You're a smart investor. You've done all the right things. You've set up and funded a self-directed IRA, then used it to purchase properties and hired a great Property Manager (Turn-Key, of course!) to handle the day-to-day business. You've gotten good legal and tax advice, your portfolio is growning with ever increasing cash flow and equity is growning in your self-directed IRA......nothing but blue skies in your retirement future.
Remember that gallon of paint? You drove by the vacant house and the front door looked shabby. You wanted to spruce up the curb appeal and thought you could save a few bucks by painting the door yourself. It seemed innocent enough, just a cheap gallon of paint and a little time. Unfortunately, that gallon of paint is about to destroy your retirement savings faster than the very worst real estate crash!
You just destroyed your retirement savings due to a little-known set of technicalities referred to as "prohibited transactions".
WHAT IS A PROHIBITED TRANSACTION?
A prohibited transaction happens when a person interacts with a self-directed retirement account (or the assets of the account) in a way that's prohibited by law.
For example, when you bought the paint for the front door, you paid for it with cash out of your pocket with the intention of getting a reimbursement from your self-directed IRA. That's where the damage was done. The IRS sees that as a loan to your IRA. It was a small loan, but an IRA owner is prohibited from loaning monty to his own IRA and they give zero exceptions to the rule. By paying for the paint with your own cash, you've committed a prohibited transaction.
If it wasn't enough that the IRS can sting you for making a loan to your IRA, they can also penalize you for "furnishing services" to your IRA. By painting the door yourself, you were contributing a service to benefit the assets of your plan. Unfortunately, the IRS specifically prohibits you (as the account owner) from furnnishing goods, services or facilities to your plan. This includes using your construction or marketing services and can also be called "self-dealing transctions".
Painting the door yourself was providing a 'service: to your own IRA, so you have committed a 2nd prohibited transaction.
WHAT ARE THE RAMIFICATIONS?
In one word..severe. If you commit a prohibited transaction with your self-directed IRA, your IRA will cease to be an IRA as of the first day of the year when the prohibited trasaction was committed. You are in for a firestorm of past-due income taxes along with very severe penalties and interest.
How bad can it really get for you? Unfortunately, it's actually possible to wipe out the entire value of your self-directed IRA as a result of a prohibited transaction committed long ago. That's because most prohibited transactions are not discovered until many years later when a self-directed IRA is being audited by the IRS. In the intervening years, the income taxes, penalties and interest you could owe have grown, compounded and expanded! It's a bad situation.
The bottom line...Prohibited transactions are the mortal enemy of self-directed IRA owners. One prohibited transaction can literally cause you to lose everything you've worked so hard to build for your retirement.
While this may be a very simplistic example and it seems unlikely the IRS would ever connect the paint to the asset (unless you asked for a reimbursement from your IRA), this is a very realistic senario that you need to keep in mind. Having a Property Manager make all repairs to your property is a must, when owning rental property in an IRA! Always be sure to get good legal advice from your attorney!