The IRS is very interested in Self-Directed IRA’s (“SDIRA’s”). They are especially interested in IRA’s that invest in real estate or via trusts or via “Checkbook LLC’s”. How do I know that? Two reasons. First, several IRS employees have very directly told me so. Second, the IRS has recently changed its reporting requirements in search of this very data. Specifically, every IRA is required to file Form 5498 once per year. That form tells them the value of your IRA.
Starting in 2015, the IRS has required that new data be reported on Form 5498. Among other things, they want to know whether the IRA is investing in real estate, LLC’s or trusts. In other words, what IRS employees are telling me in audits is being reflected in regulatory changes. It all points to the same conclusion: The IRS is very interested in SDIRA’s. Which means your SDIRA needs to be up-to-snuff and reflect the latest developments in the law.
The IRS correctly views SDIRA’s as cash cows for the government. Specifically, a one dollar mistake can cost the IRA owner one million dollars in taxes and penalties. You read correctly: If your IRA pays $1 to the wrong person, you could end up paying $1 Million to the government.
Here’s an example:
- Your IRA has assets & cash worth $1,666,667.
- Your IRA lends $1 to your mother.
- That loan is a very basic & blatant “Prohibited Transaction” under Internal Revenue Code Section 4975.
- Without going into details just yet, a Prohibited Transaction often results in the IRA losing 50% to 60% of its assets to government – no matter how small the Prohibited Transaction.
- 60% of $1,666,667 is $1,000,000.
- A $1 mistake can cost $1,000,000
Can you blame the IRS for looking for small mistakes that get them millions of dollars? Like it or not, that IS what they are doing. But we are not helpless.
My example above was very simplistic to make a point. Unfortunately, the Prohibited Transaction rules themselves are not so simple. There are many subtle ways to accidentally destroy your IRA. The rules are often grey, subtle and very easy to accidentally trigger. In such cases, the IRS and the Tax Court generally show no mercy. Here’s what the Tax Court had to say with regard to “mercy” and Prohibited Transactions:
“…we conclude that the prohibited transactions contained in section 4975(c)(1) are just that. The fact that the transaction would qualify as a prudent investment when judged under the highest fiduciary standards is of no consequence. Furthermore, the fact that the plan benefits from the transaction is irrelevant. Good intentions and a pure heart are no defense.”
In short, if you err, the IRS can destroy your IRA, no matter how innocent or small the error. That’s why Prohibited Transactions are the government’s #1 weapon for busting IRA’s.
I spend a lot of time with clients or in seminars educating clients on Prohibited Transactions. Here is a VERY simplified list of the most common Prohibited Transactions:
- The IRA does any kind of business with its owner, the owner’s family, certain business partners or employees. It does not matter how indirect or well-hidden the business is (e.g. – doing it in someone else’s name and then getting cash “behind the scenes”, quid-pro-quo deals with “financial friends”, etc.)
- The owner uses the IRA to benefit himself personally, no matter how indirect or small the benefit (e.g. – IRA owns a condo and the IRA owner’s teenage kids have a party in it one night).
- The IRA owner provides any sort of service to the IRA, even if uncompensated (e.g. – managing IRA rentals? Managing the IRA’s LLC?)
As I said, this list is grossly simplified. I do provide consultation and seminars that go into much greater detail and address specific situations (e.g. – rentals, flips, rehabs, assignments, etc.).
About John Hyre
John Hyre is a tax attorney, accountant and investor. His tax practice is based in Columbus, Ohio, but most of his clients are from states or countries outside of Ohio. He has been practicing for twenty years in the area of tax law, with a focus on the taxation of real estate, small businesses and self-directed IRA’s/401k’s. John frequently speaks nationally on taxation and has successfully represented clients in IRS audits and in Tax Court. He is one of the few attorneys in the country who has been (and as of this writing, is still involved in) IRS audits of IRA’s as well as IRA-related Tax Court cases. John is accepting clients from all over the US (and overseas) for tax planning consultations and representation in IRS audits or in Tax Court. He can be reached at firstname.lastname@example.org and his (tiny & primitive) website can be found at realestatetaxlaw.com or iralawyer.com.
 Emphasis mine, from Leib v. Commissioner, US Tax Court Case No. 10688-85, special thanks to attorney Quincy Long of Quest IRA for pointing this one out.