All Prohibited Transactions Are Taxable… All Taxable Transactions Aren't Prohibited [EPISODE #253]
The Big Idea
Prohibited transactions are a terrible, terrible thing for your IRA, and they are ALWAYS taxable, with penalties and interest, too. Yes, all prohibited transactions are taxable. But not all taxable transactions in your IRA are prohibited...
Points To Ponder
- Prohibited transactions are prohibited because they benefit someone other than the IRA
- Not all transactions that are taxable to your IRA are prohibited
- Zamir from Boston proposes a transaction that could be both... or neither... we take a look
Some things, you just can’t do in an IRA without totally destroying your account. Other things, you can do… but you might have to pay some taxes. Big difference… and your fellow listener Zamir has a question that shows a misunderstanding of the distinction that’s going to cause him some real trouble… and maybe you, too. I’ll shine the light on the difference RIGHT NOW…
Hello, SDI Nation. Welcome to the podcast of record for savvy self-directed investors like you!
This is Episode #253… Episode #253 of Self Directed Investor Talk… that means all of the goodies associated with today’s episode are available right there at SelfDirected.org/253 … SelfDirected.org/253.
You heard that right, folks. If you expected me to say SDITalk.com/253… well, we’ve got a BRAND NEW website and a BRAND NEW domain name… SelfDirected.org… and let me tell you… it’s AWESOME! There’s so much great content there it will BLOW YOUR MIND… seriously. Check it out, but one way or the other, today’s a day you’re definitely going to want to visit the show notes page at SelfDirected.org/253 for reasons you’ll learn momentarily…
Ok people… If you use a self directed IRA, then you’ve doubtlessly heard of this thing called a prohibited transaction, which we in the biz lovingly call a “PT” for short. And a question from one of your fellow listeners – Zamir in Boston, MA – is focused on that topic.
So let’s set the stage… because you’ll probably have a similar question at some point.
Alright: A PT is the very worst thing that can happen to, or in, your retirement account. A PT is like kryptonite, a nuclear blast and a huge tax bill all rolled into one awful event. Imagine you’ve done everything right, you’ve reached retirement age and your account is now worth a few million dollars…
…but 6 years ago, you did something stupid…or accidental… or whatever… but you did it all the same.
Maybe you paid a tiny $500 hazard insurance policy for a property in your IRA using your own money.
Maybe you borrowed a few thousand bucks from your IRA and even promptly repaid it.
Maybe you hosted a party on the wonderful apple orchard owned by your retirement account.
Hey… all of these things are PROHIBITED, flat out PROHIBITED. That means it’s totally plausible that you could lose most or even all of the millions of dollars in your IRA as a result… even if the PT you committed only involved a measly $500 hazard insurance policy.
Needless to say, the stakes are high.
Do you people know what transactions are prohibited for your IRA? I mean REALLY KNOW? If you can’t answer that with absolute firm conviction, that’s the first reason you MUST visit the shown notes page at SelfDirected.org/253 because there you’ll find our BRAND NEW ebook about this very topic called THE BREAKING POINT which you can download today – right now – at NO COST for a brief time…. There at SelfDirected.org/253.
Or hey… maybe you don’t download it… it’s only your retirement savings at stake. Your call.
So, back to Zamir, whose email to me gives away that he’s clearly quite intelligent. But he does have a fundamental misunderstanding. Here’s the relevant part of his question:
“I do some occasional contract consulting work for a company here in Boston, and I’ve been given a chance to buy into the company as a partner. I’d like to do that because it’s a very profitable business, but my only liquid funds at present are in an IRA. I was thinking of rolling that money into a self-directed IRA and buying into the company that way, but isn’t it prohibited for me to invest in an active business through my IRA?”
Zamir, thank you for the question. You’ve got a few things happening here simultaneously, and there could be a prohibited transaction, but not for the reason you think.
There’s nothing prohibiting your IRA from buying into this business, even if it does produce active income rather than passive income. It simply means that your IRA will be liable to pay taxes on that money each year once your active income exceeds a really low threshold which is currently $1,000 per year. After that, your IRA would have to pay tax on the net profits at the trust rate, which can get pretty steep pretty quickly.
But that isn’t – I repeat is NOT – a prohibited transaction.
You’re not BLOWING UP your IRA by doing that. The IRS won’t consider your IRA to be FULLY DISTRIBUTED – which is the technical term for what happens when you commit a PT – just because your IRA owns a business that produces active income. It just means your IRA will have to pay taxes each year on that income.
Now your interest in the business itself – your partnership interest – as that grows in value, I imagine you’ll sell that at some point in the future… and that is where you’ll get the tax benefits of your IRA, because your IRA won’t likely owe any tax on the profit from that sale. So you’re STILL going to get a potentially big benefit from owning that partnership interest in your IRA.
But here’s the thing Zamir – you’ve got a problem if you’re earning an income personally from this business that your IRA is about to purchase. It’s not totally clear-cut, because it’s arguable if you own just a small portion of that business, then maybe you could still collect a salary from it without it being a prohibited transaction.
But let me tell you a couple of things:
First, the IRS, when performing audits of Self Directed IRA’s, ASSUMES that there’s a prohibited transaction in every single account.
And Second, in your account, I can tell you without hesitation they’re going to look hard at it this transaction – if you were ever to be audited – if you’re also receiving a salary, even if only part time, from this business.
And THAT… the receiving of a salary from a business that your IRA owns… that’s where you’re likely to be guilty of a prohibited transaction… and it’s THAT that can easily be the death knell for your IRA.
Here’s my advice: Talk to an attorney who knows something – who knows A LOT – about this. The one I recommend is Tim Berry, his contact information is available to you on the show notes page at SelfDirected.org/253. Or find a lawyer that you know. But get some good advice. Because these are perilous waters you’re wading into, Zamir.
But what I want you to take away from this, Zamir, and the rest of Self Directed Investor Nation, is that there’s a DIFFERENCE between a prohibited transaction and a TAXABLE transaction in your IRA. Prohibited transactions are always and inherently taxable. But taxable transactions for your IRA are not always and inherently prohibited.
That’s all for today people. Remember to get our new ebook about Prohibited Transactions called THE BREAKING POINT… it’s free for a limited time if you visit today’s show page at SelfDirected.org/253.
Hey – tomorrow we’re going to talk about a huge phenomenon – the whole AirBnB & VRBO “thing” – and why it could be a ticking time bomb to rent properties from your IRA that way…
In the mean time… where your money is concerned: take the bull by the horns… and the kick the bear in the teeth.
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.