Avoiding Dangerous IRA Investments

We addressed the Checkbook IRA last month that lets you own nontraditional assets in your individual retirement account (IRA). Set it up properly, and your IRA isn’t restricted to the usual mutual funds and publicly listed stocks and bonds.

There are quite a few investments you can own through the Checkbook IRA (also known as the LLC IRA or Super IRA). But you can’t own every type of asset in your IRA. The tax law prohibits IRAs from owning certain assets and from engaging in certain transactions. There also are other assets, such as master limited partnerships (MLPs), which could trigger taxes on an IRA. It is not the job of your IRA custodian to prevent you from making prohibited investments or transactions, so you need to know the rules or work closely with an advisor who does.

The prohibited investments for an IRA are life insurance and collectibles. Collectibles listed in the tax code are art, antiques, rugs, stamps, coins, metals, gems and alcoholic beverages (such as fine wine). The IRS can add to the list through regulations but hasn’t.

There are some exceptions for metals and coins. For example, gold coins that are legal tender and minted by the U.S. Treasury, such as the American Eagles, are allowed in IRAs. There also are other narrow exceptions for certain metals investments. As we discussed in last month’s Tax Watch, you can own metals indirectly in IRAs by using exchange-traded funds (ETFs) and some other means.

The penalty is that the amount the IRA invested in a prohibited investment is treated as distributed on the date of the investment. You’ll probably have to include it in gross income and might owe the 10% early distribution penalty if you are under age 59½.

Prohibited transactions are a broader category and are the most likely to trip up someone with a Checkbook IRA. You want to be careful not to make a prohibited transaction. The penalty is that the entire IRA loses its tax-exempt status and is treated as fully distributed the first day of the year the prohibited transaction was made. There’s no option to reverse the transaction, and even parts of the IRA that weren’t included in the transaction are treated as distributed. When you have more than one IRA, only the IRA that engaged in the prohibited transaction is penalized.

The prohibited transactions are easily summarized in plain English: A prohibited transaction is any investment or deal between a related, or disqualified, person and the IRA. Another way to phrase it is: No deals are allowed involving the IRA and its owner or a person related to the IRA or its owner. Persons include entities, such as trusts, corporations, LLCs and others. It doesn’t matter if the transaction is at fair market value. Prohibited transactions are not allowed at all.

The tax code lists six prohibited transactions between IRAs and related parties.The first four transactions are specific, and the last two are general.

The specific prohibited transactions are:

• A sale, exchange, or lease of property
• A loan of money
• Furnishing goods, services, or facilities
• A transfer or the use of the income or assets of the IRA

The general prohibitions are: an act in which the related party deals with the IRA income or assets as his or her own; and the receipt of any benefit for the related party’s personal account in connection with a transaction involving the IRA’s income or assets.

A related person is the IRA owner; anyone who makes decisions for the IRA; anyone providing services to the IRA; an ancestor, spouse, or descendant of the IRA owner, of the owner’s spouse, of a decision maker for the IRA, or of anyone providing services to the IRA.

Related persons also include entities, such as a corporation, a trust, a partnership, or an estate that is 50% or more owned by any of the above persons. A partner of any entity that is on that list is a related person, as is any officer, director, highly-compensated employee, or 10% or greater owner of any of the those entities.

Here’s a situation that regularly traps unwary owners of Checkbook IRAs. The IRA purchases a rental property. The IRA owner manages the property. He might do some routine maintenance on the property and even purchase some low-cost supplies for the rental property with his own funds. Each of these acts violates the prohibited transaction rules, because the owner is furnishing goods and services to the IRA. (These actions also could be considered additional contributions to the IRA.) If the IRA owner takes payment for performing management services, then he received a benefit for his personal account from the IRA.

Suppose an IRA buys or invests in a private business for which the IRA owner works. A prohibited transaction occurs when the IRA owner draws a salary from the business or provides services to the business without payment. You can see how easy it is to fall into the prohibited transaction traps.

You might be thinking at this point that the list of related persons is comprehensive, but there are some gaps. Not included as related persons are brothers, sisters, step relatives, nieces and nephews of the IRA owner. Also not included are friends and neighbors of the owner. A “significant other” to whom the IRA owner is not married also is not a related person. These gaps might allow you some planning opportunities.

A Roth IRA is subject to the same rules as traditional IRAs and other qualified retirement plans unless specifically exempted. There isn’t an exemption to the prohibited investment and transaction rules for Roth IRAs. In addition, the IRS has gone a step further with Roth IRAs. It issued a notice stating that any transaction between a Roth IRA and a “related party” would be considered a tax shelter or an abusive transaction required to be registered with the IRS. For this notice, the IRS considered brothers and sisters as related parties. (IRS Notice 2004-8)

Though the list of prohibited transactions is long and comprehensive, the Department of Labor is allowed to grant exemptions and frequently does. It grants exemptions to specific taxpayers for specific transactions and also grants broad “class exemptions” that apply to anyone who matches the facts in an exemption. Under these exemptions, IRAs and owners have been allowed to engage in transactions involving real estate, stock, loans and more.

To find details on the exemptions, go to the Department of Labor website at www. dol.gov. Look for the “Employee Benefits Security Administration” (EBSA) among the department’s agencies. On the home page for EBSA, look for “Technical Guidance.” It recently was in the column on the left, but the Labor Department frequently changes its website. You can look at the class exemptions that have been granted to see if what you want to do qualifies. You also can look at individual exemptions to see if there is something close enough to make it worth your while to apply for one.

With an individual or class exemption you might be able to use an IRA to buy real estate (including a vacation home), invest in your business, or lend money to a relative. I don’t recommend engaging in these transactions on your own. The rules are technical, and you have to comply fully with them. You should consult with an accountant or attorney who is well-versed in the rules for IRAs and retirement plans.

I discuss prohibited investments and transactions and other IRA investment pitfalls in my report, “IRA Investment Guide: A Road Map for Avoiding the Traps and Penalties for IRA Investments.” It’s available through “Bob’s Library” under the “About Bob Carlson” tab on the web site at www.RetirementWatch.com.