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When a person first discovers that his retirement accounts don’t have been chained to Wall Street stocks his mind starts to think about the investment possibilities. However, prohibited transactions is an important topic when looking into self-directed IRA and Solo 401k investing. Typically people are limited by the investment options (only stocks, bonds, mutual funds, etc) but that can be eliminated by setting up a proper solo 401k account or setup an account with a proper custodian that allows such transactions. The other limitation is one that is bound by IRS rules and cannot be removed but is fairly simple to follow.

The general premise behind prohibited IRS transaction rules is that the government wants you to grow your retirement account as big as possible because they plan to tax it later on when you distribute the funds to yourself for spending. Without prohibited transactions rules, anyone in their right mind would grow their retirement account and then make losing investments that actually put their retirement funds into their own hands. The prohibited transaction rules make the above scenario illegal. In order to be legally compliant, every retirement plan transaction must involve a genuine effort to benefit the retirement plan itself without benefiting the plan owner or his relatives.

Here are some common strategies that are wrongly believed to successfully circumvent the rules. One is when two people what to benefit from each other and each others IRA. They swap benefits for personal gain. For example, Bob and Tom each have a self-directed IRA. Tom’s IRA loans $10,000 to Bob and Bob’s IRA loans $10,000 to Tom . This doesn’t break the rules that are most focused on, but it does break the usually ignored rules. For each loan transaction the borrower is not a disqualified person. However, the loan is a conflict of interest for the IRA owner because he expects to receive a loan back from the other person’s IRA. Because his decision to extend the loan from his IRA involves the expectation of a chain of events that is designed to benefit him personally, this is a prohibited transaction. Another example would be if Bob’s IRA and Tom’s IRA each bought a vacation home and each let the other person stay in the condo. When An IRA owns real estate its owner and any disqualified individuals are not allowed to make personal use of the property even if paying rent. When Bob vacations in a property owned by Tom’s IRA and Tom vacationed in property owned by Bob’s IRA this is a prohibited transaction. Again, what makes it prohibited is the fact that when the IRA owner made the decision to enter into the transaction, he expected to receive a personal benefit (whether direct or indirect) as a result of the transaction.

Another common work around is when people want to sell their house and can’t find a buyer. So the person finds a friend to buy the house and later the friend sell the house back to his/her IRA. People think this does not break any rules since the friend is not related and thus is not a disqualified person. The IRS see the friend as a strawperson who is involved for all the wrong reasons and really does not want the house but is helping to add separation to the real estate transaction. The law removes the strawperson to examine the real transacting parties. The IRS sees it as you sold your house to your IRA and that is a prohibited transaction.

You need to clearly understand the rules and don’t enter into these types of transactions. Focus on growing your retirement account without engaging in conflicts of interest.

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