While purchasing property within your self-directed IRA account can be lucrative – and can also provide tax advantages – there are other ways that you can invest in the real estate arena without having to buy tangible properties. One way is to become a private lender.
In fact, one of the biggest reasons that many investors will pass on good real estate opportunities isn’t because they feel that the property would result in a loss, but rather because they just simply don’t have the funds that are required.
By using the money that is in your self-directed IRA, though, you can make this a win-win scenario for both the investor and for yourself – and you can oftentimes obtain a higher-than-market return on these funds.
When you loan money to an investor using your self-directed IRA funds, he or she can repay your IRA account – along with the additional interest – and, because your IRA is a tax advantaged entity, the money that goes back into the account will be able to grow either tax-deferred (with a traditional IRA structure) or tax-free (with a Roth).
The loans that you make with your IRA funds that involve real estate will act just like a mortgage, and they are typically referred to either as mortgage deeds or as trust deeds. Because this type of loan can often take place when the purchaser of property does not secure the funds through a traditional bank or other lender, they are oftentimes also termed as “hard money” loans.
You may make either secured or unsecured loans with your self-directed IRA funds. The most common type of loan will usually be a secured loan. A secured loan is a loan in which the borrower pledges an asset – such as the underlying property – as collateral for the loan.
So, if the borrower should default on his or her payments, you as the lender would be able to take possession of the property or other underlying asset, and in turn, sell it in order to recoup some or all of your loaned funds. When this occurs with real estate, this re-possession is typically considered a foreclosure.
Because there is an asset pledged as collateral, secured loans will usually be considered more secure from a lending perspective than an unsecured loan. With an unsecured loan, funds are loaned based only upon the creditworthiness of the borrower. (Unsecured loans may also be referred to as a “signature” loan or a personal loan). Some examples of unsecured loans include credit cards and personal lines of credit.
Unsecured loans are considered to be more risky for a lender, as there is nothing to recoup if the borrower should default. For this reason, the interest rate that is charged for an unsecured loan is generally higher than that charged on secured loans.
In many instances, lending to property purchasers through your self-directed IRA account will be a safer way to go, as the real estate will act as collateral for the loan. In this case, once you start working with a borrower, there are some steps that must be followed in order to put the loan in place.
These steps will typically include the following:
- Property Appraisal – You will first want to have the property appraised. This can help to ensure that the underlying property (collateral) is worth as much – or ideally, more – than the amount being borrowed.
- Title Search – You will also need to contact a title company in order to perform a title search. This can help you to see if there are any unresolved liens on the property.
- Legal Paperwork – Provided that the title is clear, and that the value of the property is sufficient in terms of the amount being borrowed, you will then move forward with having your attorney review the paperwork for the transaction.
- Fund Escrow – Before the closing date of the loan, your IRA custodian should forward the necessary amount of funds from your IRA account to a closing or an escrow agent.
After the loan has closed, your IRA custodian should receive a copy of the recorded mortgage from the closing agent. You (or your IRA custodian or third part loan processor) will then begin to receive the repayments from the borrower, which will be deposited back into your IRA account.
Receiving the loan repayments from a borrower can be set up in a couple of different ways. The way in which this occurs can be dependent on whether you have your IRA set up via a custodian or as an IRA LLC.
For example, if working through an IRA custodian, the payments from the borrower should be sent directly to the custodian, and the check should be made out to your custodian for the benefit of (or FBO) your IRA.
This would look like the following:
ABC Company Custodian FBO “Your Name” IRA Account
Upon receiving each of the loan payments, your IRA custodian would deposit the money into your IRA account. (Likewise, if the property has any type of expenses, such as for repairs and / or mortgage, the funds that you use for these must come out of the IRA account).
Rather than using your custodian to receive the loan payments, you could instead opt to use a third party loan processor. Before moving forward with this option, the loan processor will typically require copies of all related documents, such as the loan paperwork between you and the borrower.
You may alternatively have the borrower send the loan repayments directly to you. In this case, however, you are not allowed to deposit these funds into any personal accounts, but rather you should forward them to your IRA custodian or third party loan processor for deposit into your self-directed IRA account. Likewise, the borrower should make out the check for the benefit of your IRA account, and not to you personally.
When setting up any type of loan through your self-directed IRA account, it is recommended that you consult with your advisory team, such as your accountant and / or attorney, in order to be sure that everything has been properly initiated, and that the transaction is in compliance with IRS rules.
Also, there are some specialists in the market place who focus primarily in the area of private lending via self-directed IRAs. So, if you do plan to use your IRA funds for lending purposes, you may want to locate a specialist in this niche and add them to your self-directed IRA advisory team.
The funds that are in your self-directed IRA can be loaned to other investors for many different reasons. These include the purchase of real property, as well as for the purchase of mortgage notes, tax lien certificates, and / or for private placements.
But, prior to moving forward with any such transaction, it is essential to have a good understanding of the IRS (Internal Revenue Service) rules that are associated with these types of transactions.
This is because, just like taking part in any other type of prohibited transaction, not following these rules can result in penalties to your self-directed IRA account – including the loss of its tax-advantaged status.
For instance, while you are allowed to loan money to any other person, this does not include those who are considered “disqualified” by the IRS. Here again, according to the IRS, these individuals include:
- Yourself (as the IRA account owner)
- Your ancestors (such as your parents and / or grandparents)
- Your Lineal descendants (including your children and grandchildren)
- The spouses of your lineal descendants
- Fiduciaries and other individuals or entities that provide service to the self-directed IRA account
- Any business entities that are related to the account in which any of the above-mentioned individuals has an interest or 50% or more.
In addition to rules that are set by the IRS, it is also important to know whether or not your particular state has any additional regulations when it comes to these types of private lending situations.
If the loans that you make with your self-directed IRA funds are properly set up, and they are provided to those who make their regular repayments on time, this can be a good source of income for you that will typically earn above market rate returns.
In addition, when these funds then continue to grow either on a tax-deferred or a tax-free basis in your IRA account, this compounding can result in an even higher return on your money over time.
When a borrower makes his or her monthly loan repayments for money that was loaned through your self-directed IRA, what are the options that are available in terms of sending in these funds?
There are several alternatives here, which may depend on how the IRA account is set up. These include the following possibilities:
- Sending the money directly to the IRA custodian
- Sending the money to a third party loan processor
- Sending the money directly to you, the IRA owner
In all cases, though, the check must be made out FBO (for the benefit of) the IRA account, and not to you personally.