Don't Mess With IRS Rules - Prohibited Transactions & Section IRC 4975 :

Don’t Mess With the IRS

We field quite a few calls from ‘creative’ investors scheming to get around the IRS rules for self-directed IRA investing. As somebody that takes a lot of these calls, I am often surprised by the lack of respect that the IRS gets from the average US tax payer. I understand that very few people have ‘warm and fuzzy’ feelings about the IRS; I mean it is pretty rare that a surprise contact by the IRS is a good thing! So I understand the distaste with the IRS, however I think people should be careful not to confuse dislike with a lack of respect.

The fact is, the IRS is pretty darn good at what they do once they open an audit. IRS audits are extremely thorough. If you break a rule and your IRA is audited you are probably going to get busted and the penalties can be extremely damaging to your IRA. On top of that, unlike within our Judicial System, the accused is guilty until proven innocent – not the other way around. The burden of proving innocence falls on the accused taxpayer.

The IRA prohibited transaction rules can be found section 4975 of the IRS code. In respect to buying real estate within an IRA the rules are you (and your direct lineal relatives) cannot use the asset that your IRA owns. Additionally, your IRA cannot have transactions (buy/sell) with you or your direct lineal relatives. These rules are pretty cut and dry and there is no legitimate way to get around them. If your IRA owns a property, there is no way for you to use the property or benefit from the property in any capacity. Likewise, if you own an asset personally there is no way to move it into your tax-deferred IRA.

We know these rules well because we remind people every day. We want all IRA owners – clients, prospective clients and otherwise, to know the rules so they never have to dread the call from the IRS. Our number 1 job is education because we want every single person we speak with to know the rules. While we do not take legal or fiscal responsibility for the self-directed IRA, we do feel a personal responsibility for your education.

We like to think of ourselves as the angel on your shoulder when you make an investment decision. You, of course, make your own decision. But we try to whisper in your ear, “Prohibited Transaction”, and “Self-dealing, don’t do it”. We want you to have as much money as you can legally acquire when you’re ready to retire.

And of course, you want that too. We often get asked the question “how would the IRS know if I use the property?” As an administrator of self-directed IRAs, we don’t get involved with how likely it is that someone gets caught in a prohibited transaction; we are focused on not allowing clients to get their IRA involved in a prohibited transaction in the first place. Granted, there are not IRS police spying on your IRA-owned property trying to catch you in the act of using the property. However, if you or your IRA gets audited there is a very high likelihood of getting caught if you did in fact break the rules.

Another unique thing about the IRS that you should understand is they don’t just look at the transaction itself, they also look at the circumstances involved. We’ve had prospective clients propose structured arrangements to get around the rules. We’ve heard things like “what if I sell my personally owned property to my friend and then buy it back with may IRA…. how would the IRS ever know?” The fact is, it would take the IRS all of about 2 minutes to see what you’ve done and to declare the arrangement as a prohibited transaction. Buying the property with your IRA from your friend is not directly a prohibited transaction; however, the arrangement of selling something you own to the friend and then buying back with the IRA is most definitely a prohibited transaction. Additionally, not only did you break a rule, but you intentionally created a scheme to get around the rules….The IRS is not going to take this lightly.

Other investors suggest using an LLC to get around the IRS rules. LLCs can sometimes be useful in structuring real estate investment. However, they are not magical entities that make all the rules disappear. If your IRA invests in an LLC, then the rules apply to the IRA now apply to the LLC as well.

The penalties for prohibited transactions can be extremely harsh. The IRS does not tie their hands down by telling you exactly what will happen if your IRA takes part in a prohibited transaction. Each case is judged on a case by case basis. You will almost certainly lose your IRA tax-deferred status (the IRA would be immediately distributed to you personally). This can create an unexpected tax liability as well as penalties if you are under the age of 59.5. On top of that, they will most likely impose a 15% prohibited transaction penalty. There have been extreme cases when the prohibited transaction resulted in 100% loss of the IRA. Prohibited transactions are not to be taken lightly.

The bottom line is this: your IRA receives special tax treatment from the IRS. IRAs have built in tax-deferred growth. In order to maintain that treatment, it is important that the IRA investments are just that…investments. If you want to use the IRA funds or benefit from the IRA funds then you should take a distribution, pay the tax and then do whatever you like with the funds. However, while they remain in the IRA you (and your direct lineal family members) should not benefit from what the IRA is doing. So next time you are trying to think of a creative way around the IRS rules, STOP!…. there is no legitimate way to get around the IRS rules.