Prohibited transaction blows up IRA

Prohibited Transaction Blows Up IRA Bankruptcy Protection

Prohibited Transaction the Culprit: Court Rules IRA not Protected

In a relatively recent court case, Kellerman v. Rice (9/14/2015) the US District Court (E. Arkansas) ruled that the couple seeking bankruptcy would not be able to protect their IRA due to an improper real estate deal. Therefore the IRA assets, which would have been normally protected from creditors under bankruptcy laws, would be exposed to claims of creditors.

Self Dealing – A Prohibited Transaction

The Kellerman’s used IRA money to buy land.  This can be ok if the proper rules are followed. However, in this case they were not. The Kellerman’s IRA bought into an LLC that the Kellerman’s owned and since they controlled the LLC, this was a “prohibited transaction.”

Blowing Up Your IRA

Prohibited Transaction Blows Up IRA Bankruptcy Protection
Prohibited transaction blows up an IRA (courtesy Andrew Kuznetsov)

If you want to buy real estate with IRA funds, you must use IRA money only. If you need to take a loan to buy or develop that real estate, then the loan must be backed by the IRA only.  An investor can not sign off on an IRA loan personally. If an investor tries to mix IRA money with personal non-IRA money, KABOOM! This prohibited transaction will blow up the IRA.

Think of it like the separation of a corporation from personal. If you commingle activities, you could lose the corporate “veil” of protection.

That means, the IRA could lose its tax-advantaged status! The entire balance potentially becomes immediately taxable that year. And outside of an IRS Ruling, it’s unlikely this can be fixed. Especially if it was your fault! Imagine the additional tax when your $750,000 IRA becomes immediately taxable!

Furthermore, if the IRA loses its status as an IRA, the funds lose the asset protect privileges of IRAs under Federal and/or state asset protection and bankruptcy laws.

What You Should Consider

Prohibited Transaction Blows Up IRA Bankruptcy Protection
Photo Courtesy of LendingMemo

If you are contemplating investing in non traditional assets for your IRA, like real estate, gold bullion or shares in a small company, understand the rules. I heard stories about an expert on IRAs who invested in his own pub! he manages the pub himself and (I am fairly certain) pays himself a salary from that pub. You can’t do that! If discovered his IRA will blow up!

Even the experts can mess this up. So understand that this stuff is complicated. Seek experienced advice. And understand that in many cases, investing through the IRA may not be optimal.

Another Note of Caution on IRA Investing

better with a financial advisor
5 questions to ask when considering hiring a financial advisor

There are so many tax break on real estate that it often makes more sense to invest outside the IRA. Benefits like

tax deductible, interest on mortgages; and other expenses, along with depreciation and Section 1031 exchanges, make using an IRA less attractive. If the only cash you have is in an IRA, then you should be extra cautious about doing this.

Seek qualified counsel when dealing with your IRA. Some mistakes are irreversible. 

Fools rush in where angels fear to tread. Do you have questions?  Would you like to inquire about working and planning with retirement planning expert Chris Grande? Go to Chris’s inquiry page HERE.

Want more information about IRA’s? We have some resources for you:

6 Inherited IRA Mistakes to Avoid

Why Your Teenager Should Consider a Roth

IRA Rollover vs IRA Transfer – Don’t Make This Mistake (updated ruling!)

Presenting the Roth IRA Video