Disqualified Persons
A "Disqualified Person" is an individual or entity, as defined by the IRS, legally prohibited from engaging in certain transactions with a self-directed retirement account to prevent self-dealing and conflicts of interest.
Key Takeaways
- Disqualified persons are individuals or entities legally prohibited from transacting with self-directed retirement accounts (SDIRAs, Solo 401(k)s) to prevent self-dealing.
- The definition includes the account holder, their spouse, lineal ascendants and descendants (and their spouses), fiduciaries, and entities they control.
- Any transaction with a disqualified person is a 'Prohibited Transaction,' leading to severe tax penalties and account disqualification.
- Examples of prohibited transactions include buying/selling assets to disqualified persons, or allowing personal use of retirement account assets by disqualified persons.
- Due diligence and professional advice are crucial to identify and avoid disqualified persons in all self-directed real estate investments.
What are Disqualified Persons?
In real estate investing, particularly when utilizing self-directed retirement accounts like a Self-Directed IRA (SDIRA) or Solo 401(k), a "Disqualified Person" refers to an individual or entity that is legally prohibited from engaging in certain transactions with the retirement account. These rules are established by the IRS under ERISA (Employee Retirement Income Security Act) to prevent self-dealing and conflicts of interest, ensuring the retirement account's assets are used solely for the benefit of the account holder's retirement.
The primary goal is to prevent the account holder or closely related parties from personally benefiting from the retirement funds outside of the legitimate growth of the investment. Any transaction between a self-directed retirement account and a disqualified person is considered a "Prohibited Transaction" and can lead to severe tax penalties, including the disqualification of the entire account.
Who Qualifies as a Disqualified Person?
The IRS defines a broad range of individuals and entities as disqualified persons. Understanding these categories is crucial for investors to avoid inadvertent violations.
- The account holder and their spouse: This includes the individual who owns the SDIRA or Solo 401(k) and their legal spouse.
- Ascendants and Descendants: Parents, grandparents, children, grandchildren, and their spouses. This covers direct lineal relatives.
- Fiduciaries: Anyone who provides investment advice for a fee, or has discretionary authority or control over the account's assets, such as the trustee or custodian of the SDIRA.
- Entities controlled by disqualified persons: Any corporation, partnership, trust, or estate in which disqualified persons own 50% or more of the beneficial interest.
Real-World Example: Avoiding Prohibited Transactions
Consider an investor, Sarah, who has a Self-Directed IRA with $200,000. She finds an excellent rental property for $180,000 and wants her SDIRA to purchase it. Her brother, Mark, owns the property. Because Mark is Sarah's sibling, he is considered a disqualified person. If Sarah's SDIRA were to purchase the property directly from Mark, it would constitute a prohibited transaction.
Similarly, if Sarah's SDIRA owned a rental property and she, her spouse, or her children lived in it, even if they paid market rent, it would also be a prohibited transaction. The retirement account cannot directly or indirectly benefit a disqualified person. This means no personal use of assets, no buying assets from or selling assets to disqualified persons, and no providing services to disqualified persons using SDIRA funds.
Consequences of a Prohibited Transaction
If a prohibited transaction occurs, the IRA or Solo 401(k) loses its tax-advantaged status as of the first day of the tax year in which the transaction occurred. The entire fair market value of the account's assets is then considered a taxable distribution to the account holder. This means the investor would owe income tax on the full amount and, if under age 59½, potentially a 10% early withdrawal penalty. This makes understanding and adhering to disqualified person rules paramount for self-directed investors.
Frequently Asked Questions
Who specifically is considered a 'disqualified person' by the IRS?
A disqualified person is defined by the IRS and includes the account holder, their spouse, lineal ascendants (parents, grandparents) and descendants (children, grandchildren) and their spouses, as well as any fiduciaries to the account. It also extends to entities (corporations, partnerships, trusts) in which these individuals hold a 50% or greater interest.
What types of transactions are prohibited with a disqualified person?
A prohibited transaction is any direct or indirect transaction between a self-directed retirement account and a disqualified person. This includes buying property from or selling property to a disqualified person, providing services to a disqualified person, or allowing a disqualified person to personally use an asset owned by the retirement account (e.g., living in an SDIRA-owned rental property).
What happens if an investor engages in a prohibited transaction with a disqualified person?
The consequences are severe. The retirement account loses its tax-advantaged status, and the entire fair market value of its assets is considered a taxable distribution to the account holder. This results in immediate income tax liability and potentially a 10% early withdrawal penalty if the account holder is under 59½.
How can investors ensure they avoid prohibited transactions with disqualified persons?
To avoid issues, always conduct thorough due diligence on all parties involved in a transaction with your self-directed retirement account. Consult with a qualified SDIRA administrator or tax professional to confirm that no disqualified persons are involved, directly or indirectly, in any aspect of the investment or its ongoing management.