Self-Directed IRA Rules: Understanding Who is a Disqualified Person
When it comes to investing IRA dollars, many investors don't realize there are actually very few assets you cannot invest in. While the IRS is very clear that IRA funds cannot be used to purchase life insurance or collectibles, it leaves the door open on investing in a wide array of alternative assets, such as private equity, real estate, promissory notes and precious metals.
But the IRS does put up guardrails when it comes to who your self-directed IRA can transact with. In order to steer clear of any unintended penalties and potential hefty tax consequences, your IRA needs to follow IRS rules regarding prohibited transactions and avoid interacting with a disqualified person.
Because it can be confusing to determine who is and who is not allowed to transact with your self-directed IRA, here is a closer look at disqualified persons.
What is the definition of a disqualified person?
One of the basic tenets of self-directed IRA investing is that you and your family cannot personally benefit from the assets you invest in (“self- dealing”), and your IRA cannot transact with a disqualified person. These IRS rules are designed to prevent misuse of retirement assets for personal benefit of disqualified persons (rather than for the retirement of the IRA owner).
For example, if your self-directed IRA owns a single-family house by the beach, you, your spouse and your children can’t stay there for spring break—because all of you are considered to be disqualified persons. Or, if you want to invest in your daughter’s startup, you’ll have to do it outside of your IRA—because your daughter is a disqualified person.
Examples of a disqualified person include (but are not limited to):
- Your spouse
- Your “lineal ascendants” (parents, grandparents, their spouses, etc.)
- Your “lineal descendants” (children, grandchildren, their spouses, etc.)
- Your fiduciary (anyone who exercises discretionary authority or control in managing your IRA and/or provides investment advice to your IRA for a fee)
- Any corporation, partnership, trust or estate in which disqualified persons have a 50% or greater interest
- Certain officers, directors, or highly-compensated employees of companies where the IRA owner owns or controls 50% or more
Who is not considered to be disqualified person?
The list below identifies types of people who are not technically considered disqualified parties. However, as mentioned above, the spirit of the IRS rule is intended to benefit the IRA, not relatives of the IRA’s owner. If you intend to have your IRA transact with any of these individuals, we encourage you to discuss doing so with your tax and or legal advisor:
- Your brothers and sisters
- Your brothers-in-law and sisters-in-law
- Your nieces and nephews
- Your aunts and uncles
- Your cousins
Co-Investing with a disqualified person
Although your IRA cannot engage in transactions with disqualified persons, you are permitted to co-invest with them. For instance, if you want your IRA to partner with your son to invest in real estate, your IRA can own a percentage of the property while your son can also own a percentage. As long as neither of you are personally benefitting from the property by, say, living in it or using it for vacations, it is not considered to be a prohibited transaction.
But keep in mind, you must ensure that all income and expenses proportionally related to your IRA’s ownership stake in the property flow directly into and out of your self-directed IRA. You should not write a personal check to cover any expenses related to the property, and your IRA cannot write a check to your son related to the property.
Why should your IRA avoid transacting with a disqualified person?
It is very important that your self-directed IRA does not transact with anyone who is considered to be a disqualified person. Doing so means you could face severe tax consequences. Your IRA could lose its tax-free status if it’s a Roth account or its tax-deferred status if it’s a traditional IRA.
Before investing, I strongly encourage you to be sure you are familiar with the IRS rules regarding prohibited transactions and disqualified persons, or at least engage the services of a tax or legal advisor who is familiar with those rules. You can start with PENSCO’s Opportunity Analyzer which can help you determine if a deal you’re considering might be prohibited, and work with a financial professional who can help to ensure you understand the rules of the road when it comes to self-directed retirement investing.
 You can review IRS Publication 590 and IRC Section 4975 to determine if someone is a disqualified person.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.