While most investors don’t know this, the IRS permits an IRA to lend money (IRA loan) to non-disqualified persons. For those who do not know, a disqualified person includes:
- The IRA holder (you)
- Ancestors or lineal descendants of the IRA holder
- Entities in which the IRA holder holds a controlling equity or management interest
In the traditional sense, a 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. The loan is paid off over a predetermined period of time. There are two types of loans by the borrower: secure and unsecure. However, in the case of real estate, a hard money loans is a way to borrow without using traditional mortgage lenders. Loans come from individuals or investors who typically lend money on the property you’re using as collateral.
Using your Self-Directed IRA for IRA Loans
You can use a self-directed IRA to facilitate note or loan transactions. This has become a popular investment category over the last several years. Securing a traditional loan from a bank or financial institution is still difficult since the 2008 financial meltdown. 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 IRA loan receives interest, which is exempt from tax. This is the primary reason why using retirement funds to make hard money loans is attractive to so many investors. Additionally, you have the potential to diversify your retirement portfolio by generating a steady stream of interest income without tax. In some cases, the Self-Directed IRA allows investors to lend money to a non-disqualified family member, such as a sibling or cousin who in need of funds. This makes it a win-win for both parties.
Below is a step-by-step breakdown on how to use a Self-Directed IRA (checkbook IRA) to make a loan to a non-disqualified person:
How to Make a Loan to a Non-Disqualified Person
- Establish your 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 plan to use for tax-free investments to the new IRA custodian.
- A special purpose LLC will be established that your IRA wholly owns.
- Establish a bank account for your LLC.
- Notify the IRA custodian that you wish to have the funds sent to the new LLC bank account. The IRA assets/cash will transfer 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 a secure or unsecure loan. Based off the terms of the IRA loan, the borrower will send the interest and principal payments back to the LLC.
- Since the IRA owns the LLC, it’s treated as a disregarded entity. This is for federal income tax purposes. No federal income tax return will be necessary for filing. All income and gain from the real estate investments will flow back to the IRA without tax.