Prohibited Transactions Solo 401k

Self-Directed Solo 401k Prohibited Transactions Review and Illustrations

Summary

The self-directed 401k plan is often overlooked because the most common retirement plans for the self-employed have traditionally been the SEP IRA and the SIMPLE IRA. While IRAs are generally less expensive to adopt and administer, they generally don’t allow for high contributions or as broad investment types as defined contribution plans such as the solo 401k plan.

Even though you can invest your solo 401k (referred by other names such as small business 401k, self-employed 401k, owner only 401k, Solo K, etc.) in many types of alternative investments (e.g., real estate, notes, LLC, Gold, etc.), you still must be careful not to engage in prohibited transactions when investing your Solo 401k. A transaction is deemed prohibited if it benefits you, as trustee/participant of the Solo 401k plan, or other disqualified persons such as your beneficiary, spouse, son, daughter, father or mother, to name a few.

Simply stated, any transaction that does not only benefit your solo 401k, but instead you personally or someone you know who is defined as a disqualified individual by the IRS will be deemed prohibited.

Self-Dealing

Prohibited transactions are often referred to as “self-dealing.”

This means your Solo 401k/self-directed 401k is prohibited from engaging in transactions that benefit you, your direct family, or your business. The negative consequences to your Solo 401k include tax penalties and loss of tax deferred status. Simply put, prohibited transactions are investments or forms of self-dealing that would put the government at risk of losing its tax on the solo 401k. To be clear, prohibited transactions only occur when funds within your solo 401k are used improperly. You can always withdraw from your solo 401k, pay the tax (and penalty if you are under 591/2 and no exceptions apply) and spend the money any way you wish, because now the government got their tax and the money you are spending is no longer solo 401k money. They worry when you spend money within your solo 401k on certain items because they think you might just be planning to beat them out of the tax that you would have paid on a solo 401k distribution.

Prohibited Transactions Examples

Real estate

The rules prohibit your Solo 401k / Self-Directed 401k retirement account from holding property in which you or disqualified persons currently occupy or plan to occupy. In other words, the property must be for investment purposes only.

Illustration 1

A lease between Solo 401k plan and daughter of Solo 401k plan trustee

Matt’s Solo 401k owns an apartment building. One of the tenants is his daughter Susan. As a party-in-interest, Susan’s leasing of the apartment is a prohibited transaction because the apartment is Solo 401k asset.

Illustration 2

Sale or exchange or leasing of any property between a plan and a disqualified person

Jay holds a parcel of land in his self-directed solo 401k plan. He now wants to build a retirement home on the property. Jay wires funds from his self-directed solo 401k bank account to purchase the property. This investment would result in a prohibited transaction because Jay falls under the disqualified party category. You are not allowed to build your own home on a parcel of land owned by your solo 401k plan.

Private company

Your Solo 401k / self-directed 401k can’t purchase private shares (for example, company shares that are not traded in a public exchange such as New York Stock Exchange or NASDAQ) in your own business or of a disqualified person (e.g., your son, daughter, father and mother to name few).

Illustration 1

The purchase of shares by Solo 401k in your own corporation

John personally owns 15% interest in a private corporation that he manages. Two years later he decides to use his Solo 401k plan to purchase Nick’s, another shareholder, 20% worth of shares. This is a prohibited transaction because John already owns and manages the corporation.

Illustration 2

Susan uses assets from her self-directed 401k plan to purchase 100,000 shares of a new private
law practice. Because of this investment, Susan is elected to the board of directors and is named
general counsel (i.e., trustee/fiduciary dealing with the income or assets of a plan in her own
interest or for her own account).

Promissory Notes

You can’t loan your Solo 401k or self-directed 401k funds to a disqualified person such as your father, mother, son, or daughter for example.

Illustration 1

promissory note to daughter

Tina loans $50,000 from her Solo 401k to her daughter charging her 10% interest per year. This is considered a prohibited transaction because Tina’s daughter is considered a disqualified person.

Illustration 2

Lending of money or other extension of credit between a plan and a disqualified person.

Sue’s solo 401k plan has a balance of $100,000. Her father recently started a new business and needs a short-term loan to cover payroll. Sue offers to loan $60,000 from her solo 401k to her father in a form of a promissory note paying 8 (eight) percent interest in 12 monthly installments. This investment deemed prohibited because Sue’s father falls under the disqualified party umbrella.

Family Member

Illustration 1

While helping a family member is something one should not have to think twice about, helping a family member with your solo 401k plan can result in a prohibited transaction under the Internal Revenue Code (the “Code) and the ERISA rules.

For example, a son asks his mother, who is an advisor at a broker-dealer, to manage his self-directed 401k plan, any compensation paid to the mom would be a prohibited transaction. That is, the son is causing a family member – a person in whom he presumably has an interest that could affect his fiduciary judgment – to receive compensation.

Such transaction is considered a prohibited transaction because the mother is a “member of the family” of the fiduciary (the son). The Code defines a family member as the fiduciary’s “spouse, ancestor (e.g., parent or grandparent), lineal descendant (e.g., child, grandchild), and any spouse of a lineal descendant.”

Such transaction would not run afoul with the prohibited transaction rules, however, if the advisor (the mom) did not receive compensation for the advice.

In sum, advisors (and their firms) should not provide advice to family members about transferring their IRAs or 401k plans or about investing their solo 401k or IRA assets… unless they waive compensation for the advice.

Roundabout Transactions; Direct vs. Indirect Prohibited Transactions

A roundabout transaction occurs when the Solo 401k participant/trustee structures one or more transactions with the purpose of making a prohibited transaction. A disqualified person may not indirectly do what cannot be done directly.

If a transaction directly violates the prohibited transaction rules, changing the transaction to remove
the disqualified person from direct involvement would still deem the transaction prohibited. Put differently, merely insulating that person from the transaction and enlisting a third party does not make a prohibited transaction allowable.

Illustration 1

You loan money from your Solo 401k /self-directed 401k to your friend (who’s not a disqualified person), and he or she then turns around and loans the same funds to your mother. This is considered a roundabout transaction and viewed by the IRS as not only prohibited but also as an attempt to evade the tax rules because you can’t loan money from your Solo 401k to your mother, even if you first loan it to your friend (who’s not a disqualified person), who then loans it to your mother.

Illustration 2

Thomas used his self-directed solo 401k plan funds to invest in a condominium in Cabo San Lucas. Thomas has now reached retirement age now wants to purchase the condo from his solo 401k plan. Thomas direct purchase from the solo 401k plan is a slam dunk prohibited transaction because Thomas is a disqualified person, and the plan cannot have a sale between itself and a disqualified party.  Thomas sells the property to Jason Shepard, and individual unrelated to Thomas. Jason and Thomas, however, have agreed that Thomas will immediately purchase the property from Jason after the transaction between Jason and the 401k plan is completed. This is clearly an indirect prohibited transaction because a disqualified person (Thomas) attempts to circumvent the self-directed 401k prohibited transaction rules by inserting a third party (Jason) into the transaction.

Disallowed Investments

For the most part you can invest your Solo 401k / self-directed 401k in any investment type with the exception of the following:

Collectibles

A collectible includes a work of art, rug, antique, metal, gem, stamp, certain coins, alcoholic beverage, and musical instruments to name a few. The U.S. Treasury has the power to add to this list any other tangible personal property.

Click here to read our blog about the negative tax consequences of investing your Solo 401k in collectibles.

Permissible Investments

A defined contribution plan such as a Solo 401k plan may invest in an almost unlimited range of investments. However, the self-directed 401k plan document provider can limit the types of allowable investments that may be made under the solo 401k plan.  For example, a solo 401k plan provider such as Fidelity Investments, Charles Schwab, E-Trade, Vanguard and Oppenheimer only allow for common investments such as stocks, bonds and mutual funds. On the other hand a self-directed 401k plan document provider like My Solo 401k Financial provides a plan document that allows for any investment that does not fall under the disallowed investment category.  Examples of permissible self-directed 401k investments include notes, options, limited partnership interests, mortgages, real estate, tax liens, crowd funding, and life insurance to name a few. While the list of permissible solo 401k investments is extensive, the trustee of the self-directed 401k must avoid prohibited transactions when selecting various investments as the responsibility for selecting solo 401k plan investments falls on the solo 401k plan trustee.

Disqualified Persons

A “disqualified person” is defined as a fiduciary, you, a member of your family or any other entity such as a corporation, partnership, trust or estate that is 50% or more controlled by you or your family members.

For a solo 401k plan, you, the solo 401k owner, are a fiduciary. This is because you have discretion and control over the plan’s investments. In other words, you can’t blame it on the bank or solo 401k provider. If you misuse your solo 401k plan, it’s your fault.

The IRS considers the following as disqualified persons with respect to Solo 401k / self-directed 401k transactions:

  • Family members such as your father, grandmother (considered ancestors)
  • Your children, grandchildren (considered lineal descendents)

For a full list of disqualified persons visit here 

Tax Consequence of Prohibited Transactions

Whether you intentionally or accidentally subject your Self-Directed Solo 401k to a prohibited transaction, the tax consequences are the same—your Solo 401k will generally be subject to federal taxes, possible state taxes and penalties.

In sum, thread carefully when investing your Solo 401k, also commonly referred to as a Self-Directed Solo 401k, Self-Directed 401k, Individual 401k, Individual K, Single K, Single 401k or Self-Employed 401k, because of the many different possible ways of structuring alternative investments such as real-estate, private investments, promissory notes, etc.

Prohibited Transaction Exemptions

Prohibited transaction exemptions can be statutory, which apply to anyone who meets the statute requirements.

The most common prohibited transaction exemption is participant loans from a QRP such as a self-directed 401k pan. For these loan conditions, See IRC Sec. 4975(d)(1).

A prohibited transaction exemption can also be granted on an individual basis which are released as “PTEs” or as advisory opinions. Individual exemptions apply only to the individual or organization that applied for the exemption. Nonetheless, individual exemptions include the DOL’s interpretation of ERISA and applicable class exemptions.

Additional Information on Prohibited Transactions

The prohibited transaction rules are found both in the Internal Revenue Code (IRC) and in ERISA.

  • Click here to learn about prohibited transactions under ERISA.
  • To learn about prohibited transactions under Internal Revenue Code click here.

The following pages also cover the prohibited transactions rules:

A Primer on Prohibited Transactions

Can’t Personally Guarantee a Loan to Your Solo 401k Plan

Don’t Personally Improve Solo 401k Owned Real Estate

No Self-Dealing Allowed

No Personal Use of Solo 40k Owned Assets

Solo 401k Prohibited Transaction Analysis

Sample List of “Qualified” vs “Disqualified” Persons

Why Not Open a Self-Directed 401k Plan QUESTION:

Why should someone not open a self-directed 401k?

  • If you plan to perform sweat equity work on the property, you should not open a self-directed 401k plan.
  • If you plan to draw a salary for managing (e.g., collecting rent checks for deposit into the 401k plan, hiring contractors for performing repairs  or improvements on the 401k owned property, seeking tenants, etc.) the self-directed 401k owned property, you should not open a self-directed 401k plan.
  • You plan to use the self-directed 401k owned property for personal or business use even if you pay a fair market rent rate, you should not open a self-directed 401k.
  • You plan to have your children or parents use the self-directed 401k owned property for personal or business use even if a fair market rate rent is paid, you should not open a self-directed 401k.
  • You or your children or parents later plan to vacation in the self-directed 401k owned property.
  • You plan to sale, exchange or deposit real estate that you own personally or through your business, or your parent or children personally own or through their business into the self-directed 401k plan.

Exchange Promissory Note Investment QUESTION:

I currently have a Trust Deed Investment with a third-party borrower for $350,000 held by me in my individual name. The trust deed is paying me interest at a rate of 12%. The trust deed is a first trust deed collateralized by a property in Denver. I have held this trust deed investment since November 2015. The broker that has administered the trust deed investment with me is located in Tampa. They are my broker in this transaction. I would like my Solo 401k trust to hold this trust deed with instead of me. I just want to make sure this is OK. The Trust Deed investment note will then be in the name Solo 401k Trust and interest will be paid by the third to my solo 401k trust after the close of escrow.

Such investment would result in a prohibited transaction. You cannot assign an investment that you personally own to your own solo 401k plan.

This would be in violation of the following rule.
“Sale, exchange, or leasing of property between a plan and a disqualified person.”
 The plan is your solo 401k, and you are a disqualified party. Other disqualified parties include the following.
  • Your Spouse
  • Your natural parents and/or your adoptive parents
  • Your natural grandparents
  • Your natural children and/or your adopted children
  • The spouses of your natural children
  • Any fiduciary of your Solo 401k
  • Any people providing services to your Solo 401k–such as your stockbroker–as well as his employees and both his and his  employees’ blood relatives
  • Your Solo 401k trust document provider or administrator

Investment Type QUESTION:

Can I invest my solo 401k in exotic cars? watches?

Good question. The IRS considers investing in cars and watches as disallowed investments. For a list of disallowed solo 401k investments, VISIT HERE.

Note Transaction with Spouse’s Solo 401k QUESTION:

Can my solo 401k trust loan money to my wife's solo 401k to take advantage of reinvesting/endorsing some tax liens? I don't think this is a prohibited transaction since my solo 41k would be lending to her solo 401k, not directly to my wife. Is that correct?

Unfortunately, it would still be prohibited for your solo 401K to lend funds to your spouse’s solo 401K. Unfortunately, there is no way around this rule. The IRS still views your wife’s solo 401k as a disqualified party because the solo 401k is for her benefit. Also, the rules do not allow for a solo 401k to obtain a loan for investing in tax liens or notes. However, the solo 4o1k plan can obtain a non-recourse loan when investing in real estate.

Pledge QUESTION:

I am trying to buy my mother a condo that she can use for her retirement. Can I pledge some of my solo 4o1k funds or assets as security for a bank loan?

Self-directed 401k owners may not pledge any portion of their solo 401k assets as security for a loan. See (IRC Sec.408(e)(3) and (4)). If such transaction takes place, only the pledged portion is considered distributed and is subject to tax and a 10 percent early distribution penalty tax if you are under age 59 1/2.

Guarantor on Loan to My Solo 401k QUESTION:

The solo 401k trust purchased a rental home. Can the solo 401k obtain a mortgage secured by the property? Also, the lender wants me to sign as a personal guarantor on the loan. Can I do that?

No such transaction is not allowed because your are a participant of the solo 401k plan; therefore, you are deemed a disqualified party and disqualified parties cannot guarantee a loan to their own solo 401k plan.

Investment Real Estate Swap QUESTION:

I have a younger brother who is interested in learning more about solo 401k accounts. We are each interested in buying real estate as our asset within our solo 401k accounts. My brother owns investment property. Can my Solo 401k Trust buy his personal investment property? If so, can my Solo 401k Trust hire my brother's property management company to manage the property after my solo 401k trust purchases it? I also personally own investment property. After my brother sets up his own solo 401k trust, can his solo 401k buy my investment property? We are not buying each others' personal residence...we are buying investment properties from each other. Is that compliant with the rules?

Good question. However, such transaction would run afoul with the prohibited transaction rules. While it is true that siblings are not disqualified parties on the surface, what would make such transaction prohibited is that the siblings would be using their respective solo 401k plans to swap their personal investment properties.

Buying or Distributing Solo 401k Owned Real Estate QUESTION:

A few years ago, my Solo 401K Trust bought a condo. It has been rented since acquisition and has proven to be a good investment.Do I understand correctly that if we wanted to convert this to a personally owned condo in 2018, we would be liable for paying tax on the full fair-market value of the condo at the time? The condo is worth somewhere around $300K, so if that's the case, the tax impact would be significant.Are there alternatives? Would there be any way to spread the tax due over a course of time?Finally, would buying it from the trust be an option? Or would that be a prohibited transaction?

Excellent and popular questions. First, no you cannot buy property such as a condo from your own solo 401k plan as that would result in violation of the following prohibited transaction rule.

“Sale, exchange, or leasing of property between a plan (e.g., Solo 401k plan) and a party in interest (the solo 401k trustee).

However, it would not be prohibited if you take an in-kind solo 401k distribution of the property (the condo) since the rules allow for distributions in the form of an asset instead of cash. You can also spread the tax liability by taking partial in-kind distributions of the property. You will need to get the property appraised each time you process a partial distribution, however.

Roundabout Prohibited Transaction QUESTION:

If I lend my brother money from my solo 401k for 3 years with 12% interest, can my brother then turn around and loan those funds to me personally?

While the solo 401k investment rules allow for promissory note investments, this transaction would result in a “roundabout” prohibited transaction because the rules do not allow for a transaction that is prohibited to be done indirectly. In other words, while your brother is not a disqualified party from a solo 401k investment perspective, if he were to turn around and loan those borrowed funds or other funds to you, the IRS would view as you essentially processing a promissory note from your own solo 401k which is prohibited. Don’t confuse this rule with the solo 401k participant loan rules, though. To learn more about the difference between a “promissory note investment” and a solo 401k participant loan” CLICK HERE.

Note Investment with Sister-in-law QUESTION:

Am I able to make a personal loan to an individual from my solo 401k? she is a sister-in-law, whom I don’t believe is a disqualified individual. Just wanted to check to see if this was allowed?

Correct that a sister-in-law is not a disqualified party from a solo 401k investment perspective. To learn more about the promissory note rules, CLICK HERE.

Director QUESTION:

I am looking to invest in a Berlin based startup using my Solo 401k Acct. Equity stake // only 0.0017 of company is less than a percent; not an employee but considering being on board of directors; Company is in medical tourism business. Are there any issues with that and/or special reporting criteria?

You cannot be and officer, director, or 10 percent or more shareholder, or highly compensated employee of the startup business as this would run afoul with the prohibited transaction rules. When a solo 401k invests via an equity investment into a business that offers good or services, this will trigger UBIT.

Reimburse QUESTION:

I bought a buy and hold property this year and wanted to set up the solo 401k to reimburse myself for the purchase and use the funds to fund the renovations. Is that possible?

What you described is not possible as it would constitute a prohibited transaction. The best you could do is take a loan from your solo 401(k) (up to 50% of the balance not to exceed $50,000) and then use the proceeds to “pay yourself back”. However, you cannot transfer property that you or your business personally owns to the solo 401(k) under any scenario.

Invest in Cars QUESTION:

I know from reading your website, that collectibles (watches, collectible coins) are not a valid use of 401k. Can investment-grade vehicles be purchased and refurbished for investment? Does the fact that a vehicle has a TITLE (like real estate) make it a legitimate solo 401k investment?

A Solo 401k may passively invest in permissible investments but can’t own & operate a business, including buying & refurbishing motor vehicles.  You could borrow through a solo 401k participant loan up to 50% of the balance of your account (not to exceed $50K) and then use those funds however you wish including buying & refurbishing motor vehicles.

Transactions Between Two Companies QUESTION:

Quick question: are transactions between: 1) a company (A) that’s 100% owned by my solo 401(k) and; 2) a company (B) that’s 100% owned by me prohibited? So for instance, if company A sold products to company B, would that be a prohibited transaction?

A Solo 401k may passively invest in a business that you and any other related persons have no other relationship with (i.e. you are not owners, employees, directors, lenders, vendors, etc.).  This means that a Solo 401k can’t operate a business and thus cannot own 100% of a business.  It also means that you (or a business that you control) can’t transact with a business that is owned by your Solo 401k.

Transfer Condo to Self-Directed 401k QUESTION:

We have 350k outstanding on an SBA loan on an office condo. Our tenant wants to lease out the whole space. We were wondering if we could transfer ownership of the condo (Under its own LLC of which we are members) to the self-directed 401k trust?

The self-directed 41k rules do not allow for such a transaction because your LLC owns the existing condo. You and your LLC are deemed disqualified parties. Such transaction would violate the following prohibited transaction rule:

Sale, exchange, or leasing of property between a plan and a disqualified person.

The property is the condo; the plan is the solo 401k plan; the disqualified party is your LLC.

Purchase Car for Business Use QUESTION:

Is it possible to purchase a car through my Solo401k and then lease it to my real estate LLC? I'll be replacing my business car this year and am considering options.

Good question. One, the regulations do not allow for investing retirement funds including solo 401(k) plans and IRAs in physical cars. Second, the rules do not allow  the solo 401(k) participant nor his or her self-employed business to use an asset of the solo 401k plan.

Art Investment QUESTION:

Can I invest my solo 401k in art work?

The regulations do not allow for investing solo 401(k) or IRA funds in works of art. The IRS considers this type of investment as a disallowed investment (collectible).  If a solo 401k invests in works of art, it will result in a taxable distribution. Here are some examples of collectibles:

  • Artwork,
  • Rugs,
  • Antiques,
  • Metals – with exceptions for certain kinds of bullion,
  • Gems,
  • Stamps,
  • Coins – (but there are exceptions for certain coins),
  • Alcoholic beverages, and
  • Certain other tangible personal property.

Purchase Land from Solo 401k QUESTION:

I am looking to build a duplex outside of tax accounts, but am thinking about buying the land initially with my 401K assets until a later date when enough money is had to fund the project. Can I buy the land with my solo 401K and then at a later date buy it off of myself with assets from an unrelated LLC? The cash I paid for the land would then be returned to my 401K and the property will be owned by a LLC unrelated to my 401K Trust.

No. The sale of an asset owned by your 401(k) to an entity that you own or control would constitute a prohibited transaction. Theoretically, you could take the land as an in-kind distribution in which case you would have to pay taxes and penalties on the value of the land at the time the distribution and transfer the title from the solo 401(k) into your name personally. In that case, you would certainly want a robust valuation to be able to demonstrate the fair market value of the property.

Assign Contract to Solo 401k QUESTION:

We're trying to verify if its possible to assign a contract from our company to our solo 401k to do a rehab? Also, we want to confirm the proper way to track it for IRS purposes and what needs to be collected.

No as such transaction would result in the violation of the following solo 401k prohibited transaction:
  • “the sale, exchange, or lease of property between a plan and a disqualified person.”
 To learn more, VISIT HERE.

Loan Solo 401k Funds to Solo 401k Owned LLC  QUESTION:

Good morning, I have a question on my solo-401k. As background, the solo 401k Trust makes investments into an LLC and becomes the sole member of the LLC. The LLC owns and rents single family homes. Is it allowed to loan the LLC money on a short term basis to make a real estate purchase?
While a Solo 401(k) can be a sole member of an LLC, the Solo 401(k) plan cannot loan money to a solo 401k owned LLC as the IRS the rules do not allow for it. However, the solo 401k owned LLC can obtain a non-recourse loan from a third party for investing in real estate, with the borrowed funds used for purchasing the new property. For a list of lenders, Click Here.
 

Lease Equipment to Business QUESTION:

Quick question. Can the solo 401k plan purchase equipment and lease it to the business?

Good question. First, the rules do not allow for a solo 401k to own equipment. Second,  the solo 401k participant/owner or her business is not allowed to lease or use property (e.g., real estate) owned by her solo 401k plan. Such transaction would run afoul with the following prohibited transaction rule:

Act by a plan fiduciary whereby plan income or plan assets are used for her own interest.

Daughter & Father Solo 401k Investment QUESTION:

My client has a solo 401k. Her father also has a solo 401(k). Each of the 401(k)’s own a half interest in a piece of real property in South Carolina. Would it be a “prohibited transaction” for my client to sell her 401(k)’s interest to her father’s 401(k)?

Yes such transaction is prohibited because her father and his solo 401k fall under the disqualified party umbrella. This transaction would run afoul with the following prohibited transaction rule:

Sale, exchange, or leasing of property between a plan and a party in interest.

Rent House Owned by Solo 401k to Ex-Husband QUESTION:

I was thinking of buying a piece of residential real estate for an investment with my solo 401k funds. I might let my ex-husband rent it. Hmmm, yay or nay as an allowable arrangement? I looked at the list of who is in, and who is out, but the ex is not on there Thanks for getting back to me. I don't want to offer it to him if it is not allowed.
If ex then you are correct he no longer falls under the list of disqualified parties.

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