In ERISA Advisory Opinion Letter No. 2011-04A, the Department of Labor's (DOL's) Employee Benefits Security Administration (EBSA) has determined that an IRA's proposed purchase of the IRA owner's promissory note and a deed of trust held by the bank which had financed the IRA owner's purchase of real estate would be a prohibited transaction. EBSA reasoned that, so long as payments were due on the note, the transaction would create an impermissible extension of credit from the IRA to disqualified persons.
Background. The direct or indirect lending of money or other extension of credit between a self-directed IRA and a “disqualified person” is a prohibited transaction. A disqualified person includes a “fiduciary” (i.e., any person who exercises discretionary authority or control over the plan's management or disposition of plan assets), a fiduciary's spouse or other family member, and a trust in which 50% or more of the beneficial interest is owned directly or indirectly by a fiduciary.
Any direct or indirect transfer to, or use of plan assets or plan income by or for the benefit of, a disqualified person, is also a prohibited transaction. In addition, a fiduciary is prohibited from dealing with the income or assets of a plan in his own interest or for his own account.
Facts. In 1993, Donald and Betty Warfield (the Warfields) bought an interest in an eight-unit apartment building in San Diego, California, for $200,000. They financed the purchase with a loan from Chase Bank (evidenced by a promissory note) amd secured by a mortgage on the property. The title to the property was held by a family trust of which Donald was the trustee and he and Betty were the sole beneficiaries. Title to the property was encumbered by a deed of trust used to secure the note held by the bank.
For years, Donald maintained an IRA of which he was the sole participant and Betty was the sole beneficiary. Donald had sole discretion over the IRA's assets.
Proposed transaction. Donald proposed that his IRA purchase the note and deed of trust held by Chase Bank. Upon the IRA's payment, the bank would have assigned the note and the deed of trust directly to the IRA. A third-party commercial bank, acting as custodian for the IRA, would have received the monthly payments on the note from the Warfields and enforced provisions of the note and deed of trust. The transaction would have been structured to avoid any new loan or other extension of credit between the IRA and the Warfields.
Conclusion. EBSA determined as an initial matter that Donald was a fiduciary and a disqualified person with respect to the IRA because he had sole discretion to direct the IRA's investments. Betty was also a disqualified person, as was the family trust because Donald and Betty were its sole beneficiaries. Thus, the proposed transaction would be a prohibited transaction since the IRA's acquisition of the note from the bank would essentially create an ongoing debtor-creditor relationship between the IRA and disqualified persons until all amounts due on the note were paid.
EBSA further determined that the IRA's purchase of the note was itself a prohibited transaction since it would be part of an agreement, arrangement, or understanding in which the fiduciary caused plan assets to be used in a manner designed to benefit the fiduciary (or persons in which the fiduciary had an interest). EBSA found that under the facts of this case, Donald, as the IRA owner and fiduciary, would have an understanding that the assets of the IRA were being used to create a prohibited transaction (i.e., an ongoing debtor-creditor relationship between the IRA and disqualified persons).
While self-directed IRAs allow many diverse types of investments, account holders need to be acutely aware of the rules against prohibited transactions. The penalties for prohibited transactions can be very severe.
For more information regarding self-directed IRAs, contact F. Moore McLaughlin, Esq., CPA at 401-421-5115 ext 212 or by e-mail at