When it comes to owning real estate assets in an IRA, it may
be tempting to live in the property or work on the property before it is
distributed out of the IRA. However, these are prohibited by the IRS and can
result in steep penalties and a distribution of the account.
At New Direction IRA, we hear a lot of questions from
investors asking what they can and can’t do with their IRA property according
to IRS rules. Here’s a few of those questions and some basics about how the IRS
treats prohibited transactions within real estate IRAs.
The Basics
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IRS audits are extremely thorough. If you break a rule and
your IRA is audited, you’re affairs better be in order. The penalties can be
extremely damaging to an 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,
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. 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.
“How would the IRS
know if I use the property?”
SDIRA administrators and providers can help account holders
avoid prohibited transactions, but their purpose isn’t to babysit investors and
make sure they follow the rules. If your IRA owns real estate and you haven’t
distributed that real estate, you cannot live in or physically work on that
property. It is prohibited to do so and could result in the distribution of
that asset.
The IRS is not likely to monitor an IRA holder’s
investments, so the agency relies on administrators to report prohibited
transactions. At New Direction IRA, we won’t process a prohibited transaction
and illegal distributions are reported to the IRS so they can be properly taxed
and penalized. And, if your IRA is audited, the IRS may be able to determine if
you lived in or worked on the property.
“What if I sell my
personally owned property to my friend and then buy it back with my IRA? How
would the IRS ever know?”
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.
The IRS doesn’t just look at transactions on paper, they
also look at the circumstances involved. The IRS has seen just about anything
an investor could propose or scheme. They can recognize these prohibited
structures and declare them as a prohibited transactions.
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, but now the onus is on you to maintain proper bookkeeping for the
account in case of an audit.
Penalties
The penalties for prohibited transactions can be extremely
harsh. Each case is judged on a case by case basis. An IRA that committed a
prohibited transaction will almost certainly lose its tax-deferred status (the
IRA would be immediately distributed to the account holder). This can create an
unexpected tax liability as well as penalties if the account holder is under
the age of 59.5. On top of that, the IRS 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:
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.
