You Can’t Do That! Prohibited Transactions 101
By Alisha Bennett
This is the first post in a new series we will be doing, entitled “You Can’t Do That!” In this series, we will be examining transactions that would be considered prohibited under IRC 26. We’ll be using both real life examples, and also theoretical situations to make our point.
This series will be a useful tool for people to understand what it is that you cannot do with an IRA LLC. IRA law allows so many things in an IRA, that it can be easy to forget that there are limitations. The few rules that apply to IRAs, involve limiting the IRA owner’s ability to invest with his own IRA, or get any benefit from his account. This includes his immediate family.
Let’s look at an example. I recently got a call from a prospective client, who proposed the following transaction, and asked me if it would be allowed: He wondered if he could loan money to his girlfriend so that she could buy a house. He then wondered if he could live in the house with his girlfriend, and pay rent.
What do you think? Can he do it? Let’s take a look at what is wrong with this transaction.
First off, his girlfriend is probably not a prohibited party. Because they are not married, she is not a spouse, and is not disqualified. If she isn’t a disqualified person, she can deal with his IRA LLC. A loan from the IRA LLC to her, would therefore not be considered a prohibited transaction. Where this transaction goes wrong, is when he asked about moving into the house that is being bought by the girlfriend. Suddenly, he is having use of his IRA funds. How, you might ask? He is indirectly benefitting from the fact that his IRA’s money was used to buy the house he is now living in, and his rent payments are being used to pay back his IRA LLC for the loan it made to his girlfriend.
Some might ask the question, “Wait a minute. He’s not dealing with his IRA LLC, and his rents are going back to his girlfriend, so what’s the big deal?” or, “So long as he pays rent, there wouldn’t be a problem, right? If he’s not living there for free, or paying a ridiculously high rent, he’d be ok.”
True, he is not dealing with his IRA LLC. He is not paying his rent money to the IRA LLC, nor has he entered into a transaction with the IRA LLC. Nevertheless, he is getting personal benefit from living in the house. Remember what it says in 4975. “any indirect benefit of the IRA funds by the IRA owner or any other disqualified person is considered prohibited.” So in this case, even though he’s not dealing directly with the IRA LLC, and even though his rents aren’t going back to the IRA LLC directly, the IRS would look through his girlfriend, and would consider him to be benefitting from his IRA funds. And as a result, the IRS would consider this to be a prohibited transaction.
Think of it this way: Just because his girlfriend is standing between him and the IRA LLC, doesn’t mean that it will fly. The IRS would look through or disregard his girlfriend, and would say “No, no, no. You’re getting personal benefit from this deal, because you’re living in the house your IRA helped buy. And your rent payments are making their way back to the IRA LLC anyway.