The IRS has always permitted an IRA to lend money (known as an IRA loan) to non-disqualified persons. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
In the traditional sense, a note payable or loan is a written promissory note. Under this agreement, a borrower obtains a specific amount of money from a lender and promises to pay it back with interest over a predetermined time period. A loan can either be secured or unsecured by the borrower. Whereas, in the case of real estate, hard money loans is a way to borrow without using traditional mortgage lenders. Loans come from individuals or investors who lend money based (for the most part) on the property you’re using as collateral.
Using a self-directed IRA to facilitate note or loan transactions have become a popular investment category over the last several years. Securing a traditional loan from a bank or financial institutions has not gotten much easier since the 2008 financial meltdown and for many borrowers, seeking a private lender is the only viable option.
When it comes to using a self-directed IRA to make a loan to a non-disqualified third-party, the interest received from the IRA loan is exempt from tax, which is the primary reason why using retirement funds to make hard money loans is attractive to so many investors. In addition, one is able to potentially diversify their retirement portfolio by generating a steady stream of interest income without tax. Moreover, in some cases, the self-directed IRA allows one to lend money to a non-disqualified family member, such as a sibling or cousin who really needs the money making it a win-win for both parties.
Below is a step-by-step breakdown of how one can use a self-directed IRA or checkbook IRA to make a loan to a non-disqualified person:
- Establish self-directed IRA with an IRA custodian or trust company that allows for alternative asset investments, such as IRA Financial Trust.
- Transfer or Rollover your retirement assets that you will be using for investment tax-free to the new IRA custodian.
- A special purpose LLC will be established that will be wholly owned by the IRA.
- Establish a bank account for your LLC. You will need to have the LLC article of formation, a Tax ID#, as well as a self-directed IRA LLC operating agreement.
- Notify the IRA custodian that you wish to have the funds sent to the newly established LLC bank account. The IRA assets/cash will then be transferred to the LLC tax-free in exchange for 100% interest in the LLC
- You as manager of the LLC will then have checkbook control over all the assets/funds in the IRA LLC to make the investment
- Send the funds to the borrower as part of a loan agreement or promissory note. You have the option of having the loan secured or not. Based off the terms of the IRA loan, the borrower would send the interest and principal payments back to the LLC.
- Since the LLC will be owned by one IRA, the LLC will be treated as a disregarded entity for federal income tax purposes and no federal income tax return will be required to be filed. All income and gain from the real estate investments will flow back to the IRA without tax.