A prohibited transaction is any action that involves your self-directed account and is expressly prohibited by the IRS. A prohibited transaction can result in your account being "fully distributed," which means all the tax advantages and protections previously offered in the account are considered void from the year in which the prohibited transaction was committed.
Since self-directed investors usually do not deliberately commit prohibited transactions and it may take the IRS years to detect one in your account, this can result in staggering fees, fines, and back taxes that may amount to 60 percent or more of your IRA's current balance. There are five common examples of prohibited transactions outside of what Tim Berry refers to as "The Catch-All" clause. They are:
1. Borrowing from or lending to your IRA 2.Buying or selling to any disqualified person
3. Investing in prohibited assets
4. Using your IRA as collateral for a loan or loan obligation
5. Taking action that directly or indirectly benefits you or a disqualified person rather than the IRA itself
Those five examples are not the only things prohibited in IRS code 26 USC § 4975. However, they are the ways in which self-directed investors most commonly commit prohibited transactions.
The best way to avoid committing a prohibited transaction is to obtain a legal opinion from a qualified expert on self-directed retirement accounts before making the investment. A qualified advisor should be able to tell you if any part of your proposed transaction is prohibited, taxable, or "dangerous" even if not outright prohibited. They should also tell you at what points in the future they should review the transaction again.
"Self-directed IRA law is incredibly specialized," observed Berry. "Your expert should have a long, long track record. If your attorney has not served hundreds (at least) of clients with self-directed IRA issues, you should keep looking."
Learn more about prohibited transactions from the SDI Primer on Prohibited Transactions at www.SDIMagazine.com.