Prohibited Transactions in a Self-Directed IRA (You Know It's a Prohibited Transaction When...)

Welcome everyone to the "Direct at IRA" podcast. This is Matt Sorenson joined by the great and powerful Mark J. Kohler. We are two tax lawyers here to teach you what is a prohibited transaction when you're using a self-directed IRA. These are IRAs that can own in real estate, private companies, you can invest crypto, all these private assets you can actually own with your IRA. But there's one critical rule The most important rule, I should say, that you need to know—

Is you're going to have fun during this podcast. That's why I'm here. Yes.

Can we do that? Yeah.

That's why I'm here.

Mark is obviously lobbying for comic relief on the podcast today. I'm like, will you be serious?

I know. He's like plowing through. I'm like, I got to get a word in here, you know, to make sure you guys are going to have a great time. But apparently you're saying there's a number one rule.

And it's the prohibited transaction rule. And it's really important.

And it sets you free. It sets you free.

Once you know it, you can be super powerful and unstoppable with your self-directed IRA.

I love it. And I was like, I love this topic because I love Jeff Foxworthy. We have some younger people here who have never heard of this guy who said, "You know you're a redneck when..." Anybody remember that joke? Well, we're here to tell you today. We're going to spatter or sprinkle in some of these great jokes of, "You know it's prohibited transaction when..." So stay tuned. It's going to be good.

Or are you going to give us one on the day?

I'm going to lead out of one. Okay. I'm going to lead with one. Okay. So everybody, you're going to— you're never going to forget. See, the beauty of this podcast today, you're never going to forget what a prohibited transaction is again. And you're going to make so much freaking money in your IRA. 'Cause we're going to make this fun to learn. Okay, so I, okay, you want one? I'm going to go with a holiday one. You know it's a prohibited transaction when your IRA owns a vacation home and somehow your whole family accidentally spent Christmas there.

If you're not laughing right now, that's 'cause you don't—

I thought that was great.

Yeah, that's 'cause, you know, sometimes delivery matters, you know? You know, comedy's all about timing. And also, you probably don't know what a prohibited transaction is, 'cause if you did know, you would be laughing. 'Cause that was funny.

So, yeah, you get it, your whole family accidentally. Yeah, yeah, yeah. Whatever.

Because they can't stay there. So, all right, let's unpack what is a prohibited transaction.

I like it.

Okay, let me say one thing at the outset here. Your IRA can really own any asset allowed by law. It just can't own life insurance, collectibles, or S corporation stock. Everything else is fair game. It can own the duplex down the street. It can own an Airbnb. It can own a vacation rental. But your family can't stay there. And this is because of the prohibited transaction.

And I want to add to this too. A lot of people hear prohibited transaction rule and they think it's all about stuff you can't buy. It's not that. You got— world is your oyster. The prohibited transaction rule is what you do with it after you buy it or who you buy it from. That's what the prohibited transaction rule is about. It's not about what you're buying. It's how you're buying. Yeah.

And there's really 3 varieties of this. We're going to teach them here.

We'll get through it.

It's pretty simple. Okay. The first is what's called a per se prohibited transaction. And like Mark said, this is about who is your IRA? Once you have money in your self-directed IRA, who is it transacting with? If my IRA is buying the duplex down the street as a rental property, who's selling that? Who's selling that property to my IRA? So I have a prohibited transaction if I have an IRA transact with a disqualified person. Well, the whole point of having a retirement account is to have one So I got one and I got to make money, so I got to transact it. But who is on the other side of the transaction?

And this is where people start to play games and want to benefit themselves and their IRA at the same time. And themselves means your mom, your dad, your kids, your spouse. You're trying to benefit your family somehow and have your IRA provide some cool asset or payment or use of property to your family. That's where, and this is the crazy part, just this principle alone, your IRA can make so much more money than a Wall Street structured product. That's the beauty of it. But then some people push the envelope even farther and say, "Ooh, ooh, that's great. Now I'm going to use that rental property." No, just enjoy the incredible ROI. Don't screw it up by trying to use it. So, first example is, I like your point. Prohibited transaction number 1 is I am doing a deal with a person that I shouldn't. I'm either buying a property from them or selling it, I'm leasing it.

So let's just go through the clear example here. My IRA is buying the duplex down the street and the seller is my father. Okay, well, my father's on this list of who is a disqualified person. It's what it's called in the tax code. This is Section 4975. I did warn you, we're tax lawyers.

Okay.

All right. You might think we're comedians or some You know, I don't know.

I know.

I don't know what you're thinking right now. Okay? I don't really don't know. Okay. But you're still listening and watching.

Okay.

So. But your father's prohibited. Now you're prohibited. So this is what we get a lot of times, too, is they're like, hey, Matt, I own this stock, or I got some options in this company I work at and they've gone up in value. And if I sell them, I'm going to pay all this tax. Can I just sell them to my Roth IRA? Well, now let's look at that again. This is your IRA buying stock, a transaction or options here. From yourself, you're disqualified. So this would cause a prohibited transaction as well. Now let me change one fact here and then I'll let you speak. I will defer to you. I will, you know, I will yield the balance of my time. Okay. Is let's say you're like, okay, let's go back to this real estate example. Now let's say that your IRA is buying the duplex down the street, but the seller is your sister. Your sister's not on the list of disqualified people. And I know you're thinking, but Matt, I thought family was prohibited. It depends on who they are in the family. Your brother or sister are actually fine. Okay, your aunt, uncle, cousin, obviously third parties, some seller you don't even know, that's totally fine. The real issue here is these certain family members that are disqualified, do not transact with them. It'll blow up your IRA. You have a distribution of your IRA. It no longer exists. If you're not yet 59 and a half, you have an early withdrawal penalty. So those are some easy examples here, I think, to get the juices flowing about what we're talking about.

And to give you kind of like why the practical reason why is the IRS knows you would not screw over your mom or dad in a transaction, but you'd screw over your sister. And that's okay. They're like, that's fine, you know.

Yeah, but so, or they thought, or they thought, you know, your mom or dad wouldn't collude in a transaction with you to avoid taxes, but your brother and sister, I don't know what they're thinking actually. Let's, let's not even worry about this. This trying to think what Congress was intending when they were—

Yeah, that's almost impossible.

That's a disaster.

Yeah. No, I actually think I'd like your example because I do want to say it. The IRS actually thinks your mom and dad would collude with you to increase the value of your IRA and screw over the IRS. But your sister would be like, hell no, just buy my house, you know, you jerk. And so that's kind of what's going on there. Okay, now that's the acquisition transaction issue. Okay, so everybody, let's knock these out. So when you're using your IRA to buy assets, you can't buy something from yourself. Your parents, your kids.

And your spouse and all the spouses for any of you in Utah.

Kind of, yeah, there you go. Now, the next rule that you want to be aware of is kind of this use and kind of transaction stuff. Like once I buy the property, so I buy it from a third party, it's all good, but now you want to go stay there. Say it's a short-term rental or it's a long-term rental and you want your kids to go live in it while they go to college. Or you want— you buy this business and you want the business to hire you or hire your kids, but your IRA owns it. And we know that the IRA could very well make more money because you're going to play games with this or benefit your family with money that's stuck in your IRA. And it could go both ways. Some people want their IRA to own the business so that it can suck money out faster. Other people want the IRA to own it so you can work in it for free and make it go up faster. You never know. So the IRS says, with all that crap going on, no, you can't do it with these prohibited parties. Once you buy something, leave it alone. Go make some money, but don't transact with it. Yeah.

So now my IRA owns that duplex that I bought from my sister. Not a disqualified person, right? I can go rent it. I can have any tenant that I want to rent that property. But it's not me, not my spouse, not my parents, not my kids, anyone on this disqualified person list. All right. And also, you can't stay there for free. Okay. So whether you, you're having a disqualified person rent from there, that's a problem. They're, they're transacting because they're paying rent to your IRA or you're staying there for free and getting some unfair benefit. This causes what's called a self-dealing prohibited transaction. So the bottom line is, once your IRA owns an asset, don't have use or benefit of it yourself or any of these people that are disqualified on the list. Now for 99.99, well, I'd say for 99.98% of you, all right, let's be precise here, this doesn't matter. But we know we run across the people that are like, they're trying to manipulate and use the IRA some way unfairly to benefit them or their kids or their spouse, or they think that the self-directed IRA gives them this freedom to use it in these ways that benefits them. No, that's not what we're talking about here. You are investing in that duplex because you think it's going to appreciate in value and cash flow rent better than the mutual fund that your IRA owned before. That's why we're buying these assets, not to have some weird use or benefit from them or to do some crazy transactions to screw over the IRS. And so that's what this prohibited transaction rule is really all about at the end of the day.

I love it. And, you know, and the reality is some of you are like, well, that's, that's not that complicated. That makes sense. And it actually is quite easy to absorb and understand and then put into practice. So I think we're ready for another You know it's a prohibited transaction when?

All right.

May I? Yeah. Okay. You know it's a prohibited transaction when your IRA buys a rental and your mom is the tenant and she pays rent in cookies. I love that one. Because your mom would do that, you know? Yeah. Like, do I have to really pay rent? Can I just bring you a plate of cookies? Mom, that is a prohibited transaction. You shouldn't even be there. Get out. I'm going to go to jail.

So, yeah, a couple more points here.

Fixer-uppers.

Okay. Yeah, fixer-uppers. A lot of clients are investing in real estate that needs to be fixed up or they're buying businesses, frankly, that need someone to get in there and run it and turn it around, maybe. All right. Now, whether you're buying real estate or you're buying a business, a lot of our clients that are business owners, real estate investors are like, I'm going in, I'm going in, put me in, coach. You know, I'm putting on the tool belt to go remodel the kitchen. The IRS is like, no, you're not.

All right.

Okay. That is self-dealing because you're adding value to the asset past doing administrative and management oversight. So once your IRA owns real estate, let's just stick with that one here for a second. Keep it simple. We can have the kitchen remodeled, but your IRA is going to pay someone to come do it. It's not going to pay your kid or your parents or yourself. It can pay some contractor, of course unrelated, to come in and remodel, improve the kitchen. And that's presumably going to increase value or get you better cash flow.

And by the way, can I just say this is okay? Now, I know some of you listening like, well, I'm not going Why don't my IRA do that? Because I'm a fix and flip expert and I make half my money when I start going in to make them better.

If you were a fix and flip expert, you actually don't work on your properties.

Fair enough. Okay, that's a good point. And also, I used a keyword there. I said I make half my money by adding value through my sweat equity. Well, what was the keyword in there? Half the value. Just, just don't— you don't need that extra half because remember, your IRA can sell this property tax-free. So you just don't— just, you don't have to have all the cake and eat it too. Say, all right, I'll hire a contractor for this sweat equity stuff. My IRA is still going to make a great return. Not as much as if you did it yourself. Granted, we get that. But don't create a prohibited transaction by going and working on the property. If you were audited, you'd have to show receipts of actually paying third parties to improve the property. You're still going to make a great ROI and you don't pay tax on the deal. Just enjoy that. You don't have to have it all. Don't get greedy. So that is that sweat equity rule of adding something to your business or adding something to that rental property that you normally would. Go do that with your own LLC. Just don't do it with the LLC that your IRA owns.

Yeah, absolutely. And so—

But you can be the manager of the LLC.

Yeah, you can. So the IRS says like, hey, look over things. You can even go to the property. You can oversee to make sure the work was done properly. All this administrative oversight management, totally fine.

Fine.

Your IRA can even own an LLC 100% and the LLC can own the property and you can be manager of the LLC. This is called an IRA LLC, checkbook IRA. We've got a lot of other content on that if you want to read up on that. Very popular, of course, for real estate investors. Now let's go over to the business too. Your IRA buys a business, go hire, the IRA's going to pay for a manager or the cash flow from the business is going to pay for a manager. You are not going to be the one working in the business, particularly when your IRA owns 50% or more of that company.

And just to give you, you may say, well, that sucks or whatever. Just know there's some guardrails. For example, if your IRA owns a minority interest, you might be able to work in the business. Now, when you do a consult with one of our tax lawyers, they'll tell you where that line is, 'cause it's a subjective line. The IRS case law says 50%, hell no. If you own 50% or more of this business in your IRA, you are not working for it. That's prohibited. But somewhere between 49% and 2%, there might be flexibility. It depends on who owns the other 50% plus, the majority. Just know there are some options there, but you and family cannot, and your IRA cannot own a majority of this company and you work for it. So you'll get to know those rules. And maybe like if Matt's IRA or someone owned an IRA and he wanted to hire someone to work for it, that's great if they're not family. It really looks at who has majority control of the company and would they normally pay someone to do this and how much. That's— the IRS is really letting people just kind of self-regulate.

Yeah. And once we're below 50%, it gets into this self-dealing issue and it's all facts and circumstances. Did your IRA own 5% or 49%? If it frankly owned 5%, we're not going to really care. If you're at 49%, it's going to be super aggressive. They're also going to look at what was the compensation you were receiving. Did you actually show up for work every day and do this as a job? You know, so it's going to kind of get into facts and circumstances. Now, there are a lot of cases on this, actually, and they're in my book. I have a whole chapter on self-dealing prohibited transactions, probably 10 to 15 opinion letters, revenue rulings, cases out there on this self-dealing prohibited transaction issue. So if you want to geek out on it or you want to test, know where the limits are, this is where it's not as cut and dry as we've been talking up to here so far. But our lawyers at Kickios Lawyers can help.

Okay. You ready for another one?

Yeah.

Okay. This is a good one.

You going to do the joke?

Yeah, I'm going to tell you. Okay. You know, it's a prohibited transaction when you use your IRA to buy a fixer-upper and the IRS shows up because your sweat equity is literally sweating. Get it? You're sweating working on it. Get it? I get it. That was pretty good. That was great. Okay.

First of all, no good comedian finishes his joke and says, Get it? Get it? Because this—

Well, you know, some of us have a little more humor.

You've been to a comedy show before, right?

Well, you know, I'm just trying to bring it out of you.

When a joke lands, it just lands.

Okay. All right. You try one here.

Okay.

You go with that, with that solo 401(k).

Okay.

Okay.

All right. So, you know, it's a prohibited transaction when your solo 401(k) buys a business and your business card says President, Treasurer, and Guy Who Definitely Pretends This isn't self-dealing.

Yeah, we're nerds. We pen drop. We don't mic drop. Okay, I got it. Let's see.

We got Mark Kohler in this one here.

Oh, okay. You know it's a prohibited transaction when you tell Mark Kohler, don't worry, I only used my IRA credit card for one tank of gas, and he passes out like a fainting goat. Oh, I don't know about that. Okay, you want to just— we're just going with these. Okay, you read that. You go with that one.

Yeah, that one sucks. All right.

Okay. Okay, let's try this one. You know it's a prohibited transaction when your IRA LLC writes you a check and you call it a management fee, and Matt Sorenson suddenly appears behind you like, "Nope, try again." You know it's a prohibited transaction when you refer to your IRA-owned rental property as our little getaway place. And Mark Kohler says, "Who's our?" Yeah, who is our in that equation? Okay, I love it. Okay. All right, let's do one more and let's team. You know, team, team play.

I'm going to try and set you up.

Okay.

I'm going to throw the alley-oop and you're going to throw it down.

Okay. All right. All right. So, you know, it's a prohibited transaction when your IRA owns an Airbnb and has a glowing 5-star review from AKA definitely not the owner, which means you cannot stay in your own Airbnb. That's owned by your IRA. I should say you cannot stay in an Airbnb that's owned by your IRA. Anyway, I hope that was fun and a few of those, but you're getting the gist here that we actually have a lot of these questions come through the office and we should probably do that or take more of those. But this is something that you shouldn't be afraid of. It's easy to understand this rule and it's so easy to make more money in your IRA, just plain in the right, in the right lanes. You don't have to get to go off-roading and start taking risks to be successful at this and, and just rapidly increase the value of your IRA.

So yeah, and we got tons of resources here. You can book a call with our team. They can help you go over the resources, understand and educate you on this. And if you have crazy complicated questions, you're like, but I want to do a deal with myself or anybody who's a disqualified person or this LLC that I'm a part of. That's where you want to talk to your tax lawyer or CPA. Our firm at KKOS Lawyers can help you with that. Also, my book, The Self-Directed IRA Handbook. I hate to plug it, but—

No, you should.

You know, it is the number one book in the field. Government regulators literally buy my book. Other competitors in the industry—

I normally wouldn't brag about that, but he does.

I'm just saying that, you know, if they're trying to learn this, where do they go?

Yeah.

Just saying.

Really, they're stalking him. It's, you know, you're looking at just glass half full. I like that. But, you know, hey, I appreciate them.

They loved it. Yeah, yeah, compliments.

I mean, if the feds have a wiretap on you, it's, you know, probably a good thing. They're trying to learn from you.

You know what, man, you really spun that the wrong way.

No, I love it. It is the best-selling book, and I love it. I have a copy of it on my desk. You guys should as well. Uh, don't give up. Keep investing. Know that you control your retirement, no one else, and you're going to be the best person to determine what really investment is going to work best for you and get you the greatest return. So keep listening, please. We're going to be here every week trying to help you on your American dream and building your retirement account. If you enjoyed this, please give us a 5-star, 2 thumbs up, double high five, whatever. And we'll see you next week for another episode of the Directed IRA Podcast. And thank you, everyone, for listening. A quick disclaimer and reminder: this presentation does not constitute an attorney or CPA-client relationship. And it is always in your best interest to consult competent legal and tax professionals when conducting your own personal transactions.

We also want to make sure you know this is not investment advice or financial advice. We're just trying to give you education, ideas, and strategies you can take to your professionals or conduct your own research on. We'll see you next time.