Creating Wealth “Prohibited and Non-Prohibited Transactions”

By Bill Rodriguez, Loan Consultant Cherry Creek Mortgage Company 303-877-6323 

            Thank you for joining me for this month’s edition of Creating Wealth. Last month I talked about how our attitudes concerning money directly impact how we choose to grow and sustain wealth. I then talked about the importance of building a team of professionals who will help guide you on the path to financial freedom. Since I began researching Self-Directed IRAs, I have been trying to understand why these transactions only represent about 1% of a 13 Trillion dollar market. My best guess is that people are concerned that these transactions will be too complicated for them to understand and facilitate. The truth is there are things you need to be aware of in structuring a Self-Directed IRA transaction to avoid some potentially serious tax consequences. If you take my advice and build a network of experienced professionals around you to help you mitigate the risk, you will find that “the rules of the road” become self evident. In this article I will begin to explain some of the basic rules of Self-Directed IRA investing.

 

Death and Taxes

            As the saying goes, there are two things that you can always count on: death and taxes. The IRS wants to ensure that you do not personally benefit from any of the proceeds from you IRA account until the appropriate age of 59 ½. For this purpose the IRS has a strict set of guidelines regarding with whom you may do business and how these transactions are to be structured to ensure that all transactions set in motion are for the benefit of the IRA, not the individual who owns account.

 

The best way to know if a transaction is allowed, or non-prohibited according to the IRS terminology, is to understand the what and whom of a prohibited transaction. When we discuss the whom, I am referring to the list of disqualified persons who cannot participate in a transaction with the IRA.

 

There are three things that need to occur for a prohibited transaction to take place:

1.)    The self-directed transaction must take place as part of your individual retirement plan which includes one of the following: Traditional IRA, Roth IRA, Keogh Plan, Simple IRA and SEP IRA.

2.)    The transaction must involve a disqualified person

3.)    The transaction must be between a disqualified person and the plan (the IRA).

 

So who is a disqualified or qualified person according to IRS guidelines?  

 

Disqualified Person(s)	Qualified Person(s)
Your spouse	Your spouse’s brothers and sisters
Your natural parents or adopted parents	Your spouse’s parents
Your natural grandparents	Your spouse’s grandparents
Your natural or adopted children	Your step-children
The spouses of your natural children	Your spouse’s step-children
Any Fiduciary of your IRA such as an employee of your IRA Administrator	Your grandparent’s spouse (if not your natural grandparent)
Anyone providing services to your IRA such as your stockbroker	Your aunts, uncles and cousins

 

Some Scenarios:

            Your client wants to buy an investment property in
Pueblo as a long term hold and finance the purchase using her Self-Directed IRA. She plans to lease the property back to her parents who want to retire there. Is this a prohibited or non-prohibited transaction? Answer: Prohibited because she cannot do business with any of her lineal decedents. If this investor wanted to rent this property to her spouse’s parents this transaction would be fine. Understanding who the disqualified person(s) are makes this a very straightforward transaction.

            You and a buddy own equal shares in an LLC that specializes in fix and flips. After hearing about Self-Directed IRAs you note that between the two of you, you have $400,000 of additional capital to invest. The plan is to write a note from your IRA to the LLC to pay for the property in cash. After the work is done and the property is sold, you pay back your IRA with interest and your LLC keeps the profits. Is this a prohibited or non-prohibited transaction? Answer: Prohibited because you have majority ownership in the LLC (50% or more) and therefore would enter into a transaction where you would personally benefit. A solution: You and your buddy would be better off becoming partners with your IRA instead of running that money through the LLC. Say you and your partner have a property you would like to buy for $200,000. To leverage your IRA dollars, your IRA puts up $50,000, your partner’s IRA puts up $50,000, and you each individually put up $50,000. As in any partnership, all holding and refurbishment costs would also be paid by each of you and your respective IRAs equally. When the house sells, you each receive one quarter of the proceeds and each IRA receives one quarter. There is more than one way to ensure that this scenario is a non-prohibited transaction, but this is the easiest and most straight forward solution.

 

In Closing:

            While it might seem like there are too many nuances to Self-Directed IRA transactions, don’t let this dissuade you or your customers from using this powerful real estate investment vehicle. Over the coming months I will be discussing these nuances in great detail, so make sure to catch subsequent issues of Creating Wealth and as always you can contact me at (303)877-6323 or brodriguez@ccmc-net.com. Or check out the following books:

 

IRA Wealth Revolutionary Strategies for Real Estate Investment  by Patrick W. Rice

How to Invest in Real Estate and Pay Little or No Taxes  by Hubert Broma