3 Bad Things That Happen IMMEDIATELY When You Commit a Prohibited Transaction [EPISODE #221]
3 things – very bad things – happen INSTANTLY, the very moment you commit a dreaded PROHIBITED TRANSACTION in your self-directed IRA, and you need to understand them. I’m Bryan Ellis. This is episode #221.
Hello, SDI Nation! Welcome to the podcast of record for savvy self-directed investors like you, where we help you build great wealth WITHOUT relying on Wall Street! Be sure to visit SDIRadio.com/221 for today’s show notes and transcript and resources I mention in today’s episode.
Over and over again, you’ve heard me warning you about the dangers of prohibited transactions in your self-directed retirement account, and particularly in self-directed IRA’s. But today we’re going a bit deeper.
But let’s start at the beginning: What is a prohibited transaction
Here’s a good generalization: A prohibited transaction results whenever you use your IRA in such a way that you, or someone related to you, derives benefit from the money or assets of the IRA outside of the context of retirement. So if you buy real estate with your IRA and then you or your family use that real estate yourselves BEFORE it’s distributed to you during retirement, that’s a prohibited transaction. If you borrow money from your IRA, that’s prohibited. If you sell to or buy from your IRA, that’s prohibited. If you use your IRA as collateral for a loan, that’s prohibited. You get the idea. The common theme is you’re doing something with your IRA that benefits you or a related party NOW rather than benefiting you during retirement.
But what REALLY happens when you commit a PT? Let’s just say that you – completely unwittingly and quite surely without malice or intent to commit a PT – do something… anything… that the IRS regards as a Prohibited Transaction. What actually happens at the moment you do the dirty deed?
Well, there are 3 distinct things that happen, and they are:
#1. SILENCE. That’s right… silence. You’ll hear nothing. You’ll see nothing. There won’t be red flags waving or IRS agents knocking down your door. There will be a whole lot of nothing. That’s because the IRS – and most likely you, too – don’t even know it’s happened. Almost nobody commits a PT intentionally, and so when it happens, you don’t even know it. And so you continue onward… potentially for years… acting as if nothing has happened, continuing to use your IRA as before.
And it may happen that nobody ever finds out you did it. Generally speaking the only way your error would be “found out” is through an audit of your IRA, which may happen soon, or a long time into the future, or never happen at all. And unfortunately, there’s no totally clear statute of limitations on this stuff. There’s case law where the IRS hit an IRA owner about 10 years after the PT.
So you commit a PT in your IRA, and you experience a whole lot of NOTHING right away. But silence isn’t all that happens, because if the IRS later determines you’ve committed a prohibited transaction, you’ll discover the next thing that happened when you did so, which is:
#2: Your IRA ceased being an IRA instantly. Actually, your IRA ceased being an IRA as of January 1 on the year when you committed the PT. So… no more deductions for your deposits. No more tax-free sale of assets and tax-free reinvestments. No more legal protection from things like lawsuits, bankruptcies and creditors. Basically, your IRA just becomes a financial account that has no benefits for you whatsoever.
Here’s the problem… you don’t know this has happened. And so you continue to use your IRA just like before… making deposits… buying assets… selling assets… the whole thing. And you think you’re using an IRA. But you’re not… which gives rise to the 3rd thing that happens immediately when you commit a PT, which is:
#3: You begin accumulating taxes, penalties and interest… at a BLISTERING rate. So maybe it’s 2016 right now and you commit a PT today, but you have no idea you’ve done so. So 2017, 2018, 2019 come along and you make a full contribution – and take a full tax deduction – for each of those years. That would be fine if your account was an IRA, but remember… it isn’t. And so you’re taking tax deductions to which you’re not entitled, and the IRS is going to hit you to repay those taxes along with penalties and interest.
But that’s not the bad part. The REALLY bad part is that every transaction you perform in your IRA from January 1 of the year you messed up, up until the present day, several years later… well, all of those transactions are FULLY TAXABLE. But you won’t be paying taxes on them, because you think you’re using an IRA… but you’re not. This is where the pain can reach stratospheric levels, because, as you know, it’s entirely plausible that you could be dealing with REALLY big profit margins in your IRA… and you’re expecting those profits NOT to be taxed. But they’re wholly taxable, and you’ll have to pay penalties and interest on top of back taxes, and all of that begins to accumulate instantly when you commit your PT.
That, my friends, is why it’s COMMON for people who commit a PT to lose half or even substantially more of the value of their IRA… they commit the PT completely without awareness and they continue on acting as if they are receiving the benefits of an IRA for many years… only to discover that those benefits vanished very suddenly several years before, and the only thing that’s been growing in the mean time is NOT their retirement savings, but their debt to the IRS. In a single moment, years of diligent saving and wise investing can be wiped out, and the IRS hasn’t shown a lot of proclivity towards mercy in these situations. It’s a horrible situation to be in.
So my friends… when using your Self-Directed IRA, always err on the side of caution, opting to seek expert advice early in the process of each investment, so you’re not stuck dealing with the ugly fallout of this problem. There aren’t very many attorneys who really know this stuff well… so I’ll save you a heap of trouble and recommend one to you… his name is Tim Berry and you can get his contact info over at SDIRadio.com/tim. If you think you’ve committed a PT, you should do yourself a favor and reach out to him right away.
My friends, we’ve got a lot of EXCITING STUFF headed your way ont his show in the coming days, so do this: If you’re listening on iTunes BE SURE to SUBSCRIBE to this show… it costs you nothing, but guarantees you that you won’t miss anything. And whether you’re listening on iTunes or in any other way, be sure you’re on the SDI Private Notification list by texting the word SDITALK to 44222.
My friends… invest wisely today, and live well forever!
Bryan Ellis is host of Self Directed Investor Talk, America's #1 radio show and podcast for affluent self-directed investors. He's also an expert in self-directed IRA's, solo 401k's and turnkey rental property investing... at least, that's what his wife tells him 🙂 He's a contributor to well-respected publications like TheStreet.com, Entrepreneur and ThinkRealty. Bryan lives in metro Atlanta, Georgia with Carole Ellis - his wife, business partner and best friend - and his 4 children ranging in age from 2 to 19.