Over the last few months, with skyrocketing interest rates and a slowdown in the real estate market, a growing number of home buyers turned to private lenders to help secure the funds necessary to purchase a home. This article will explore the details surrounding private mortgage notes and then discuss the various ways one can use a Self-Directed IRA to serve as a private mortgage lender and generate tax-free returns.
What is a Mortgage Note?
A mortgage is a type of contract and is essentially a loan secured by real estate. A mortgage note is the document that one signs as part of the home purchase process. In general, a mortgage note is a legal document that sets forth the terms of the mortgage between a borrower and a lender. A mortgage note includes terms such as:
- The total amount of the loan
- The amount the borrower will be paying as a down payment
- Schedule for loan payments under the note
- The mortgage terms – is the note fixed or adjustable interest rate
- Whether the note has a prepayment penalty.
A private mortgage note is an attractive investment for many because the note returns a steady stream of interest, and it is generally secured by the underlying property which gives the lender a solid base of collateral. In addition, there is a growing marketplace where companies are looking to buy your mortgage largely because these are collateral-backed securities.
Why Use a Self-Directed IRA to Invest in Mortgage Notes?
A Self-Directed IRA is a type of an IRA that allows for alternative asset investments, including real estate. The major advantage to make investments with an IRA, such as mortgage notes, is that all interest and returns will flow back to the IRA without tax.
Tax deferral is when all gains generated by a pretax retirement account investment flow back into the plan tax free. This allows your retirement funds to grow at a much faster pace than if the funds were held personally, allowing you to build for your retirement more quickly.
Best Ways to use a Self-Directed IRA to Invest in Mortgage Notes
When using a Self-Directed IRA to invest in private mortgage notes, there are two ways one can use a self-directed to make investments: (i) full-service custodian controlled, and (ii) checkbook control IRA LLC:
Full Service – Custodian Controlled
A custodian controlled Self-Directed IRA offers an IRA investor more investment options than a financial institution plan. A special IRA custodian, such as IRA Financial Trust, will serve as the custodian of the IRA. Unlike a typical financial institution, most IRA custodians generate fees simply by opening and maintaining IRA accounts and do not offer any financial investment products or platforms. With a full-service plan, IRA funds are generally held with the custodian, and at the IRA holder’s sole direction, will invest the funds into the investment; in this case, private mortgage notes.
The lender of the note would be titled in the name of the IRA custodian for the benefit of the IRA owner. All interest and principle on the mortgage note would be paid back to the IRA custodian for the benefit of the IRA owner. The custodian would be required to handle all IRS administration with respect to the Self-Directed IRA, including filing IRS Forms 1099-R an 5498.
Checkbook Control IRA LLC
The Self-Directed IRA LLC with “checkbook control” has quickly become the most popular vehicle for investors looking to make alternative assets investments, such as private mortgage notes which require a high frequency of transactions.
Under the checkbook IRA format, a limited liability company (LLC) is created which is funded and owned by the IRA and managed by the IRA owner. This allows the IRA owner to have more control over the investment process, as well as provide limited liability protection in addition to greater privacy.
The structure is IRS- and tax court-approved. The idea of using an entity owned by an IRA to make investments was first reviewed by the Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996). In Swanson, the Tax Court, in holding against the IRS, ruled that the capitalization of a new entity by an IRA for making IRA related investments was a permitted transaction and not prohibited. The Swanson Case was later affirmed by the IRS in Field Service Advice Memorandum (FSA) 200128011.
In the case of a private mortgage note investment, the lender of the note would be the LLC and not the IRA directly. By having the IRA own the LLC, the investment will be made in the name of the LLC giving you complete control and added protection.
For example, assume Jane Doe opened and funded a Self-Directed IRA LLC with $50,000. Assume further that Jane has asked IRA Financial to establish an LLC in her state of residence, Florida. The name of the LLC will be Hot Money Loan LLC. IRA Financial establishes the LLC, acquires a tax ID# for the LLC, provides the LLC operating agreement, and opens a bank account at Capital One. IRA Financial sends the $50,000 to the LLC bank account. Jane, as manager of the IRA LLC, sends the funds to the borrower as part of the mortgage note transaction. The note is titled in the name of Hot Money Loan LLC. Since Jane’s IRA owns 100% of the LLC, all interest and principle will flow back to the LLC without tax.
The use of a Self-Directed IRA to invest in private mortgage notes has become a hot investment over the last several years. You may choose the less hands-on approach by go full-service, or get your hands “dirty” with a Checkbook IRA LLC. Either way, the tax advantages are the same. Taxes are never due so long as the note is held in the IRA. All gains wouldn’t be taxable until assets are distributed from the plan. If you elect to use a Roth IRA, qualified distributions are tax free.