the IRS Tax Cde By Sctt Turransky Disclaimer This infrmatin is designed t prvide accurate infrmatin in regard t the subject matter cvered. It is ffered with the understanding that the presenters are nt engaged in rendering legal, accunting, r ther prfessinal services. If legal advice r ther expert advice is required, the services f a prfessinal shuld be sught. The calculatins, statements and data presented herein are deemed t be accurate but accuracy is nt guaranteed. They are intended fr the purpse f illustrative prjectins t facilitate analysis. The infrmatin prvided is nt intended t replace r serve as a substitute fr any legal, real estate, tax, r ther prfessinal advice, cnsultatin r service. The reader shuld cnsult with a prfessinal in the respective legal, tax, accunting, real estate r ther prfessinal area befre making any decisins. Neither Equity IRA, LLC nr any ther subsidiary r affiliate is a brker-dealer nr an investment adviser registered with the U.S. Securities and Exchange Cmmissin, the Financial Industry Regulatry Authrity r any state securities regulatry authrity. Neither Equity IRA, LLC r any ther subsidiary r affiliate sell any type f securities r investments. 2

3 Cntents Intrductin... 4 What is a qualified retirement accunt?... 4 Type f retirement accunts... 4 What type f investments can I buy with a self -directed accunt?... 4 Disqualified persn(s) definitin... 5 Prhibited transactin descriptin... 6 Prhibited transactin penalties... 7 Hypthetical Examples... 8 Peek vs Cmmissiner: A recent tax curt case invlving indirect prhibited transactins by an IRA FAQ s Extra readings/ references

4 Intrductin This ebk discusses self-directed retirement accunts and prhibited transactins. The gal f this ebk is t educate yu in aviding prhibited transactins s yu dn t incur the incredibly severe penalties used by the IRS. This ebk will discuss the basics f self-directed accunts, define disqualified persns, g int details f the IRS definitin(s) f prhibited transactins, discuss prhibited transactin penalties, prvide examples and wraps up with frequently asked questins. What is a qualified retirement accunt? The Emplyee Retirement Incme Security Act f 1974 (ERISA) was enacted t establish standards that apply t retirement accunts. It is the bdy f laws that regulate emplyee benefit plans with the Internal Revenue Cde (IRC). A qualified retirement accunt is either a tax free r tax deferred accunt. The funds usually cannt be accessed befre the retirement age f 59.5 withut a penalty. Retirement accunts were created by the gvernment in rder fr yu t be encuraged t take respnsibility fr yur retirement as cmpared t relying n the gvernment. These tax free and tax deferred accunts are designed fr yu t put aside mney fr retirement the gvernment t help yu accumulate wealth fr yur retirement years. Type f retirement accunts There are many different types f retirement accunts. As yu can imagine the rules and regulatins vary depending n the accunt type. Belw are sme f the mst cmmn types: Traditinal accunt: Tax deferred (pay taxes n earnings and cntributins when taken ut). Rth accunt: Tax free (pay n taxes n earnings r when take cntributins). 401k, 403b, TSP: Retirement plan ffered thrugh emplyer. Can be either traditinal Rth accunt. SEP: Self Emplyed Pensin plan. Higher cntributin limit than Traditinal r Rth IRA accunts. Tax Deferred. SIMPLE IRA: Retirement accunt with mandatry match cmpnent frm emplyer. Higher cntributin limits that Traditinal r Rth IRA. Tax deferred. Sl 401k: Plan fr 1 r 2 (spuse) persn cmpanies. Higher cntributin limit than Traditinal r Rth IRA. Tax free r tax deferred cmpnents. What type f investments can I buy with a self - directed accunt? Despite what yur financial advisr, the bank r prir plan custdian (the cmpany that cntrls the IRA mney) tells yu yur IRA is nt limited nly t stcks, bnds and mutual funds. When yu think abut retirement planning cmpanies the majrity f the big names in the industry have dne a very gd jb cnvincing the masses that their retirement dllars have t be invested in the market and in the paper assets listed abve. In reality, real estate and ther alternative assets can be and were always allwed in retirement accunts; just n ne knew abut it! Mst retirement cmpanies want yu t invest in their mutual funds (that is hw they make their mney!) As peple started t get wise t the fact that they had mre investment ptins than the 12 stcks managed by their 4

5 retirement cmpany they started t switch t a Self-Directed IRA (SDIRA), which allws the investr t cntrl what investments are bught and sld in the IRA. Recgnizing they were lsing clients t self-directed accunts, retirement cmpanies/custdians started t ffer Self-Directed IRAs hwever these IRAs were limited t paper assets. A true self-directed accunt allws yu t invest in a wide range f investments depending n the custdian. These include but are nt limited t: Stcks Bnds Mutual Funds Real Estate Private Placements Precius Metals Futures Trust Deeds Ntes Private Lending Tax Liens Tax Deeds Bat slips Oil and Gas rights There are, hwever, sme prhibited investments t what yu can buy and sell in a SDIRA. Fr example, these include: Life Insurance Alchl Cllectibles Cins (excluding gld, silver, palladium bullins and U.S. minted cins) Wrks f art Rugs r antiques Cars r bats Als, while nt illegal fr an IRA, it is illegal fr an S Crpratin t have a stck wner be an IRA. Disqualified persn(s) definitin In additin t the prhibited investment examples, the selfdirected IRA has additinal restrictins. Only yur IRA can benefit frm yur IRA s transactin. All transactins must nly benefit the IRA. T make sure yu are nt gaining benefit all transactins must be arm s length frm disqualified persns. Accrding t the Internal Revenue Cde sectin IRC 4975(e)(2) the fllwing peple are cnsider disqualified persns {exact excerpt frm cde}: (2) Disqualified persn. Fr purpses f this sectin, the term disqualified persn means a persn wh is - (A) A fiduciary (B) A persn prviding services t the plan (C) An emplyer any f whse emplyees are cvered by the plan (D) An emplyee rganizatin any f whse members are cvered by the plan (E) An wner, direct r indirect, f 50 percent r mre fa. The cmbined vting pwer f all classes f stck entitled t vte r the ttal value f shares f all classes f stck f a crpratin b. The capital interest r the prfits interest f a partnership c. The beneficial interest f a trust r unincrprated enterprise Which is an emplyer r an emplyee rganizatin described in subparagraph (C) r (D) 5

6 (F) A member f the family as defined in paragraph (6) f any individual described in subparagraph (A), (B), (C), r (E) (G) A crpratin, partnership, r trust r estate f which (r in which) 50 percent r mre fa. The cmbined vting pwer f all classes f stck entitled t vte r the ttal value f shares f all classes f stck f such crpratin b. The capital interest r prfits interest f such partnership r c. The beneficial interest f such trust r estate Is wned directly r indirectly r held by persns described in subparagraph (A), (B), (C), (D), r (E) (H) an fficer, directr, a 10 percent r mre sharehlder r a highly cmpensated emplyee (earning 10 percent r mre f the yearly wages f an emplyer) f a persn described in subparagraph (C), (D), (E), r (G) (I) A 10 percent r mre partner r jint venture f a persn described in subparagraph (C), (D), (E), r (G). In simple English this means the fllwing peple are cnsider disqualified frm benefiting r interacting with yur IRA: Yu (cvered in sectin describing fiduciaries) Anyne prviding services t the plan Descendants f IRA wners/spuse Ancestrs f IRA wners/spuse Spuse Businesses wned by disqualified peple (if the business is wned by yu, yur wife, etc.) After reviewing this list, there are usually 2 cmmn respnses. The first is that the family member list is limited and aunts, uncles, brthers, sisters and ther family members are nt n the list. While the IRS currently allws transactins with these peple that des nt mean they always will. Als, keep in mind while these transactins are nt prhibited yu prbably want t avid them if pssible as they culd draw unnecessary IRS attentin. The ther cmmn line f thught yu might have had was a quid pr qu arrangement. Example: Kristina and Jim each have an IRA with vacatin prperties in Tampa Bay, Flrida in their IRAs. A quid pr qu arrangement wuld be that Kristina stays at Jim s vacatin hme fr free and Jim stays at Kristina s fr free. This is cnsidered illegal because bth Jim and Kristina are gaining indirect benefit frm the IRA. Prhibited transactin descriptin Listed belw are prhibited transactins. Here is the direct language frm the Internal Revenue Cde 4975(c)(1): Fr purpse f this sectin, the term prhibited transactin means any direct r indirect - (A) Sale r exchange, r leasing f any prperty between a plan and a disqualified persn; (B) Lending f mney r ther extensin f credit between a plan and a disqualified persn (C) Furnishing f gds, services, r facilities between a plan and a disqualified persn (D) Transfer t, r use by r fr the benefit f, a disqualified persn f the incme r asset f a plan (E) Act by a disqualified persn wh is a fiduciary whereby he deals with the incme r assets f a plan in his wn interests r fr his wn accunt r (F) Receipt f any cnsideratin fr his wn persnal accunt by any disqualified Please nte the wrds any direct r indirect ; meaning the scpe f prhibited transactin is very brad. Additinally, please nte items C and D. This is the part f the cde which 6

7 prevents any persnal benefit frm IRA transactins. Yu cannt receive any benefit, gds and services frm yur IRA. But it ges bth ways. The IRA can t get any benefit, gds r services frm yu. This means yu can t manage the tenants, vacancies r d repairs n the prperty! The fllwing are additinal detailed descriptins f the things yu (r ther disqualified persns) cannt d with a SDIRA: Buy a prperty in yur IRA that yu currently wn Live in a prperty that yur IRA wns Use yur IRA prperty as yur persnal vacatin hme Buy a huse in yur IRA and lease it t yur daughter t use as a cllege huse Buy a huse in the IRA and persnally guarantee the lan D wrk (such as repairs r prperty management activities) n a prperty wned by yur IRA. Be a custmer f the assets wned by yur IRA Yu cannt gain any benefit frm the IRA r have the IRA gain benefit frm yu IRA wns a rental and the rent check is paid t yu Disqualified persns cannt spend persnal mney n an IRA prperty The best way t avid prhibited transactins is t keep everything at arm s length. Hwever, please be aware f what happens if yu dn t keep things at an arm s length as described next. Prhibited transactin penalties As anyne wh has filed taxes incrrectly will tell yu the IRS can have sme pretty hefty penalties. The penalties n IRA s and disqualified persns wh engage in prhibited transactins are sme f the mst severe. Prhibited transactins are smething the IRS takes very seriusly and s shuld yu. The IRS has a page that discusses retirement tpics, specifically prhibited transactins. Belw are the fllwing maximum cnsequences n an IRA accunt that engages in a prhibited transactin with a disqualified persn: Generally, if an IRA wner r his r her beneficiaries engage in a prhibited transactin in cnnectin with an IRA accunt at any time during the year, the accunt stps being an IRA as f the first day f that year. The effect f this is the accunt is treated as distributing all its assets t the IRA wner at their fair market values n the first day f the year. If the ttal f thse values is mre than the basis f the IRA, the IRA wner will have a taxable gain that is includible in his r her incme. T avid having the entire IRA lsing its IRA status many individuals set up multiple accunts s that if a prhibited transactin accidently ccurs in ne IRA the ther accunts might nt be affected. Wrse, thse are just the penalties n the IRA. There are als penalties n the disqualified persn. Here are the IRS maximum penalties applied t each disqualified persn invlved in the prhibited transactin: A disqualified persn wh takes part in a prhibited transactin must crrect the transactin and must pay an excise tax based n the amunt invlved in the transactin. The initial tax n a prhibited transactin is 15% f the amunt invlved fr each year in the taxable perid. If the transactin is nt crrected within the taxable perid, an additinal tax f 100% f the amunt invlved is impsed. Bth taxes are payable by any disqualified persn wh participated in the transactin (ther than a fiduciary acting nly as such). If mre than ne persn 7

8 takes part in the transactin, each persn can be jintly and severally liable fr the entire tax. The amunt invlved in a prhibited transactin is the greater f the fllwing amunts: - The mney and fair market value f any prperty given and - The mney and fair market value f any prperty received. If services are perfrmed, the amunt invlved is any excess cmpensatin given r received. The taxable perid starts n the transactin date and ends n the earliest f the fllwing days - The day the IRS mails a ntice f deficiency fr the tax - The day the IRS assesses the tax - The day the crrectin f the transactin is cmpleted. As yu can see these penalties are very significant. What des that mean in real numbers? Hypthetical Examples These examples discuss the maximum ptential penalty. Example 1: Wendy has 200k in a self-directed traditinal accunt. She is 42. Her daughter Lisa is ging t cllege and Wendy buys a prperty n campus. She paid 110k cash fr the prperty and had n financing. Lisa lives in the prperty but all legal dcuments have Lisa s friends and rmmates n the lease. Wendy refers t the prperty in her recrds as schl husing. Wendy thinks that since Lisa is nt n any f the legal dcuments she has snuck it by the IRS. Fast frward 3 years. Wendy s IRA has dne very well. The 90k nt invested in the campus prperty is nw wrth 130k. The campus huse has als appreciated and if it were assessed by an appraiser it wuld get a fair market value f 125k. Therefre the ttal fair market value f her IRA is $255,000. Unfrtunately, the IRS is auditing Wendy and as they lk thrugh the persnal return they ntice that Wendy lists Lisa as a dependent. They lk up Lisa and realize they have sent mail t her at the campus huse. The IRS determines Wendy s IRA and Lisa participated in a prhibited transactin. The fllwing penalties wuld have t be paid: Wendy: Since nly Wendy s IRA was invlved in the transactin and nt Wendy; nly Wendy s IRA gets penalized. Wendy s IRA lses its IRA status and the ttal value f the IRA is treated as a distributin that Wendy wes tax n. Fr simplicity, we will assume this is 35%. Als, since Wendy is 8

9 distributing mney befre she turned 59.5 she wes a 10% early distributin penalty. Tax n distributin 35% X $255,000 = $89,250 Early distributin penalty 10%*$255,000 =$25,500 Ttal wed: $114,750 In additin, the remaining mney in her IRA n lnger is tax deferred and is nt in an IRA anymre. All gains are nw taxed as incme. Lisa was the disqualified persn wh engaged in the transactin. She als has t pay penalties. Since there is n recrd f what her prtin f rent is the IRS views the entire rent amunt ($1,000 a mnth, $12,000 a year) was the funds invlved in the prhibited transactin. The tax Lisa culd we culd lk smething like this: 15% excise tax n ttal 15% X $36,000 = $ % excise tax if nt crrected in tax perid 100% X $36,000 =$36,000 $41,400 Example 2: Kyle has been ding real estate investing fr a lng time. He is very successful at it, even thugh he is nly 41. He just learned he can d real estate related transactins with a Self-Directed IRA. He just set up a Rth IRA with 150k in it. Kyle wants his dad Jake t get invlved in real estate investing and lends 65k a real estate investing cmpany Jake wns s the cmpany can purchase a prperty. Since Jake is his dad, Kyle hked him up with a 0% lan. Repayment plus 10% interest is due within 7 years when Jake sells the prperty. 4 years later IRS did sme digging int Kyle s accunt and learned abut the prhibited transactin. Penalties are as fllws: Kyle s accunt is n lnger cnsidered a qualified accunt and all earnings are n lnger tax free. Kyle never paid taxes n 100k f the Rth accunt as they were earnings (this is the benefit f the Rth accunt!). He des nt we taxes n the mney cntributed t the Rth (he paid this when he cntributed t the Rth). Hwever, since the earnings has been in his accunt less than 5 years and he is less than 59.5 he wes taxes n the earnings in the Rth plus the early distributin penalty. His penalties lk like this: The ttal wed t the IRS between bth parties: $156,150 All assets wned by the IRA are still wned by Kyle but he wes taxes n any earnings. 100k earnings in Rth that taxes were never paid n at incme rate (assume 35%) 35% X $100,000 $35,000 10% penalty fr early withdraw 10% X $100,000 $10,000 Ttal wed $45,000 Jake wes the fllwing: 9

10 15% excise tax per year n amunt brrwed 15% X 4 X $65,000 $39, % excise tax if nt crrected within the tax perid 100% X $65,000 $65,000 Ttal Jake wes IRS $104,000 Ttal Jake and Kyle we IRS $146,000 Bth f these examples are hypthetical maximum examples. These examples are intentinally very brad and severe t illustrate the need t keep all transactins arm s length. The pint f this sectin was t help make yu aware f the maximum f what the IRS culd d if yu perfrm a prhibited transactin with a disqualified persn. Just understand it is nt wrth ding. The next sectin is a very simplified discussin f an actual curt case. The case was recent ccurring mid-year Peek vs Cmmissiner: A recent tax curt case invlving indirect prhibited transactins by an IRA In the 2013 case Peek vs Cmmissiner, tw unrelated individuals cmbined their IRAs and cntributed them t a newly created business. They were traditinal accunts and each bught half f the stck f the new cmpany. Hwever, they used wner financing t purchase the assets and they persnally guaranteed the wner financing lan. In 2003 and 2004 their traditinal accunts were cnverted t Rth accunts. Subsequently, the cmpany was sld in 2006 and n taxes were paid due t its Rth status. The persnal guarantees made in 2001 made the IRA(s) lse IRA status. The tw business partners were cnsidered wners f the business in 2001 (nt the IRA(s)) and therefre wed taxes n the sale f the business in Yu can find ut mre abut this case in Reference 4. FAQ s Can I get a lan n a prperty in my IRA? This lan wuld be either fr a purchase, refinance r repair. Yes! Yu can btain a lan fr any and all f thse ptins. Hwever, yu (r any ther disqualified persn) cannt persnally guarantee this lan. The lan must be made exclusively n the asset. Can I perfrm wrk n my IRA prperties? N, wrk cannt be perfrmed by yu r any disqualified persn. Mst CPAs and Custdians will advise yu t hire a 3 rd party t d repairs and perfrm prperty management. What if I d the wrk fr free? This is still a prhibited transactin. In fact, it is a huge red flag t the IRS if the IRA recrds have n accunting r expenses fr a prperty manager r a subcntractr fr the repairs f the prperty. 10

11 What is best way I can determine if my actins culd be cnsidered a prhibited transactin? When I get asked this by my clients I nrmally suggest that they cnsider the fllwing: Imagine yu are an IRS emplyee incentivized t find errrs in peple s returns. Yu need t ask yurself the same questins yur ptential auditr is asking when reviewing yur file. Wuld the IRS agent cnsider it a prhibited transactin? Are yu gaining benefit? Is yur IRA interacting with a disqualified persn? Are yur actins questinable enugh fr them t flag the accunt fr further investigatin? Nrmally, if yu apply this lgic t yur actins a reasnable persn shuld be able t avid prhibited transactins. Keep it arm s length and when in dubt always cnsult a prfessinal. If I pay fair market price can I perfrm a prhibited transactin with a disqualified persn? N. What if I get checkbk cntrl? What if it was an hnest mistake? Regardless f intent IRS penalties still apply. In fact, this came up in a curt case in 1987, Rutland vs Cmmissiner. The fllwing ruling was stated: Thus, we cnclude that the fact that the petitiners may have acted in gd faith with respect t the transactins in dispute ffers n defense t the impsitin f the excise tax under sectin 4985(a). What if the disqualified persn in the transactin was my girlfriend and nt my wife? Wuld this be permissible because she is nt related t me? Depending n hw yu file taxes she may nt be a disqualified persn. That desn t mean yu shuld d it. This wuld be a great example f yu having t place a call t a prfessinal. Yu shuld be asking yurself is there any way yu culd be gaining benefit? If s, yu prbably dn t want t d it. It is still in the IRA. Checkbk cntrl nly allws yu t write the checks fr the IRA versus having a custdian t d it. All prhibited regulatins apply. 11

12 Extra readings/ references If yu wuld like t investigate this in further detail, yu might be interested in lking at the fllwing in greater detail. 1. Equity IRA s website 2. Hme page f the Internal Revenue Service: 3. ERISA Wikipedia page me_security_act 4. Recent Tax Curt Case Expses Risks f Indirect Prhibited Transactins by IRAs nattachment/edbbd00a-2b3e-40d7-81cd- 0942e0978ab5/article-Recent-Tax-Curt-Case- Byline.pdf 5. Real Estate Investment Using Self-Directed IRAs and ther Retirement Plans, Dyches Bddifrd, H Quincy Lng, Jake Yeiter 6. Leverage yur IRA Matthew Allen and Edwin Kelly 7. Crnell s law schl department psts the cde: 8. IRS website retirement tpics- prhibited transactins Emplyee/Retirement-Tpics---Prhibited-Transactins 9. IRS website- retirement plans investment FAQs - Investments-FAQs 10. Leagle Rutler vs Cmmissiner case (1987) xml/RUTLAND%20v.%20COMMISSIONER 12