IRA and Prohibited Transactions By Leonard J. Witman, Esq.
In today’s economic environment, people continue to look for creative ways to access capital for investments. Often times, if a person does not have sufficient personal assets for an investment, they may turn to their IRA. However, when investing IRA assets in a non-traditional manner, it is extremely important to insure that you don’t engage in a prohibited transaction. The consequences of an IRA entering into a prohibited transaction are draconian in that the entire value of the IRA (at the beginning of year in which the prohibited transaction is entered into) is treated as having been distributed to the IRA owner.
A simple example of how a minor oversight can cause an IRA to commit a prohibited transaction is as follows. Sally decides to buy a condo that has been on the market near the beach for over two years. The current asking price of $500,000 which is more than Sally can afford from her current non-retirement assets. However, Sally has an IRA worth a little over $500,000 and decides to use the IRA to purchase the condo for investment purposes. The IRA is transferred to a custodian that (for a higher then usual custodial fee) permits the IRA to invest in non-traditional investments. The custodian makes it clear that it is just the custodian for the IRA’s investment and that they are not and will not give the IRA owner tax advice.
Everything is going well until the toilet gets clogged and Sally needs to hire a plumber. Sally hires a plumber for $200 to fix the problem and pays the plumber with a check from her personal checking account. Sally doesn’t think about this being a problem. However, this is now deemed to be a prohibited transaction since the IRA should be paying for all of the expenses associated with the condo including minor repairs. Now, Sally’s IRA, which was growing tax deferred, is deemed to be currently taxable and if she is under 59 ½, in addition to the income tax owed on the IRA deemed distribution, Sally will also have to pay a 10% premature distribution excise tax.
When a person owns an IRA, the custodian of the IRA annually files Form 5498 with the Internal Revenue Service (with a copy to the IRA owner). Currently, this Form does not require the custodian to report how the IRA’s assets are being invested. However, the current draft of the 2014 Form 5498 will require that the custodian insert a code reflecting the type of investment held by the IRA (whether it is stocks, bonds, silver, gold, real estate, etc.). This will be a significant departure from the current reporting requirement and is another way for the Internal Revenue Service to monitor IRAs to ensure that they are being invested properly.
The draft instructions for 2014, Form 5498 state that if the IRA owner engages in a prohibited transaction, the IRA is deemed to have made a distribution to the IRA owner on the first day of the tax year when the prohibited transaction occurred. In fact, the Internal Revenue Service in the instructions state that “IRAs that include or consist of, non-marketable securities and/or closely held investments, in which the IRA owner effectively controls the underlying assets of such securities or investments, have a greater potential for resulting in a prohibited transaction.”
As always, it is extremely important to make sure any investments made with an IRA do not engage in a prohibited transaction. With the new proposed Internal Revenue Service reporting requirements for IRA custodians, transactions which were previously under the radar will now be subject to greater scrutiny by the Internal Revenue Service.