In general, a prohibited IRA transaction is any misuse of an IRA account or annuity by the owner of the IRA, its beneficiary, or any disqualified person. One of the most common prohibited transactions is known as automatic trading, which is when the owner of an IRA tries to do business with himself. You can't buy or sell property, you can't lend you money from the IRA, and you can't pay any IRA expenses or take any IRA income personally. You cannot use any IRA assets for personal gain in any way, this is a prohibited transaction.
And the lack of consumer education is worrying, since avoiding “errors” in an IRA that could cause a prohibited transaction is still the responsibility of the account owner. The additional complications that arise with the various types of alternative investments in an IRA stem from the fact that, technically, an IRA is an entity separate from the owner of the IRA that will ultimately use the money and benefit from it. This, once again, can be considered a prohibited transaction and disqualifies the IRA (since the owner of the IRA would be a party to the prohibited transaction). Prohibited transactions themselves may include buying or selling property between the IRA and a disqualified person, making IRA assets available to a disqualified person, or using IRA funds to compensate a disqualified person.
IRS Publication 590 defines a prohibited transaction as any misuse of your IRA by you, your beneficiary, or any disqualified person. Larry is the owner of the IRA and therefore cannot bring any value to the investment that comes from outside the IRA. Now that we've established what you can't invest in, here's a list of 90 things you can invest in with a self-directed IRA. Jack should not have allowed his son to live in a rental property held in his IRA and should only have allowed tenants who don't fall into the category of disqualified people.
Fortunately, in the past, the IRS has been fairly lax in pursuing and trying to enforce transactions prohibited by the IRA. Other types of investments that can be held in an IRA, but that are not traditional publicly traded securities, include investments in limited liability companies (which, in turn, can invest in anything from energy interests to equipment leasing agreements, tax liens or even agricultural crops), shares in a small (private) company, or even direct investment in real estate. There are specific people (known as disqualified individuals) whose IRA prohibits their IRA from transacting. While the most “common” disqualified person associated with an IRA is the owner of an IRA himself, it's important to note that family members are also disqualified people.
Larry should have hired someone to do the work and paid him with IRA funds to avoid a prohibited transaction. Any repair, improvement or maintenance must be done by a remunerated, non-disqualified person to avoid any unfair advantage for your IRA investments. They exist to prevent you and your IRA from having an unfair advantage over other investors and to prevent you (or you, through your family) from directly benefiting from the IRA at least until you retire.