Hard money lending is one of the most popular passive investments out there. Whether the loan is to an individual, a business, or real estate developer, lending money passively is viewed as a great return on investment. However, the major downside of using non-retirement funds to engage in hard money lending is that the interest received from a borrower is subject to ordinary income tax and not capital gains. This article will explore the tax advantages of using a retirement account to make hard-money loans.
- A self-directed retirement plan allows one to make alternative investments, such as hard money loans
- You, as the lender, decide the terms, repayment schedule, and collateral used for the loan
- The interest earned by the loan will flow back into your plan without tax
Basic Loan Terminology
The individual or entity that is lending the funds is known as a lender and the individual that receives the loan funds is called a borrower. A loan can be used for personal or business purposes. Interest is the charge for the use of borrowed money and interest income is the money the lender receives from lending money to someone else. All interest income is taxable as ordinary income to the lender unless specifically excluded.
What is a Hard Money Loan?
Essentially, a hard money loan is a short-term financing alternative to traditional lending institutions, such as banks. Generally, hard money loans are used for real estate investments, but can be used for any reason, especially when it comes to using retirement funds. These types of loans are typically used by those who may not have the best credit or are need of quick financing – something not associated with a regular loan.
When using an IRA or 401(k) for a hard money loan, the plan is the lender. The loans are usually short-term and can range from several months to a few years. As the trustee of the plan, you get to set the interest rate of the loan and the repayment terms. Since there’s no middleman, a loan and its terms can be agreed to rather quickly. Your retirement plan will lend the money out to the borrower, and he or she will pay the loan back to the plan. You now have a guaranteed rate of return on the money loaned out.
Taxation of Hard Money Loans
In general, most interest income is taxable as ordinary income on the borrower’s federal tax return, and is therefore subject to ordinary income tax rates. Taxable and tax-exempt interest is reported on Form 1099-INT. Even if you do not receive a Form 1099-INT from other sources, you must report any taxable interest income on your tax return.
A lender may also be required to pay income tax on what is known as imputed interest. For example, a lender lends a borrower money at zero interest, and the lender does not make any profit from the deal. As a result, one may assume that the loan doesn’t have any tax implications for the lender. In many cases, though, you’d be incorrect. The Internal Revenue Code requires you to charge a certain amount of interest for a loan—and even if the lender does not, the lender can be taxed as if they did. The IRS refers to this as “imputed interest.”
If a lender lends a borrower money at a “below-market-rate” of interest, the lender may owe tax on what the IRS calls “imputed interest,” even if little or no interest is actually paid to the lender. The government sets a minimum loan interest rate, known as the Applicable Federal Rate, each month. Loans made at rates below the AFR may result in imputed interest. In other words, if a lender charges interest at a rate below the AFR, the lender is required to report the difference between the interest actually received and the interest the government assumes you collected as taxable income.
Tax Advantages of Retirement Plans
The primary reason why using an IRA or 401(k) plan to save is so popular is because of the power of tax deferral. Tax deferral is when all gains generated by a pretax retirement account investment flow back into the retirement account without tax. 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. This is also known as compounding interest, which Albert Einstein has coined the 8th wonder of the world.
Tax deferred investments though an IRA or 401(k) generally help investors generate higher returns. That’s because the money that would normally be used for tax payments is instead allowed to remain in the account and earn a return. For example, if one contributed $5,000 to an IRA from ages 25-73 years old, assuming an 8% rate of return, he or she would have $2,450,660.82 at age 73. Whereas if they used personal funds, assuming a 25% income tax rate, they would only have $1,282,823. This example shows you the power of tax deferral.
Therefore, if one uses retirement funds to engage in hard money loans, all interest received from the loan would go back to the plan without tax.
Self-Direct Your Retirement Plan
If you have a “regular” IRA through a bank or other financial institution, or a workplace 401(k) plan, you generally cannot engage in alternative investments, including hard money lending. Therefore, you must self-direct your plan. By working with the correct provider, you are not limited in the types of investment choices you have. Basically, you can invest in anything you want so long is it’s not prohibited by the IRS.
The primary reason one would need to establish a Self-Directed IRA or Solo 401(k) plan to make a hard money loan is that these traditional financial institutions make money selling traditional investments, such as equities or mutual funds, in addition to providing investment advice; that is their business model. They do not have expertise in the custody of alternative assets, such as loans, and would rather steer their clients into investments they can profit on.
Why Are Hard Money Loans the Most Tax Advantaged Investment?
As we touched on earlier, you are in control of the investment. You decide on the interest rate to charge, the time-frame of repaying the loan back, and all other details. This is a significant advantage for you and your retirement plan. It’s virtually impossible to do this with any other type of investment. Of course, you do take on the risk that the borrower will abide by the terms of the loan and repay it in a timely fashion.
Another factor to consider is the collateral being put up by the borrower. This will depend on who the borrower is – someone you know and trust, an investor in need of capital or maybe an entrepreneur looking for funding for a new product or business. You need to lay out exactly what happens if they default on the loan. Generally, an asset is used as collateral, which can then be sold to make up for the loan. This helps reduce the risk to the lender (your retirement plan in this case).
Anyway you slice it, hard money lending may arguably be the best tax-advantaged investment for your retirement plan. You can choose several small, short-term loans, or go big with a larger loan that can generate income for several years. Just keep in mind that the funds you lend are no longer in the plan to make other investments.
Numbers don’t lie. Using personal funds to do a hard money loan will trigger ordinary income tax and not the lower capital gains rate on the interest received. Hence, using personal funds to make hard money loans is not a highly tax-efficient investment. This is all the more reason why using retirement plan money to make a hard money loan is so tax advantageous. All interest will be sheltered from all forms of taxation while it remains inside your plan.
You are in control of the transaction so it’s up to you to mitigate risk by only lending to someone you trust, defining the loan terms completely, and deciding on collateral ahead of time in case the borrower defaults. It’s best to work with a professional before engaging in hard money loan transaction.