Generally, a prohibited IRA transaction is any misuse of an IRA account or annuity by the owner of the IRA, its beneficiary, or any disqualified person. One of the most common prohibited transactions is known as automatic trading, which is when the owner of an IRA tries to do business with himself. You can't buy or sell property, you can't lend you money from the IRA, and you can't pay any IRA expenses or take any IRA income personally. You cannot use any IRA assets for personal gain in any way, this is a prohibited transaction.
In essence, prohibited transactions do not limit WHAT an IRA can invest in, but rather WHO an IRA can transact with. For example, an IRA can buy rental property at a good price from a friend, but that same IRA can't buy property owned by a parent, spouse, or child. In general, if the holder of an IRA (owner of an IRA) or the beneficiary of an IRA makes a transaction that violates the rules of prohibited transactions set out in section 4975 of the Internal Revenue Code, the individual's IRA would lose its tax-exempt status and all the fair market value of the IRA would be considered a taxable distribution, subject to ordinary income tax. Fortunately, the reality is that prohibited IRA transactions are quite rare, due to the simple fact that the vast majority of IRA assets are only invested in traditional publicly traded securities, where a prohibited transaction is generally not feasible in the first place.
Certain transactions and levels of participation between the owner of the IRA (or a disqualified person) and the IRA are also prohibited. The reality is that the transaction rules prohibited for IRAs have existed for as long as the IRAs themselves have existed. And, of course, it would be forbidden to attempt to transfer existing real estate from the owner of an IRA to the IRA (since even the sale of the real estate at a fair market price by the owner of the IRA to the IRA is still a prohibited transaction, since the owner of the IRA is still a disqualified person). And the IRA itself must pay for those services with the IRA's own cash, since the owner of the IRA paying for the services on behalf of the IRA asset would again be a prohibited transaction or, at least, a considered contribution.
In addition, since an IRA is intended to be treated as a retirement account with tax preferences separate from the IRA owner's other assets, the Internal Revenue Code also contains a series of “prohibited transactions” rules designed to prevent the IRA owner from using the account to enrich himself or his family members (without actually making a taxable withdrawal). In addition, most IRA custodians or fiat IRA providers only offer “traditional investment opportunities”, when, anyway, there is virtually no possibility of initiating a prohibited transaction. Which, once again, can be considered a prohibited transaction and disqualify the IRA (since the owner of the IRA would be a party to the prohibited transaction). In fact, the GAO expresses concern that some types of alternative investments are sold in self-directed IRA accounts in a way that enriches the seller or promoter if the transaction closes, but denies any liability if the investment turns out to be a prohibited transaction, since in situations where the self-directed IRA provider offers “control of the checkbook”, ultimately, it remains the owner of the IRA to determine that all and each of the checks comply with the transaction rules prohibited.
In addition, it is essential to recognize that, for a transaction to be considered a prohibited transaction, only one of the above-mentioned exchanges need to take place between the owner of the IRA (or another disqualified person) and the IRA. This means that it is time to be more aware of the risks of prohibited transactions and of the situations that can trigger them, not only with regard to self-managed IRAs and the increasing use of various types of “alternative investments” that may have adverse consequences, but also to “simpler” situations, such as possible prohibited transactions with financial advisors who are compensated for investing the IRA dollars of family members. In other words, “ignorance” is no excuse when it comes to prohibited IRA transactions, nor are the assurances of a self-directed IRA provider about the viability of holding several alternative assets in a self-directed IRA. .