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Self-Directing Your Retirement Plan? Watch Out For Prohibited Transactions and Disqualified Parties

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    Many of our clients use Self-Directed IRAs and Solo 401(k)s to invest in real estate. They self-direct the retirement account's assets into private real estate deals consisting of rental property and syndicates. This type of investing is a great strategy, but to the unknowledgeable, it's fraught with landmines.

    What are Prohibited Transactions?

    Prohibited transactions can lead to huge tax issues for the unaware investor. Prohibited transactions occur when an investor uses retirement funds from a 401(k) or IRA in a manner that that IRS does not allow.

    Prohibited transactions generally include the following transactions:

    1. A disqualified person’s transfer of plan income or assets to, or use of them by or for his or her benefit
    2. A fiduciary’s act by which he or she deals with plan income or assets in his or her own interest
    3. A fiduciary’s receipt of consideration for his or her own account in a transaction that involves plan income or assets from any party dealing with the plan
    4. Any of the following acts between the plan and a disqualified person:
      1. Selling, exchanging, or leasing property
      2. Lending money or extending credit
      3. Furnishing goods, services or facilities

    Tax on Prohibited Transactions

    The initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the tax period. If the transaction isn’t corrected within the tax period, an additional tax of 100% of the amount involved is imposed.
    Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.
    Amount involved.

    The amount involved in a prohibited transaction is the greater of the following amounts.

    • The money and fair market value of any property given.
    • The money and fair market value of any property received.

    If services are performed, the amount involved is any excess compensation given or received.

    Who are Disqualified Persons?

    If you are a disqualified person who takes part in a prohibited transaction, you must pay a tax on prohibited transactions.

    You are a disqualified person if you are any of the following.

    1. A fiduciary of the plan.

    2. A person providing services to the plan.

    3. An employer, any of whose employees are covered by the plan.

    4. An employee organization, any of whose members are covered by the plan.

    5. Any direct or indirect owner of 50% or more of any of the following:

    • The combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4).
    • The capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4).
    • The beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4).

    6. A member of the family of any individual described in (1), (2), (3), or (5). (A member of a family is the spouse, ancestor, lineal descendant, or any spouse of a lineal descendant.)

    7. A corporation, partnership, trust, or estate of which (or in which) any direct or indirect owner described in (1) through (5) holds 50% or more of any of the following:

    • The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation.
    • The capital interest or profits interest of a partnership.
    • The beneficial interest of a trust or estate.

    8.An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in (3), (4), (5), or (7).

    9. A 10% or more (in capital or profits) partner or joint venturer of a person described in (3), (4), (5), or (7).

    10. Any disqualified person, as described in (1) through (9) above, who is a disqualified person with respect to any plan to which a section 501(c)(22) trust is permitted to make payments under section 4223 of ERISA.

     

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