Investors Guide To Loan Investing
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Using an IRA to invest in private loans, or a hard money loan is an excellent strategy to significantly enhance your returns.

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Hard Money Lending | IRAs

We use the term IRA loosely to refer to any retirement account including:  a standard IRA, Roth IRA, SEP-IRA, Money Purchase Plan, 401K, and Defined Benefit Plan.  There are many legal differences between the retirement accounts, but for purposes of hard money lending and private money lending, we will lump them  together as one for ease of reference.  Since different states use different security instruments for loans, the generic reference of “mortgage” or “note” should be interpreted to mean a mortgage, trust deed, promissory note, or land contract.

Most people believe that funds in IRAs are limited to investments in stocks and bonds.  That isn’t true.  IRAs can invest in a variety of alternative investments such as private placements, limited partnerships, mortgages, real estate, and just about any other type of investment.  The key is to use a special custodian to manage and properly account for your transaction.  The custodian’s handling of alternative investments is typically referred to as “self-directed” IRA custodians and are an excellent way to make private loans, or a hard money loan as they are sometimes called.

Let’s begin exploring note investing in your IRA by considering a simple case:   Joe Investor makes a $100,000 interest only loan to Mr. Smith, at 6% interest and originates the loan using his self-directed IRA.  For our first case, let’s assume that Mr. Smith pays each loan payment on time and pays the loan off within 5 years.

Life is good for Mr. Smith and Joe Private Investor.  Mr. Smith receives a private loan he may not otherwise have obtained, and Joe Investor enjoys 6% tax deferred income[1] in his IRA.

So how does one make this simple hard money loan using IRA funds?   It’s not much different than originating a mortgage from your traditional checking account.  Follow these six steps:  

Step 1: Open a self-directed retirement account.

Many of us are accustomed to using the big brokerage houses as the custodian for our retirement savings.  But those firms only permit investors to invest in publicly traded securities and a personal loan is not an available option.    But there are numerous companies that specialize in enabling you to self-direct your investment into an area often referred to as alternative investments.

Step 2: Vest the note for the hard money loan properly. 

In a traditional transaction, your note may be vested in your name, or your company’s name.  But in a self-directed IRA, there is usually a bit more detail in the vesting of the note.  An example of a typical IRA vested note will reference the custodian and the account number as well as the IRA holder: 

ABC Custodian Company, FBO “Joe Investor IRA Account # 123456”.

Step 3: Sign agreements which authorize the custodian to fund the note.

The custodian will have pre-established procedures for you to follow, and most will have the form of agreement they need you to sign. Brokers specializing in private money lending will gladly assist you.   This agreement authorizes the custodian to release the funds.  Most custodians will have a checklist you can use to make sure you cover each step as the loan is originated.

Step 4: Close the transaction.

Many investors use an escrow, title company or attorney to close the transaction.   Select a party that has worked with a self-directed custodian and your life will be much easier.

Step 5: Send copies of the security agreements to custodian.

Once the note is funded, the IRA custodian will need to hold the actual promissory note and recorded security instrument (deed of trust, mortgage, etc.).    This is similar to a conventional IRA brokerage house holding your stock certificate.   

Step 6: Coordinate with the servicer to send payments to the custodian.

Most investors use a 3rd party loan servicer to collect payments from the borrower.  The servicer will likely have an authorization agreement which specifies to whom the payments are sent.

Avoiding Hard Money Lending | IRA Pitfalls

While it’s nice to think that all borrowers will pay their mortgages as reliably as Mr. Smith does, it unfortunately is not the case.  Note private investing gets more complicated when the borrower does not pay on time and there are a number of issues particular to retirement accounts that make note investing even more risky if you do not know what to look out for.   

Hard Money Advances

There are many times when investors need to advance funds against the mortgage.  An advance is a payment of funds by the private investor for something that was supposed to have been paid for by the borrower, or for services required to protect the collateral.  One advance example is for insurance.  The borrower’s home insurance may lapse and to continue to protect your note, you will need to either advance to renew the policy, or advance to a specialty insurance company to force place insurance. Delinquent property taxes are another example when an advance could be necessary on private loans.

With a traditional loan investment, the issue of advancing funds centers on coming up with the advance funds.  But with a self-directed retirement account, you first have to figure out how to get the money into the IRA account before you can advance it.  If you have already maxed out your contribution to your IRA, you may not be able to advance.

Advances can be significant.  Consider a foreclosed home from a hard money loan, that upon possession required a $40,000 remodel to get a fair market value for the property.  Or, consider a bankruptcy which lasts for several years and requires advances of tens of thousands of dollars in attorney and Sherriff or trustee fees.

Note that you are not permitted to pay for any IRA owned asset expenses personally if your IRA is unable to, as this would be considered a prohibited transaction (e.g., self-dealing with your IRA). Your first remedy for a shortfall of funds in your IRA would be to transfer funds from any IRA you may have at another institution, or to rollover funds from a qualified pension account. 

If those potential solutions fail, there are still other alternatives.  The Department of Labor, which governs retirement accounts, has issued some recent guidelines that enable you to make a loan to your IRA.   A loan may be made to your IRA if it is interest free, unsecured and provided  it is:

a)      For the payment of ordinary operating expenses;

b)      For a purpose incidental to the operation of the IRA.

If the loan is anticipated to be for more than 60 days, the documentation for the loan must be created and signed prior to the expiration of the 60 day time period.  Loans may not be used to increase the buying power of the IRA.  For example, you cannot loan your IRA $100,000 to buy another property.

Prohibited Transactions | Hard Money Lending & IRAs

When using an IRA to invest in notes or real estate, it is critical to avoid conducting a prohibited transaction.  This type of transaction is any improper use of your retirement account by you, your beneficiary, or any disqualified person.  Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).

The following are examples of prohibited transactions with a traditional IRA:

  • Borrowing money from it. (Except as outlined in this article.)
  • Selling property to it.
  • Receiving unreasonable compensation for managing it.
  • Using it as security for a loan.
  • Buying property for personal use (present or future) with IRA funds.

Essentially, you need to conduct business with unrelated third parties.  So you would not want to make a loan to a stranger, and then hire your spouse to service the loan.  Or you would not want to hire your brother to do your taxes for a fee charged to the IRA.  Be very careful.  Prohibited transactions are not always obvious.  Consult a CPA, an attorney, or your custodian well versed in these types of transactions before you experiment on your own.  Several of the self-directed custodian companies maintain a directory of professionals that specialize in this area and can be of tremendous assistance.

If the IRS determines you have conducted a prohibited transaction, your entire IRA may be disqualified and subject to substantial penalties, fines and taxes.

Unrelated Business Taxable Income (UBTI)

UBTI is generally defined as the gross income derived from any unrelated trade or business regularly carried out by an exempt organization.  The tax on the unrelated business taxable income is called Unrelated Business Income Tax (UBIT).

Most frequently, UBTI comes into play when debt is involved in a real estate transaction.  An example would be if your IRA buys a home for $100,000 using $20,000 of its own funds and borrowing $80,000.  Although the transaction is perfectly fine to do in an IRA, the IRS will not let you benefit from the entire income (or gain) of the property.  You may only benefit from the income (and gain) as it relates to the equity or IRA funded part; in this case, the $20,000.   This may mean that you pay tax on 80% of the investment income and gain (if any) and receive the tax-free or deferred benefit from your IRA on 20%.  The debt financed portion is referred to as “Unrelated Debt Financed Income (UDFI). 

Most people believe UBTI is not permitted within an IRA.  It is permitted. You just have to be aware of it, and make sure your tax accountant files the appropriate form (IRS 990 T form: see www.irs.gov for the form and its instructions).  If you are investing in a partnership that is purchasing real estate or mortgage notes, be especially careful that you know exactly how the partnership is planning to use leverage, if at all.  The partnership’s use of leverage, if not properly documented and treated, could create unintended UBTI potentially subjecting it to significant fines and penalties.

In the note business, UBTI can come into play if you foreclose on a home and inherit an existing lien.   Let’s assume your IRA lends a 2nd mortgage for $50,000 and the 1st is $100,000.   If the investor foreclosed, the investor would inherit $100,000 of debt and could be subject to UBTI. 

Interestingly, the UBTI in this scenario only comes into play if the investor converts the property to a long term rental hold.  But because the debt was acquired as a normal part of the operations of the mortgage note, UBTI is not considered if the investor diligently liquidates the property.

There are many complicated rules surrounding leverage and the use of retirement accounts.   Be aware of the leverage and the impact to your IRA and consult professionals to guide you to make prudent business decisions.

Using a Corporation or an LLC

If you are going to make multiple loans from your IRA, you may wish to consider establishing an LLC or a Corporation.  When you set up this entity, you can have your IRA be the 100% owner of the company and you may make yourself the manager / president.  As the manager, or president, be sure you do not pay yourself, as that would be a prohibited transaction.  Be aware that most custodians will no longer accept single member entities like LLCs funded solely by an IRA and managed by the IRA for fear that the IRA owner will inadvertently expose their IRA to disqualification as a result of a prohibited transaction.  Most custodians will review investment transactions they execute for their clients with the intent to prevent prohibited transactions. 

When the IRA funds are invested in an LLC, and the IRA owner is the LLC manager, the custodian is no longer involved in the transaction execution as it would be handled directly by the IRA owner and manager.  Some custodians have addressed their concerns about potential prohibited transactions, while still accepting single member investment entities, by requiring an independent and qualified professional like a CPA or attorney to sign an agreement with the client that requires them to review and approve each transaction.

The benefit of setting up your IRA this way is that when your IRA ‘buys’ 100% interest in the new LLC or Corporation, the cash is transferred to the checking account of your new company.  The mortgage notes are now vested in the name of the company, not your IRA and you have checkbook control of your IRA, which makes it easier to make loans, advance funds, etc.  Be careful.   Operating your IRA this way also makes easier to unwittingly conduct a prohibited transaction because each check and transaction is not being scrutinized by the custodian.


[1] If the account is a Roth IRA, it will be tax free income.

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