The Roommates

Joe and Mary are married and each of them has an IRA. They decided that a single family rental property would fit into their retirement portfolio.

They both had enough money to make the purchase individually, but they decided that they would like to have income for both IRAs at the same time. They completed the necessary documentation to have their self-directed IRA custodian make the purchase for an undivided 50% interest for each IRA. The income from the rental was $1,500 per month; each of the IRAs would receive 50%, or $750. The cash return on the investment was 8%, and they were happy with this. They also knew that the property would appreciate in the area they purchased the rental.

The rental agreement was year to year, with a 5% increase annually.

Everything went fine and Joe and Mary’s IRAs collected the $750 each monthly. The annual real estate tax payments they made totaled $3020. Maintenance was running $1,000 annually. Effectively this cost each IRA $2,010 annually, and was well within their projections of income to their IRAs.

After two years, their tenant decided to take a job in another city and did not renew his rental agreement with Joe and Mary.

Joe and Mary had the IRA advertise for renters, but they were unsuccessful for three months, and cash flow to their IRA from the rental dried up. They didn’t want to continue to have other cash in their IRA pay for the required monthly outlays. Mary’s daughter Jackie was attending college and needed to have a place to live. Joe and Mary decided to rent the property to Jackie and her three roommates. It was a great solution, as the three roommates would pay five hundred dollars per month each, Jackie could live in the dwelling rent-free, and Joe’s and Mary’s IRA would receive the rental income they needed.

Every month,¬†administrator received the rent from the roommates in a single envelope, and credited Mary’s and Joe’s IRAs. One month, Jackie collected the rents from the roommates but sent her own personal check to the bank to cover the payment. The bank immediately called Mary and Joe to ask what the $1,500 check from Jackie was related to. Mary and Joe said it was for the rental payment for the property.

Unfortunately for the IRAs and for Mary and Joe, this transaction was prohibited. Because Jackie is a family member she was a disqualified person and could not receive any benefit from Joe and Mary’s IRA investment. It doesn’t matter that someone else actually paid the rent; by rule Jackie was not permitted to live there. Had Joe and Mary just rented to four different roommates, there would have been no problem.

Disqualified persons, including family members, cannot receive a benefit from their IRA or plan. This includes rent-free use of a property the IRA owns.

The Condo in Maui

Steven and Susan really liked the income potential of a condo in Maui. They were able to purchase a condo/time share unit there and lease it out through a servicing company in Lahaina. The property, located in Wailea, cost Susan’s self-directed IRA $200,000 for her portion. The income would be an estimated $25,000 per year from vacationers, with a strong promise that the income would increase annually.

Susan had rolled a large 401(k) from a previous employer into a traditional IRA. Because she wasn’t working, her income, along with Steve’s, was under $100,000 for the year. She decided to convert her traditional IRA, then worth $250,000, to a self-directed Roth. With loss carry forwards they had from previous years, and a mortgage interest deduction, their tax would only be $30,000. Steve and Susan paid the tax partially from a home equity line from one of their rentals, and partially from personal funds. So the income from the $200,000 investment would be tax free forever, as would the income from any other investment she made with the remaining $50,000 and income from investments made by her IRA.

Liking Wailea, Susan and Steven decided that they would take advantage of their time share, and made reservations for Hawaii through the leasing agent. The leasing agent sent the reservation to The administrator Group. administrator promptly called Susan and told her that their reservation had to be cancelled for their fall vacation, as their personal use of their condo, even on a time share basis, was prohibited. Susan’s administrator professional, Irene, explained that Susan could potentially loose her entire Roth IRA if she went through with her plans. However, Irene offered them an easy answer: Susan could rent any other unit that neither she nor any other disqualified person owned or had an interest in. It might not be the same as Susan’s unit, but it would not be illegal and Susan’s IRA would not be in danger of suffering a huge loss, including all her IRA funds, plus tax and penalties.

Susan and Steve had a great vacation in the condo complex, noticing, with satisfaction, as they walked by their IRAs unit, that a nice couple from Minnesota was renting it for a month!

Good Hunting

Terry and Ben were business partners and hunters. They decided to invest funds from their Individual (k) plan in a hunting lease in northern South Dakota, which they could sublease to other hunters. They were also were permitted to own a small hunting lodge on that lease. Because they thought this would be a good opportunity to make money in their 401(k) plan accounts, they directed the trustees of the plan to make the purchase of the lease and build a small lodge at the same time.

Using the Roth 401(k) deferrals in their accounts, they each contributed $20,000 through the plan to buy the lease and build the lodge. The trustee of the plan executed the purchase through the third party record keeper for the plan, administrator Group, which perfected the lease and building in the name of Duckblind LLC 401(k) plan for the benefit of Terry and Ben Roth 401(k) accounts. Ben and Terry were happy not to have to do the paperwork on that one.

On a trip to another hunting lease belonging to friends in North Dakota, Ben and Terry decided they would stop by and help fix up the lease and lodge owned by their Individual 401(k). A friend, Gordy, accompanied them. Ben and Terry were lucky Gordy came along. It turns out that Gordy was a pension consultant. Lucky, because Ben and Terry were about to enter into a prohibited transaction with their 401(k)! Gordy explained that they couldn’t work on their lease, or the lodge, nor could they hunt on that particular lease either.

Enlightened about what they could and could not do on the property held by their self-directed Individual(k), Ben and Terry traveled on to a lease not owned by them or any other disqualified person, where they enjoyed great hunting!

Trying to Get Around the Rules

Al has a great investment property in a major city that he purchased several years ago for $20,000. However he realizes that his tax benefits would be much greater if his self-directed Roth IRA owned the property. Al cannot have his Roth IRA buy the property from him without a Prohibited Transaction Exemption. He is not confident the Department of Labor will permit this, so he sells the property to his good friend Mark.

Mark is not aware that Al is trying to get around the prohibited transaction rule by doing this. Al simply tells Mark that he needs to transfer some assets and that he will sell the property to Mark for $20,000. Al will pay all costs, and he will pay Mark $2,000 for helping him out. The title company will record the property transaction in Mark’s name, and all title insurance, documentary fees, and transfer taxes will be paid by the seller, Al.

When the sale was recorded, Al directed his IRA administrator to purchase the property from Mark for $25,000. The IRA administrator worked with the title company to execute Al’s direction. During the process, Mark called up the IRA administrator and wanted to know how IRAs could buy and sell property, as he had never heard of this before. Mark mentioned to Kate, the administrator, that he was just doing this deal with his friend Al, and that he would like to do the same thing. Being responsible, Kate told Mark that she would look at the transaction more closely and let him know more, and of course he could buy and sell real estate with his IRA or 401(k) plan for that matter.

Here is the analysis: Al was right. The Department of Labor would not grant him a prohibited transaction exemption. The property was not being sold at fair market value, there was a commission involved, and it certainly was not an arms length transaction, just for starters. Further, Al was in the process of entering into a prohibited transaction with his IRA, and at the very least was violating the “indirect rule.” In essence that rule says: That which can be done directly should not be done indirectly. Mark told Al what he had learned after speaking with Kate. Al already knew, as Kate had already called Al when Mark phoned.

Al lost $5,000 because he thought that he could get around the rules. Mark didn’t want the property and quitclaimed it back to Al. However, Mark determined that self-directed IRAs were right for him and his real estate business. Having gotten first-hand education, Mark went on to do many successful deals through his IRA and 401(k). Al, having gotten an education too, teamed up with Mark to invest properly in real estate and note transactions using his Roth IRA. This time without trying to get around the rules.

The Kitchen Fire

Joe had his self-directed IRA purchase a triplex and had the IRA borrow 60% of the purchase price from national non-recourse lender. The triplex was fully rented, and the Net Operating Income was sufficient to make the $6,250 mortgage payments, plus Insurance and Real Property taxes.

About a month after the purchase, a kitchen fire started in one of the units. Smoke damage caused that unit plus one of the others to be uninhabitable until the damage was repaired and the units cleaned up. Joe’s IRA filed an insurance claim promptly, but the insurance company could not respond in time to meet the obligations of the IRA to pay the $6,250 mortgage.

Joe had only $2,000 left in cash in his IRA, but the mortgage payment was due. He decided to make the payment personally so that his IRA would not be in arrears. This could be considered an excess contribution. Joe was entitled to make a $5,000 contribution to his IRA during the year. He should have made that contribution to the IRA, and have the IRA pay the $6,250 to the mortgage company.

The next month turned out better. He didn’t have to have any more out of pocket expenses in his IRA, and the insurance paid the claims of loss to his IRA. Had Joe had another month of insufficient cash, he could have made contributions to his IRA, and claimed them as excess contributions, subject to an excess contribution filing, and 6% potential penalty annually, until the excess was removed, or contributions he was entitled to each successive year added up to the amount of the excess.

For this reason, it is always wise to have sufficient cash or liquid assets in his IRA to meet contingencies such as these.


Frank’s girl friend Edie had a mother who wanted to live close to her grandchildren, but couldn’t afford the cost of a town house. Frank decided to be a Good Samaritan and find a way to buy a townhouse for his girlfriend’s mother. I addition, Frank was about to get engaged to Edie. Frank learned that he could use his IRA to buy the property, but there wasn’t enough there to pay the $152,000 for the purchase. Edie however had the difference plus more. Edie thought that she would lend her boyfriend’s IRA $100,000 on an unsecured basis at 6% simple interest for 15 years, so that his IRA could buy the town house. Edie’s mother would rent the town house from Frank’s IRA at a rental rate that would pay the loan owed by Frank’s IRA to Edie plus condo fees, taxes and insurance.

Frank instructed his administrator to purchase the property for all cash. In addition he had his IRA execute a rental agreement with Harriet, Edie’s mother.
Is there a prohibited transaction in this case? Frank’s IRA received funds from his girlfriend, permitting his IRA to buy a townhouse, so that Harriet could live in it. Frank’s IRA got an asset subject to a non-recourse loan, and a non-disqualified person received the benefit of the home from her daughter. The IRA owner, Frank, did not receive any disqualified funds because Edie was not his spouse.

The only question remaining is: what if Edie and Frank get married? Harriet would then become his mother-in-law, that is, a family member. Perhaps then, the transaction would be truly prohibited.

Room for Expansion

Jeff had a growing medical practice and decided that he would close down his Defined Benefit Plan and convert it to a Defined Contribution Plan to cover himself and his employees.

He opened an administrator self-directed 401(k) plan. On filing the final tax reports, he rolled his plan balance into the new plan. His Defined Benefit Plan had $2.5 million to roll to his 401(k). Jeff opted to have an audited financial statement for his plan every year to keep everything completely clean. In addition, he offered his employees the ability to have in-service withdrawals after two years, and also to borrow personally from their account balances, up to the maximum of 50% of their account. He further allowed them to provide other security for the amount they borrowed.

All eligible employees were 100% vested in all contributions made by Dr. Jeff, as well as their own 401(k) deferral money. They could even roll their old 401(k) plan funds and IRAs into Dr. Jeff’s plan if they chose.
From all points of view, Dr. Jeff had a very flexible plan with all options that any employee could want. He also hired an administrator to take care of the plan needs for his employees and himself.

Dr. Jeff subsequently decided he would like to purchase an office building with part of his $2.5 million, and have it as income property. As Trustee of his plan, he directed himself (in the capacity of Trustee), in writing, to purchase a $3 million office building in a strip center. His local banker would lend him $1.5 million on a non-recourse basis, leaving $1.5 million from his self-directed 401(k) to fund the purchase. The office building would be owned beneficially by Dr. Jeff 401(k) plan, with Dr Jeff as trustee, for the benefit of Dr. Jeff.
Dr Jeff then reasoned he would be better off moving his medical practice into the building, as well as retaining the other tenants. One of these tenants was a foreign exchange business owned by his wife Juanita.

While planning the lease agreements and amount of space Jeff would need, his lawyer, Chuck, saw that Dr. Jeff’s 401(k) plan would be the owner of the building. Chuck informed Dr. Jeff that his planned expansion was not permitted. Chuck told Dr. Jeff that he could have his 401(k) plan administrator use a portion of the office building for plan administration. Of course this hardly met Jeff’s expectations of the number of businesses he would be able to include in the building, but it kept the transaction legal. Even more, Juanita had to move her business out of the building before closing. Her continued use of the property owned by her husband Jeff’s 401(k) plan constituted a prohibited transaction.

The news wasn’t all bad. Because the debt involved in the acquisition of the property was for his qualified plan, the debt portion would not be subject to Unrelated Debt Financed Income Tax. Not a huge consolation, but at least Jeff preserved the integrity and tax-deferred status of his account!

Quick Takes

  • Your IRA makes a loan to a relative (do you mean a sister or brother? If so has to be explicit) to purchase her home. Although the Internal Revenue Code states disqualified persons include ascendants, descendants and spouses thereof, you should not take the risk. The IRS also has issues with people who may influence an IRA or qualified plan owner’s decisions, including siblings.¬†
  • Your wife’s brother bought the house they grew up in from their parents, four months ago, when they moved to Florida, and turned it into rental property. He had a bad experience as a landlord and decided to sell it. Your wife’s IRA bought the house from him and then rented it out to their aunt. Asking for a self interested prohibition (not a complete sentence).
  • Your Individual (k) plan purchased a condo in the mountains of Colorado. Your Plan rents the condo out to vacationers for $1,200/week. With family vacations in the summer, hunters in the fall, and skiers in the winter you have almost no vacancies except during the month of May. With all of that use it is in need of minor fix-up – paint-up – clean-up every year. You definitely do not stay at the condo, and work on the maintenance. Stay anywhere during your vacation except at a property owned by your plan or IRA.
  • You are the owner of 40% of the stock of Widgets, Inc., a C-Corp., but serve in no other capacity with the company. The company is growing very rapidly & needs to expand. Sprockets, Inc., who owns the building next to Widgets, Inc., files bankruptcy. The building is put up for sale at a significant discount to fair market value, by the bankruptcy court. Widgets, Inc. is short of funds and doesn’t have a track record long enough to satisfy the bank. So, your IRA buys 75% of the building for cash, and Widgets, Inc buys 25%. Your IRA then leases it’s 75% to Widgets, Inc., at fair market rents & gives them an option to buy out its 75% within five years, at today’s fair market value, for $10,000 in option consideration. Avoid this prohibited transaction. If it has that much value, take a distribution from your IRA, pay the tax and then make the investment.
  • Eric wants to buy tax liens and has created an LLC in which he owns 50% of the shares. His IRA owns the remaining 50%. Eric instructs the administrator to purchase the shares (from whom, the LLC?) for $30,000. Eric purchases the remaining 50% of the shares with a home equity line of credit for $15,000. (need to clarify in each case who the shares are being purchased from.) Sounds easy, but you may never buy or sell assets for or to your IRA, unless you receive a Prohibited Transaction Exemption from the Department of Labor.
  • Lloyd and Mary personally are members of an LLC which bought a property in Denver about 5 years ago. The ownership of “1095 Lincoln Ave LLC” consists of 4 couples, each of whom invested $30,000 in the venture to own 25% of the entity. One of the couples is troublesome and the other members are tired of dealing with them. It is likely that the difficult couple would be interested in selling their share to the other members at fair market value which they have determined to be $50,000. If Lloyd and Mary’s children have Roth IRAs with an aggregate value of $50,000, they tried to buy out the 25% share of the LLC and get rid of this problem for their parents. Fortunately, the administrator was able to let them know that it wouldn’t work for their disqualified children to buy into this LLC.
  • Candy and Bo partner their IRAs together to purchase a condo in Maui. They have owned it for several years and would like to at last enjoy vacationing there but only over one winter. They would like to distribute the property from their plans and within 60 days roll it back into their plans and use it during the 60 day distribution period. This is probably the only way to live in the Maui condo that the IRA owned. The property must be legally distributed, deeded, tax withholding paid, and rolled back in 60 days or less. If you pay the withholding from the IRA, you need to get it back from the IRS through your 1040 income tax return.