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Using a Self-Directed IRA for Promissory Notes/Loans

pocket IRA for notes/loans
6 Minute Read

IRA Financials Self-Directed IRA or Solo 401(k) allows you to use your retirement funds to invest in promissory notes and loans directly from your mobile device through our app or directly through your computer. With our Self-Directed retirement plans you no longer need a third-party IRA custodian involved in every aspect of your investment transaction. Furthermore, you can rollover, deposit, or transfer funds between your investment and IRA seamlessly and without delay.

Why Promissory Notes/Hard Money Loans?

In general, a note (or promissory note as it’s often called) is simply a promise to pay. If you lend money to a third-party, a document is created that dictates the terms of the loan that says the borrower will pay back the lender. A note can either be secured or unsecured. Some examples of common notes are:

  • Mortgage Loans
  • Personal Loans
  • Business Loans
  • Real Estate Loan (Hard Money Loans)
  • Treasury Notes
  • Peer-to-Peer Loans

When you open a Self-Directed IRA with IRA Financial you can invest in a wide range of alternative investments for a flat annual fee. While some companies limit you to precious metals and cryptos, IRA Financial allows you to invest in what you know.

Learn More: Using Retirement Funds to Invest in Real Estate

Related: Beginners Guide to Alterative Investments

Secured or Unsecured Notes

When it comes to notes, it’s important to understand the idea of secured vs. unsecured notes.

A secured note essentially means that if someone defaults on the loan, the lender receives something in return as payback. The note is “collateralized.” In the case of a mortgage, the loan is collateralized against the actual home. If you default on your mortgage payments, the bank will foreclose on the property and take ownership.

On the other hand, if you fail to repay a non-secured-backed note, the lender has no legal recourse against the borrower. No collateral is repossessed or foreclosed.

Therefore, when making note investments with a self-directed IRA, it is important to consider whether the loan will be secured or unsecured. Clearly, a secured loan offers the borrower more security and protection in the case of a borrower default.

Hard Money Loans

A hard money loan is simply a loan that is backed or secured by an asset, such as real estate. For example, a real estate developer who wants to develop a property seeks out investors to help finance the project. Since 2008, for many small real estate developers or general partners, acquiring bank financing in these circumstances still remains quite difficult.

Hence, the real estate developer or general partner may then look to secure a loan from a hard money lender, such as a self-directed IRA investor who is willing to give them the money that is secured by the underlying real estate asset(s) connected with the real estate project. If the borrower defaults on their loan, the lender would have the legal rights to the real estate secured by the loan.

Peer-To-Peer Loans

The Peer-to-peer lending industry has increased in popularity significantly over the last 10 years. Peer-to-peer lending platforms such as Lending Club and Prosper allow investors to invest in notes offered by the site.

Under a traditional peer-to-peer lending platform, borrowers are matched directly with investors through a lending platform. Investors can see and select exactly which loans they want to fund. Peer-to-peer loans are most commonly personal loans or small business loans. The majority of peer-to-peer loans are not secured, or asset backed.

Small Business Loans

When a small business or start-up business needs working capital or seed capital, it is common to look for investors to either invest in the company in the form of equity (stock) or debt (loan). In most cases, if a small business cannot acquire financing through a bank, they may have to seek out private investors, such as self-directed IRA investors. Small business loans can either be secured or unsecured.

Tax Advantages

The advantage of using retirement funds to invest in notes/loans investments is that all the income and gains generated by the debt investment would not be subject to any tax or penalty. Instead of paying tax on the returns, such as interest, associated with the debt investment, tax is paid at a later date, leaving the investment to grow unhindered. Using a self-directed IRA to make a loan or invest in a debt instrument is tax advantageous. The tax on the interest payments can be deferred in the case of a pre-tax IRA or exempted permanently in the case of a Roth IRA.

In addition, self-directed IRA investments are made when a person is earning higher income and is taxed at a higher tax rate. Withdrawals are made from an investment account when a person is earning little or no income and is taxed at a lower rate.

Read More: Tax Deferral vs. Tax Free

Why Use an IRA to Invest in Notes/Loans?

Unfortunately, none of the major financial institutions will allow you to use IRA or 401(k) plan funds to invest in Notes/Loans or essentially anything outside of Wall Street. The reason for this is simple: banks do not make money when you invest in non-traditional equities, such as private loans. They make money when you buy stock, mutual funds, and other financial products they market. As a result, a large number of individuals are turning to a Self-Directed IRA to invest in notes or other debt instruments.

Unrelated Business Taxable Income

In general, almost all retirement account investments generating passive income will not be subject to Unrelated Business Taxable Income (UBTI or UBIT) or Unrelated Debt Finance Income (UDFI) Tax.

The UBTI tax is only triggered if:

  • Retirement account uses margin to buy stock
  • Retirement account invests in an active business through a passthrough entity, such as an LLC

The UDFI tax is triggered if:

  • An IRA uses a nonrecourse loan (real estate acquisition financing to purchase real estate)
  • Exemption for 401(k) plans
    • IRC 514(c)(9)

The UBTI & UDFI Trigger the Same Tax Rate

Because the UBTI and UDFI trigger the same tax rate, which is a maximum of 37% for 2019, if you plan to invest into loan/debt related investments using a self-directed IRA and the underlying investment will not involve an investment into a business operated via a passthrough entity, such as an LLC, has debt or margin, then the UBTI tax rules will likely not be triggered.

Your IRA Financial assigned specialist will help you understand the potential application of the UBTI/UDFI tax rules and potentially reduce or eliminate it.

Read More: How to Calculate Tax on UDFI

Act Quickly on Investments

With a Pocket IRA for notes/loans, you will have the power to act quickly on a potential investment opportunity. When you find an investment that you want to make with your IRA funds, as manager of the Checkbook IRA LLC, simply write a check or wire the funds straight from your Self-Directed IRA LLC bank account. The Pocket IRA for notes/loans allows you to eliminate the delays associated with an IRA custodian, enabling you to act quickly when the right investment opportunity presents itself. In addition, with the Pocket IRA structure, all income and gains from IRA investments will generally flow back to your IRA LLC tax-free. Because an LLC is treated as a pass-through entity for federal income tax purposes and the IRA, as the member of the LLC, is a tax-exempt party pursuant to Internal Revenue Code Section 408, all income and gains of the IRA LLC will flow-through to the IRA tax-free!

How Does Investing in Notes/Loans Work?

IRA Financials Self-Directed IRA is an IRS approved structure that allows one to use his or her retirement funds to make debt and other investments tax-free and without custodian consent. The process is simple and can be completed in a few easy steps:

  1. Establish self-directed IRA with IRA Financial Trust & Capital One online though our mobile app. You will need to decide if you want a traditional Self-Directed IRA or an IRA LLC.
  2. Your IRA cash/assets can be rolled over to IRA Financial Trust tax-free directly from our mobile app. Alternatively you can fund your new Self-Directed IRA directly with your bank account. In 2022, individuals under 50 can contribute $6,000 per year. Individuals over 50 can add $7,000 to their Self-Directed IRA annually.
  3. If you pursue a traditional Self-Directed IRA, you can begin investing directly from our app. However, if you pursue a Self-Directed IRA LLC, there are a few additional steps you will need to take:
    1. As manager of the LLC, you will open a bank account for the LLC at any local bank. IRA Financial will draft an LLC Operating Agreement identifying you as manager of the LLC and the IRA as the sole member.
    2. You, as manager of the LLC, will then have checkbook control over all the assets/funds in the IRA LLC to make the debt/note investment. Because the LLC is owned 100% by an IRA, it will be treated as a disregarded entity for tax purposes. There is no need to file a federal income tax return and all income and gains will flow back to the IRA without tax.

With IRA Financials Self-Directed IRA, you will have the power to act quickly on a potential investment opportunity. When you find an investment that you want to make with your IRA funds, as manager of the Checkbook IRA LLC, simply write a check or wire the funds straight from your Self-Directed IRA LLC bank account. The Pocket IRA for notes and loans allows you to eliminate the delays associated with an IRA custodian, enabling you to act quickly when the right investment opportunity presents itself.

In addition, with the Self-Directed IRA structure, all income and gains from your IRA investments will generally flow back to your IRA LLC tax-free. Because an LLC is treated as a pass-through entity for federal income tax purposes and the IRA, as the member of the LLC, is a tax-exempt party pursuant to Internal Revenue Code Section 408, all income and gains of the IRA LLC will flow-through to the IRA tax-free!

Read More: Promissory Note Checklist

The following debt investments have been popular with our self-directed IRA clients in 2019:

  • Hard money loans to real estate investors – secured
  • Hard money loans to real estate investors – unsecured
  • Private business loans
  • Peer-to-peer loan platforms
  • Mortgage notes

How to Get Started

We’re here to help. Contact IRA Financial to establish a Self-Directed IRA for notes/loans directly at 800-472-0646 or fill out one of our contact forms to speak with a tax specialist.

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[10:44 PM] Valerie Marszalek-Boik