Hard money lending using IRA often proves an excellent strategy to significantly enhance your returns.
Hard Money Lending | IRAs
We use the term IRA loosely to refer to any retirement account. These include standard IRA, Roth IRA, SEP-IRA, Money Purchase Plan, 401K, and Defined Benefit Plan. Many legal differences exist between the retirement accounts, but for purposes of private / hard money lending, we lump them together for ease of reference. And, since different states use different security instruments for loans, the generic reference of “mortgage” or “note” often means a mortgage, trust deed, promissory note, or land contract.
Using IRA to fund a hard money loan
Most people believe funds in IRAs are limited to investments in stocks and bonds. That isn’t true. IRAs invest in a variety of alternative investments such as private placements, limited partnerships, mortgages, real estate, and more. Use a special custodian to manage and properly account for your transaction to fund a hard money loan. The custodian’s handling of alternative investments is typically referred to as “self-directed” IRA custodians. They’re an excellent way to make private / hard money loans, or do “note investing” as its sometimes called.
Let’s begin exploring note investing in your IRA by considering a simple case. Joe Investor originates a $100,000 interest only loan to Mr. Smith, at 6% interest. And, he originates the loan using his self-directed IRA. For our first case, let’s assume that Mr. Smith pays each loan payment on time and pays the loan off within 5 years.
The transaction proves profitable for Mr. Smith and Joe Private Investor. Mr. Smith receives a private loan he may not otherwise have obtained, and Joe Investor enjoys 6% tax deferred income in his IRA.
Originating the hard money loan
So how does one make this simple, hard money lending using IRA funds? Similar to originating a mortgage from your traditional checking account, follow these six steps.
Step 1: Open a self-directed retirement account.
Many of us typically use the big brokerage houses as the custodian for our retirement savings. But those firms only permit investors to invest in publicly traded securities. Therefore, personal loans aren’t available options. But there are numerous companies that specialize in enabling you to self-direct your investment to “alternative investments.”
Step 2: Vest the note for the hard money loan properly.
In a traditional transaction, your note vests in your name, or your company’s name. But a self-directed IRA involves a bit more detail in the vesting of the note. The below example of a typical IRA vested note references the custodian, account number and IRA holder.
ABC Custodian Company, FBO “Joe Investor IRA Account # 123456”.
Step 3: Sign agreements which authorize the custodian to fund the note.
The custodian requires you to follow pre-established procedures. And most will have the form of agreement they need you to sign. Also, brokers specializing in private money lending will gladly assist you. This agreement authorizes the custodian to release the funds. Most custodians provide a checklist you can use to make sure you cover each step during loan origination.
Step 4: Close the transaction.
Step 5: Send copies of the security agreements to custodian.
Once the note is funded, the IRA custodian will need to hold the actual promissory note and recorded security instrument (deed of trust, mortgage, etc.). This is similar to a conventional IRA brokerage house holding your stock certificate.
Step 6: Coordinate with the servicer to send payments to the custodian.
Avoiding Hard Money Lending | IRA Pitfalls
While it’s nice to think that all borrowers will pay their mortgages as reliably as Mr. Smith does, it unfortunately is not the case. Note private investing gets more complicated when the borrower does not pay on time and there are a number of issues particular to retirement accounts that make note investing even more risky if you do not know what to look out for.
There are many times when investors need to advance funds against the mortgage. An advance is a payment of funds by the private investor for something that was supposed to have been paid for by the borrower, or for services required to protect the collateral. One advance example is for insurance. The borrower’s home insurance may lapse and to continue to protect your note, you will need to either advance to renew the policy, or advance to a specialty insurance company to force place insurance. Delinquent property taxes are another example when an advance could be necessary on private loans.
With a traditional loan investment, the issue of advancing funds centers on coming up with the advance funds. But with a self-directed retirement account, you first have to figure out how to get the money into the IRA account before you can advance it. If you have already maxed out your contribution to your IRA, you may not be able to advance.
More on Hard Money Advances
Advances can be significant. Consider a foreclosed home that upon possession required a $40,000 remodel to reach fair market value. Or, consider a bankruptcy lasting several years and requiring advances of thousands in attorney, sheriff or trustee fees.
Note that you are not permitted to pay for any IRA owned asset expenses personally if your IRA is unable to, as this would be considered a prohibited transaction (e.g., self-dealing with your IRA). Your first remedy for a shortfall of funds in your IRA would be to transfer funds from any IRA you may have at another institution, or to rollover funds from a qualified pension account.
If those potential solutions fail, there are still other alternatives. The Department of Labor, which governs retirement accounts, has issued guidelines that enable you to make a loan to your IRA. A loan may be made to your IRA if it is interest free, unsecured and provided it is:
a) For the payment of ordinary operating expenses;
b) For a purpose incidental to the operation of the IRA.
If the loan extends beyond 60 days, you must create and sign documentation within the 60 day period. Loans may not be used to increase the buying power of the IRA. For example, you cannot loan your IRA $100,000 to buy another property.
Prohibited Transactions | Hard Money Lending & IRAs
When using an IRA to invest in notes or real estate, it is critical to avoid conducting a prohibited transaction. This type of transaction is any improper use of your retirement account by you, your beneficiary, or any disqualified person. Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
The following are examples of prohibited transactions with a traditional IRA:
- Borrowing money from it. (Except as outlined in this article.)
- Selling property to it.
- Receiving unreasonable compensation for managing it.
- Using it as security for a loan.
- Buying property for personal use (present or future) with IRA funds.
Essentially, you need to conduct business with unrelated third parties. So you would not want to make a loan to a stranger, and then hire your spouse to service the loan. Or you would not want to hire your brother to do your taxes for a fee charged to the IRA. Be very careful. Prohibited transactions are not always obvious. Consult a CPA, an attorney, or your custodian well versed in these types of transactions before you experiment on your own. Several of the self-directed custodian companies maintain a directory of professionals that specialize in this area and can be of tremendous assistance.
If the IRS determines you have conducted a prohibited transaction, your entire IRA may be disqualified and subject to substantial penalties, fines and taxes.
Unrelated Business Taxable Income (UBTI)
UBTI: the gross income derived from any unrelated trade or business regularly carried out by an exempt organization. The tax on the unrelated business taxable income is called Unrelated Business Income Tax (UBIT).
Most frequently, UBTI comes into play when debt is involved in a real estate transaction. An example would be if your IRA buys a home for $100,000 using $20,000 of its own funds and borrowing $80,000. Although the transaction is perfectly fine to do in an IRA, the IRS will not let you benefit from the entire income (or gain) of the property. You may only benefit from the income (and gain) as it relates to the equity or IRA funded part; in this case, the $20,000. This may mean that you pay tax on 80% of the investment income and gain (if any) and receive the tax-free or deferred benefit from your IRA on 20%. The debt financed portion is referred to as “Unrelated Debt Financed Income (UDFI).
More on UBTI
Most people believe UBTI is not permitted within an IRA. It is permitted. You just have to be aware of it, and make sure your tax accountant files the appropriate form (IRS 990 T form: see www.irs.gov for the form and its instructions). If you are investing in a partnership that is purchasing real estate or mortgage notes, be especially careful that you know exactly how the partnership is planning to use leverage, if at all. The partnership’s use of leverage, if not properly documented and treated, could create unintended UBTI potentially subjecting it to significant fines and penalties.
In the note business, UBTI can come into play if you foreclose on a home and inherit an existing lien. Let’s assume your IRA lends a 2nd mortgage for $50,000 and the 1st is $100,000. If the investor foreclosed, the investor would inherit $100,000 of debt and could be subject to UBTI.
Interestingly, the UBTI in this scenario only comes into play if the investor converts the property to a long term rental hold. But because the debt was acquired as a normal part of the operations of the mortgage note, UBTI is not considered if the investor diligently liquidates the property.
There are many complicated rules surrounding leverage and the use of retirement accounts. Be aware of the leverage and the impact to your IRA and consult professionals to guide you to make prudent business decisions.
Using a Corporation or an LLC
If you are going to make multiple loans from your IRA, you may wish to consider establishing an LLC or a Corporation. When you set up this entity, you can have your IRA be the 100% owner of the company and you may make yourself the manager / president. As the manager, or president, be sure you do not pay yourself, as that would be a prohibited transaction. Be aware that most custodians will no longer accept single member entities like LLCs funded solely by an IRA and managed by the IRA for fear that the IRA owner will inadvertently expose their IRA to disqualification as a result of a prohibited transaction. Most custodians will review investment transactions they execute for their clients with the intent to prevent prohibited transactions.
When IRA funds are invested in an LLC managed by the IRA owner, the custodian is no longer involved in the transaction execution. Transaction execution would be handled directly by the IRA owner and manager. Some custodians have addressed their concerns about potential prohibited transactions, while still accepting single member investment entities, by requiring an independent and qualified professional like a CPA or attorney to sign an agreement with the client that requires them to review and approve each transaction.
More on LLC
Setting up your IRA this way proves beneficial in certain ways. When your IRA ‘buys’ 100% interest in the new LLC or Corporation, the cash transfers to your company’s checking account. The mortgage notes vest in the name of the company, not your IRA. And, you control the checkbook of your IRA, making it easier to originate loans, advance funds, etc. However, be careful. Operating your IRA this way also makes easier to unwittingly conduct a prohibited transaction. Reason being, the custodian doesn’t scrutinize each check and transaction.