Prohibited transactions: the rules that can destroy the whole account

This is the page to read twice. Everything else about self-directed IRAs is logistics. This is the part with teeth.

The rule

Section 4975 of the Internal Revenue Code prohibits, between a retirement plan and a disqualified person:

1. Selling, exchanging, or leasing any property
2. Lending money or extending credit in either direction
3. Furnishing goods, services, or facilities in either direction
4. Transferring plan assets to, or using them for the benefit of, a disqualified person
5. A fiduciary dealing with plan income or assets in their own interest
6. A fiduciary receiving anything from a party dealing with the plan in a transaction involving plan assets

Read items 4, 5, and 6 again. Those are the catch-alls, and they are wide. They do not require a bad outcome, a loss, or an intent to cheat. Benefit flowing to a disqualified person is enough.

Who is disqualified

You. Your spouse. Your parents, grandparents, and further ancestors. Your children, grandchildren, and further descendants, plus the spouses of those descendants. Anyone providing services to the plan. Any entity in which those people together own 50% or more.

Not on the list: your siblings, your aunts and uncles, your cousins, your in-laws other than your own spouse, your friends, and your business partners below the 50% threshold. Your brother is not a disqualified person. Your son is.

That asymmetry is the single most commonly misremembered fact in this subject.

The consequence

For an IRA, if a prohibited transaction happens, the account stops being an IRA as of the first day of that taxable year. The entire fair market value is treated as distributed to you on that date.

So: ordinary income tax on the full balance, a 10% additional tax on the whole thing if you were under 59 and a half, and the loss of decades of tax deferral. If the violation happened three years ago and you are only finding out now, you also have amended returns, interest, and possible accuracy penalties.

There is no proportionality here. The size of the violation has no bearing on the size of the consequence.

Worth knowing for contrast: inside a 401k the mechanic is different. The disqualified person pays a 15% excise tax on the amount involved, and the transaction can be corrected, with a much harsher tax if it is not. The plan generally survives. An IRA does not get that grace.

The five that cause most of the damage

1. Paying an expense personally. The tenant calls, the pipe is burst, the custodian needs three days, so you put $900 on your card and plan to reimburse yourself. That is furnishing goods and services to the plan and extending credit to it. Two prohibitions in one helpful gesture. The fix is a cash reserve inside the account, always.

2. Doing the work yourself. Sweat equity is prohibited. Painting, mowing, tiling, even coordinating contractors in a way that resembles providing management services. Hire it out, pay from the account.

3. Personal use. One night in the property is a violation. So is storing a boat in the garage, so is letting your daughter stay there while she looks for a place, so is renting it to your parents at full market rate. Value flowed to a disqualified person. That is the whole test.

4. Guaranteeing the loan. If the account borrows, you cannot sign a personal guarantee. That is an extension of credit from a disqualified person to the plan. The loan must be non-recourse, which is why non-recourse lending to IRAs is its own small industry.

5. Taking a fee, or benefiting indirectly. You cannot pay yourself to manage the property. Subtler versions catch more people: directing the account to invest in a company where you hold a role, routing the property management to your own company, using the account's purchase to make a personal deal possible. These are self-dealing under items 4 through 6, and intent is not the test.

How to stay out of trouble

Adopt one mental model and apply it without exception: the IRA is a stranger who happens to trust you.

A stranger's property is not a place you sleep. You do not lend a stranger money and you do not borrow theirs. You do not work on a stranger's building for free, and you do not take a cut of a stranger's rent. You do not do a stranger a favor and you do not accept one.

If a proposed action would be strange to do for an actual stranger, stop and call your attorney before you do it for the account.

The three questions before any action

1. Does any disqualified person touch this, in any role, however small?
2. Does any value move between the account and a disqualified person in either direction?
3. Does any disqualified person get any benefit from this beyond the account's own growth?

One yes means stop. Not proceed carefully. Stop, and get an opinion from a tax attorney who does this specific work, in writing, before anything happens.

The economics justify it easily. A few thousand dollars of legal advice against the entire balance of a retirement account is not a close call.