Factual Situation: You are the owner of an IRA with substantial assets. You are also the owner of several vacant building lots whose present value is substantially less than your tax basis/acquisition cost. These building lots were purchased using a loan from a commercial lender that has a very high interest factor but the lots do not secure the loan. Your query is whether the IRA can purchase the assets and the proceeds from the sale be used to pay down (50%) of the loan and perhaps re-negotiate the loan.
Issue #1: Can the IRA purchase real estate such your building lots?
Answer: Yes, but there are a few caveats. Most IRA administration companies do not allow the IRA to purchase assets, such as real estate, in any type other than securities or interests in partnerships or property that are traded on public markets. However, self directed IRAs are permitted by the IRC and there are now many companies who offer these services.
Issue #2: Is purchasing the lots from myself by my IRA a “prohibited transaction” that will subject me to penalties?
Answer: Yes. And it makes no difference whether the lot is owned by your spouse or whether the IRA is owned by her. Prohibited transactions are of two types: property and/or parties. An example of a prohibited asset would be a life insurance policy (but not an annuity) regardless of the identity of the seller of the policy. An example of an asset purchased from a prohibited party would be one from yourself, your spouse, your children and grandchildren (includes their spouses), your parents and grandparents, your fiduciary (usually a trustee), an entity (corporation, LLC, LLP, LP or partnership) in which you own directly or indirectly 50% or more of the equity (this latter group includes those held by a fiduciary or service provider such as a CPA, financial planner, etc), and an entity that is a 10% or more partner or joint venture of an entity that is 50% or more owned directly or indirectly or held by a fiduciary or service provider.
The penalties include the re-characterization of the consideration paid as taxable income, the payment of any applicable early distribution penalties, any other penalties and interest charges by reason of your income taxes being understated or paid late, and a 15% prohibited transaction penalty.
Issue #3: If the real estate is sold to a party who is not a prohibited party and that party then sells the real estate to my IRA, is that a prohibited transaction?
Answer: No, providing both transactions when taken together are not deemed to subject to the “Step Transaction Rule”. This court made doctrine allows the IRS to merge the two transactions as if they were both done at the same time. In this case, the result from the application of the rule would be a prohibited transaction. This doctrine is always a concern in any complicated multi-stage transaction and experienced counsel can, in almost all cases, avoid its application by careful planning.
Issue #4: What can be done to avoid the step transaction rule?
Answer: Several things. There is no check list of items that creates a safe harbor. But the case law reveals that the typical steps are (i) the elapse of a significant time period between the transactions during which market and other forces can affect the economics of each transaction; (ii) making sure there is no oral or written agreement between the parties to carry out the transactions in a particular way to achieve a particular tax result; (iii) the parties have to be unrelated both before and after the transactions; and (iv) constructing the transactions in the form and manner of analogous commercial transactions.
Issue #5: What is the best way for a self directed IRA to hold and manage non-market traded assets such as real estate, business investments in partnerships, joint ventures and privately held stock?
Answer: The IRA organize an LLC as a single member entity with the IRA holder being the sole manager. There is a caveat however, the recognition of this method for managing IRA assets has not been given regulatory approval by the IRS and the one or two cases on the subject are unclear. Nevertheless, it has become a common practice. With careful planning and operation of the IRA any possible negative outcomes can probably be avoided.
Issue #6: With the above considerations in mind, is it possible to avoid the prohibitions and issues identified above?
Answer: Yes, but there are unavoidable risks which is the very reason the step transaction rule would be held not to apply. The risks are that the purchaser could sell to some third party for their use or investment and not to your IRA.
Issue #7: If one of the lots had a vacation home on it, could it be used by the IRA owner or any of his family or extended family?
Answer: No. See the answer to Issue #2. It would make no difference whether market rent was paid or not. The result would be the same.
Issue #8: If the lots secured the loan and the loan was paid in whole or in-part, would this be a prohibited transaction? Would there be other issues?
Answer: Yes. It would be a prohibited transaction. In certain se to narrow circumstances debt is permitted providing it is not a co-obligation or guaranteed by the IRA owner or a prohibited person.