Question:

Quincy,

I don’t know how “indirect” is defined, exactly and to what extent it stretches.

Here’s the scenario.

Kyle has a co-worker, Jim, who is considering investing with us via a note and self-directed IRA.

We are also considering working with Jim and kids in some real estate transaction where the kids manage a property we acquire in the future.

If Jim’s IRA has an option on a property or a holds a lien/note on a property but does not have ownership (3rd party/we own), can his children live in the property or manage it?  I’m guessing this is a no because it could be considered an indirect benefit.

Is there any scenario where something like this could work?  What if we give his IRA a lien on a property we own, Property A?

Then, at some point in the future, we buy a new property, Property B, maybe using some of the cash we received from Jim’s IRA, some from our w-2 income (all coming out of our bank account) but his IRA has no relation to new property B.  Could Jim’s kids be involved in living or managing the new property?  These wouldn’t be concurrent transactions, nor contingent on one another, nor identical in value.  So, it seems to me like there wouldn’t be a problem.  Once the cash is infused into our bank account it becomes our money, right? How could you say that part of our bank account belongs to Jim?  We could use it to buy another property at some point as it’s now our money.  If Jim’s kids are involved in a future transaction with us, then that shouldn’t be a problem at that point, right?

Answer:

I would definitely say that if Jim’s IRA had a lien or even an option on a particular property that it is not a good idea for them to live in or manage that property.  Some people would probably argue with me about that, but I try to take a conservative approach on these issues.  You make a very good point when you say that you don’t know how “indirect” is defined, exactly, and to what extent it stretches.  The best sense I can give you is that if as a result of an IRA investment a benefit accrues to a disqualified person, then that may be considered to be a prohibited transaction.  Unfortunately there isn’t much guidance on the issue, except for the few cases and Advisory Opinion Letters from the Department of Labor.  In case you are a nerd like me and want to go to the source, I have attached my 2012 IRA Entity Investments paper which describes the rules and has what I consider to be major cases attached to it.  This whole discussion reminds me of that famous quote from Supreme Court Justice Potter Stewart in 1964 when discussing how to define obscenity.  In the opinion, he wrote:

 

I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description [“hard-core pornography”]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that. [Emphasis added.]

—Justice Potter Stewart, concurring opinion in Jacobellis v. Ohio 378 U.S. 184 (1964), regarding possible obscenity in The Lovers.

As applied here, it may be very difficult, if not impossible, to intelligibly define what an “indirect” benefit is, but the IRS will know it when they see it!

I get the sense of what you’re saying below.  Obviously the more disconnect there is between Jim’s IRA money and his kids the better.  I am not saying that just because Jim loans you money you can never enter into any transaction with Jim’s kids.  I’m simply saying that there can be no direct or indirect connection between the two events.  In the end I am not the arbiter of what is or is not prohibited.

I appreciate so much that you are asking questions and trying to get a sense of what the rules are.  I realize that I may be frustrating you by not telling you “the answer” but all I can do is provide some education to you (and indirectly to Jim).  In the end Jim will have to make his own decision.