If you’re searching “Private money lending in an IRA” we have the knowledge and experience you need. When you use an IRA to invest within a private loan or hard money loan, it is a great strategy to enhance your returns.
HARD MONEY LENDING
The term IRA is used loosely when it comes to referring to any type of retirement account such as the standard IRA, SEP-IRA, 401K, Roth IRA, Money Purchase Plan and the Defined Benefit Plan. There are a lot of legal differences in retirement accounts, but when it comes to the purposes of hard money lending as well as private money lending, they will be lumped together as one for an easier reference. Since various states will use different security instruments for loans, the generic reference of note or mortgage shouldn’t be interpreted to mean trust deed, mortgage, land contract, or promissory note.
Many people honestly believe that funds that are in IRA’s are limited to only investments in bonds and stocks. That just isn’t true. IRA’s are able to be invested in various alternative investments like private placements, mortgages, limited partnerships, real estate, and just about any other type of investment that you can think of. The key is to be able to use a special custodian, like Pensco Trust Company, that will manage and properly account for your transactions. The custodians handing of alternative investments are normally referred to as self-directed IRA custodians and are a great way to make hard money loans or private loans.
We will now begin to explore note investing in your IRA by considering a simple case: Bob investor makes a $100,000 interest only loan to Mr. Barker at 6% interest and originates the loan using his self-directed IRA. For it being our first case, we should assume that Mr. Barker pays each loan payment on time and pays the loan off before 5 years.
Life is great for Mr. Barker and Bob private investor. Mr. Barker gets a private loan that he may not have gotten and Bob investor enjoys 6% tax deferred income in his IRA.
So, how would you make this simple hard money loan using IRA funds? It isn’t very different than getting a mortgage from your traditional checking account. Simply, follow the six steps below:
Open Self-Directed Retirement Account
Most of us are used to using the big brokerage houses as our custodian for our retirement savings. But, it is those firms that will only permit investors to invest in publicly trader securities and personal loans are not an option. There are plenty of companies that do specialize in self-directed investments which allow you to move into an area that is referred to as alternative investments.
Properly Vest a note for Hard Money Loans
When it comes to traditional transactions, your note may be vested in your name or the name of your company, but in a self-directed IRA there is normally more details when it comes to vesting the note. An example of this we will reference the custodian and the account number and IRA holder:
XYZ Custodian Company, FBO “Bob Investor IRA Account #098765”.
Sign all agreements which will authorize your custodian to fund the note.
The Custodian will then have pre-established procedures that you will need to follow and most will have a form agreement for you to sign. Brokers that specialize in private money lending will be glad to help you. This particular agreement will authorize the custodian to release the funds. Many custodians will also have a checklist that you can use to ensure that you will cover each step as the loan begins.
Close the transaction.
Most investors will use an escrow, attorney, or title company to close the transaction. Select the right party that has worked with a self-directed custodian and your life will be so much easier.
Send Copies of the security agreement to your custodian.
Once the note has been funded, the IRA custodian will need to keep the actual promissory note and recorded security instrument such as a mortgage, deed of trust, etc. This is very similar to the conventional IRA brokerage holding on to your stock certificate.
Get with a servicer to send payments to your custodian.
Many investors will use a third-party loan servicer in order to collect payments from the borrower. The servicer will then have an authorization agreement which will state who the payments are sent to.
AVOIDING HARD MONEY LENDING
Even though it is nice to think that all borrowers will pay on their mortgages as reliably as Mr. Barker does, it is normally not the case. Believe it or not, note private investing will get more complicated when the borrower does not pay on time and then there are more problems that are particular to retirement accounts that will make note investing very risky if you do not know what to look for.
Hard Money Advances
There are plenty of times when an investor needs to have advanced funds against their mortgage. An advance happens to be a payment of funds by the private investor for something that should have been paid for by the borrower, or for services that are needed to collect collateral. One advance example happens to be insurance. The borrower’s home insurance may lapse and in order to protect your note, you will need to advance to renew the policy or advance in order to force place insurance from a specialty insurance company. Delinquent property taxes are another good example when it comes to advancing may be needed on a private loan.
When it comes to traditional loan investment, there is an issue when it comes to advancing funds which is coming up with the advanced funds. With a self-directed retirement account, you will first need to figure out how you will get the money into the IRA before you are able to advance it. If you have already maxed out the contribution to your IRA you may not be able to get an advance.
Advances can be large. Consider a foreclosed home from a hard money loan, that upon possession needs $50,000 to remodel it to get it to fair market value for the property, or you can consider bankruptcy that will last for several years and will require the advance of thousands of dollars in Sheriff or trustee and attorney fees.
Make notes that you are not allowed to pay for any type of IRA owned asset or IRA expenses personally, as this is considered prohibited transactions such as being considered self-dealing with your IRA. You will need to remedy for the shortfall of funds on your IRA which would be to transfer funds from any other IRA that you might have at another institution or to rollover funds from another qualified pension account.
If those solutions do not work, there are other types of alternatives. The Department of Labor, which governs over retirement accounts has recently issues some guidelines that will enable you to make a loan to your IRA. The loan may be made to your IRA, if it is interest free, unsecured, and provided that it is:
- A) For the payment of any ordinary operating expenses, or
- B) For the purpose of incidentals to the operation of the IRA.
If the loan is supposed to be for longer than 60 days, then the documentation for the loan must be created and then signed prior to the expiration of the 60 day period. Loans cannot be used to increase your purchasing power of your IRA. Take for example, you are not able to loan your IRA $100,000 to purchase another property.
PROHIBITED TRANSACTIONS
When it comes to using an IRA to invest in real estate or notes, it is vital to avoid completing a prohibited transaction. It is this type of transaction that is improper use of your retirement account by you, your beneficiary, or any other disqualified person. A disqualified person is your fiduciary or members of your family such as your spouse, a lineal descendant and any spouse of a lineal descendant.
The below examples are prohibited transactions with the traditional IRA:
- Selling property to it
- Using it as security for a loan
- Borrowing money from it, except as outlined within this article
- Purchasing property for personal use for future or present with IRA funds
- Receiving any type of unreasonable compensation for managing the IRA funds
Essentially, you will need to conduct your business with any unrelated third parties. So you would not want to make a loan to a stranger, then hire your spouse to service the loan. You would not want to hire your brother to do your taxes for a certain fee charged to the IRA. You must be very careful. The prohibited transactions are not always obvious. You should consult the attorney, a CPA, or your custodian that is well versed in these types of transactions before you are able to experiment on your own. There are several self-directed custodian companies that will be able to maintain a directory of professionals that will specialize in these areas and will be a lot of help.
If the IRS determines that you have conducted a prohibited transaction, your whole IRA may then be disqualified and subjected to substantial fines, taxes and penalties.
UNRELATED BUSINESS TAXABLE INCOME (UBTI)
Unrelated business taxable income is normally defined as the gross income that comes from any unrelated business or trade that is normally carried out by an exempt organization. The tax that is on the UBTI is called the UBIT or Unrelated Business Income Tax.
Most of the time, UBTI will come into play when there is debt involved in a real estate transaction. Take for example if your IRA purchases a home for $100,000nd you use $30,000 of the IRA funds and borrow $70,000. Even though the transaction is fine to do with an IRA, the IRS will not allow you to benefit from the whole income of the property. You may only benefit from the income as it relates to the IRA funded part which would be $30,000. This means that you would be paying 70% tax on the investment income and income of the property if there is any and then receive tax-deferred benefit from your IRA of 30%. The debt financed portion is known as the Unrelated Debt Financed Income or UDFI.
Many people truly believe that the UBTI is not permitted within your IRA. It is actually permitted. You will have to be completely aware of it and ensure that your tax accountant files that right form (IRS 990 T form). If you are investing in a partnership that happens to be purchasing mortgage notes or real estate, you should be very careful that you know exactly how the partnership is planning to use the leverage, if at all. The use of leverage in the partnership, if it is not properly documented and treated may then create unintended UBTI which is potentially subjected to large penalties and fines.
When it comes to the note business, UBTI may come in to play when you foreclose on a home and take the existing lien. Take for example your IRA lends a second mortgage for $50,000 when the first mortgage is $100,000. If the investor foreclosed, then the investor would then inherit $100,000 worth of debt and may be subjected to UBTI.
What you may not know is that this type of scenario only really comes into play if the investor converts the property into a long-term rental hold. Due to the debt being acquired was a normal part of the operations of the mortgage note, the UBTI would not be considered if the investor liquidates the property.
There are a lot of complicated rules that surround leverage and the use of retirement accounts. You should be aware that the leverage and impact to your IRA and consult professionals in order to guide you to ensure that you are making prudent business decisions.
USING AN LLC OR CORPORATION
If you plan to make several loans from your IRA, then you may want to become an LLC or corporation. When you set this up, you will have your IRA be the owner of the company while you may be the president. As the president, ensure that you do not pay yourself, as that would be a prohibited transaction. Be aware that many custodians will not accept single member entities such as LLC’s that are funded solely by an IRA and managed by the IRA for fear that the IRA owner will expose their IRA to disqualification as the result of prohibited transactions. Many custodians will review your investment transactions that they execute for their clients with the intent to prevent any prohibited transactions.
Whenever an IRA fund is invested in and LLC, the IRA owner will be the president and the custodian is no longer involved with the transaction execution as everything will be handled by the IRA owner and president. There are some custodians that have addressed several concerns about having a potential prohibited transaction, while still managing to accept the single member investment entities, which require a qualified and independent professional such as an attorney or CPA to sign an agreement that states the client requires that they review and then approve each transaction.
The benefit of setting up an IRA that way is that when your IRA purchases 100% interest in a new corporation or LLC, the cash is then sent to the checking account of your new company. The mortgage notes that you have vested are in the name of the company and not your IRA and you have checkbook control of your own IRA, which makes it easier to advance funds, make loans, etc.
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