Self-Directed IRA to buy notes is increasingly growing in popularity for many retirement account investors. This type of investment is also known as a Self-Directed IRA hard money loan.
What is a Self Directed IRA?
A Self-Directed IRA (SDIRA) is not a term you will not find anywhere in the Internal Revenue Code (IRC). A Self-Directed IRA simply refers to an IRA account which allows the IRA holder to invest in traditional assets. This includes stocks, bonds and ETFs (Exchange Traded Funds). More notably, it also allows the IRA holder to make alternative assets, such as real estate or even cryptocurrencies. In the last several years, the number of Self-Directed IRA accounts has grown significantly.
What is Note Loan?
A note is a type of contract whereby the lender and the borrower’s obligations are stated in the actual terms of that loan. If one member of the party does not follow these rules, the other member has a right to sue. For many Self-Directed IRA investors in 2018, note loans are an attractive investment option for generating strong returns in a tax-deferred or tax-free manner. This is in the case of a Self-Directed Roth IRA.
No Tax on Interest Earned When Using a Self-Directed IRA to Buy Notes
The best part of using a Self-Directed IRA to invest in notes is that you get to invest in what you know and understand. Additionally, Self-Directed IRAs are often seen as a valuable diversification option and hedge against inflation. Moreover, the interest you generate from the note loan flows back to the Self-Directed IRA without tax.
In general, note loans can either be secured or unsecured. When using a Self-Directed IRA to invest in note loans it is critical that the borrower not be a “disqualified person.” A “disqualified person” is essentially the IRA holder and any of his or her lineal descendants. Additionally, any entities such persons control. In other words, one cannot use a Self-Directed IRA to buy notes to lineal descendants or an entity associated with a “disqualified person.”
5 Steps to Using a Self directed IRA to buy notes
Below is a step-by-step breakdown of how you can use a Self-Directed or checkbook control IRA to make a loan to a non-disqualified person or invest in a note loan:
Establish a Self-Directed IRA
First, you need to establish a Self-Directed IRA with an IRA custodian or trust company. The company must allow 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.
Establish an LLC
In the case of a checkbook control Self-Directed IRA solution, a special purpose LLC will be established. The IRA completely owns the LLC (limited liability company). Keep in mind, there’s no requirement to establish an LLC to invest in note loans. The IRA custodian can transfer the funds to the borrower on behalf of the IRA. However, using the LLC will likely cut down on annual IRA custodian transaction fees.
Establish a bank account for your LLC.
The next step is to establish a bank account for your limited liability company. You will need to have the LLC article of formation, a Tax ID number, as well as a Self-Directed IRA LLC operating agreement.
Notify the Custodian
Notify the IRA custodian that you wish to have the funds sent to the new LLC bank account. The custodian will then transfer The IRA assets/cash to the LLC tax-free in exchange for 100% interest in the LLC. Alternatively, if you don’t use an LLC, the IRA custodian will transfer the funds to the borrower on behalf of the LLC.
As manager of the LLC, will then have checkbook control over all the assets/funds in the IRA LLC. Now, you have the authority to send the funds to the borrower as part of using your self directed IRA to buy notes. You have the option of having a secure or a loan that isn’t secure. Depending on the terms of the loan, the borrower will send the interest and principal payments back to the LLC or the IRA custodian directly if they don’t use an LLC.