Prohibited transactions — what they are and why they matter
A "prohibited transaction" is a specific category of activity the IRS forbids between an IRA and certain people connected to the account owner — getting this wrong can disqualify the entire account, so it's one of the most important rules to understand before you direct your own investments.
Explanation
A prohibited transaction is any improper use of an Individual Retirement Account (IRA) by the account holder, a beneficiary, or a disqualified person — as defined under Internal Revenue Code (IRC) Section 4975. The concept exists because the tax advantages of an IRA are meant to fund the account holder's retirement, not to subsidize their day-to-day finances or benefit people close to them today.
Because a Self-Directed IRA (SDIRA) lets you invest in a much broader range of assets than a standard IRA, the opportunities to accidentally trigger a prohibited transaction are greater. Understanding the rules upfront is the single best way to protect your account.
Who counts as a disqualified person
A disqualified person is any individual or entity that the IRS prohibits from engaging in transactions with your IRA because of their relationship to you. Disqualified persons include you (the IRA holder), your spouse, your ancestors (parents, grandparents), your lineal descendants (children, grandchildren) and their spouses, and any entity in which you or another disqualified person owns 50% or more. For the full list and examples, see "Disqualified persons — who counts and why".
The six categories of prohibited transaction
IRC §4975(c)(1) defines six categories. A transaction between your IRA and a disqualified person that falls into any of them is prohibited:
Sale, exchange, or lease of property between the IRA and a disqualified person — for example, selling a property you personally own to your IRA.
Lending money or extending credit between the IRA and a disqualified person — for example, taking a personal loan from your IRA, or personally guaranteeing a loan the IRA takes out.
Furnishing goods, services, or facilities between the IRA and a disqualified person — for example, doing repair work yourself on a rental property held inside your IRA.
Transferring, or allowing the use of, IRA income or assets to or by a disqualified person — for example, letting a family member live in IRA-owned real estate rent-free.
Self-dealing by a fiduciary — any act where a fiduciary uses the IRA's income or assets in their own interest or for their own account.
Receiving personal consideration — a fiduciary receiving any kind of compensation from a party who is doing business with the IRA.
The common thread across all six is that your IRA must transact at arm's length with people outside your close family and your controlled entities. Your IRA is a separate taxpayer — treating it otherwise is what gets account holders in trouble.
Common examples
The most frequent prohibited-transaction mistakes are intuitive once you see them:
Using IRA funds to pay a personal expense, then intending to "pay it back."
Buying a vacation property with your IRA and spending a weekend there.
Hiring your spouse, parent, or child to manage an IRA-owned business or rental property.
Having your own business rent office space from your IRA.
Using IRA-owned assets as collateral for a personal loan.
None of these are allowed, even if the pricing would be fair, even if the arrangement is documented, and even if you intend to reverse it.
Consequences of a prohibited transaction
The consequence depends on who engaged in the prohibited transaction:
If the account holder or their beneficiary engages in a prohibited transaction, the IRA loses its tax-advantaged status as of January 1 of the year the transaction occurred. The entire account is treated as distributed at its fair market value on that date. That means the full account balance is taxable as ordinary income in that year, and if the account holder is under age 59½, the 10% early-withdrawal additional tax also applies.
If another disqualified person engages in a prohibited transaction (not the account holder), the IRS imposes an excise tax equal to 15% of the amount involved, assessed annually until the transaction is corrected. If it is not corrected within the IRS's taxable period, an additional 100% tax applies. These excise taxes are reported on IRS Form 5330.
For a more detailed walk-through of the correction process and the tax treatment in the year of the violation, see "What happens if you make a prohibited transaction?".
How to avoid a prohibited transaction
The rule of thumb: the IRA transacts with the outside world, not with you or anyone connected to you. Before you direct any investment, confirm that every counterparty is outside the disqualified-persons list, that no disqualified person benefits personally from the transaction, and that no personal funds or personal credit are intermixed with the IRA. When in doubt, pause and get advice before the transaction, not after.
We recommend consulting a tax advisor or attorney for guidance specific to your situation.
Common questions
Does the same rule apply if the transaction is at fair market value?
Yes. Price is not the test. A transaction with a disqualified person is prohibited regardless of whether the terms are fair. The IRS's concern is the relationship, not the price.
What if I didn't know the other party was a disqualified person?
Intent does not change the tax outcome. Prohibited-transaction rules are strict-liability — the IRS looks at what happened, not why. That is one reason due diligence on every counterparty matters.
Can my IRA buy an investment from a friend or a coworker?
Generally yes, as long as the friend or coworker is not a disqualified person and you are not benefiting personally from the arrangement. Business partners can become disqualified persons in certain ownership scenarios — see "Disqualified persons — who counts and why".
If a prohibited transaction happens, can it be undone?
For transactions involving a disqualified person other than the account holder, there is an IRS-defined correction process that can reduce the 100% excise tax. For transactions involving the account holder, the account is already deemed distributed — there is no unwind. We recommend consulting a tax advisor or attorney for guidance specific to your situation.
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