Private Lending with Self-Directed IRAs

May 30, 2017

Self-directed IRAs offer investors an opportunity to invest in alternative assets, either through managed funds or directly. When the assets are private – that is, not registered with the SEC – ownership might be limited to accredited (i.e., wealthy) investors. An accredited individual earns $200,000 a year ($300,000 for joint filers) or has net wealth of at least $1 million, not including a primary residence.

Secured Notes

Secured notes are promissory notes backed by assets. In the real estate context, a mortgage note is a type of secured note, backed by a mortgaged property. A secured note is the more general term, including promissory notes on commercial property debt. Secured notes transfer ownership of the debt associated with property, not the property itself (unless a foreclosure occurs). In other words, a note owner obtains a lien on the underlying property enabling foreclosure if default occurs.

A homeowner signs a mortgage note at the closing. The note establishes the owner’s promise to repay mortgage or face foreclosure. Frequently, government-sponsored agencies such as Freddie Mac and Fannie Mae buy these notes from mortgage lenders. The GSAs bundle the notes into pools and sell to investors mortgage-backed securities backed by the cash flows from the pools. However, accredited or sophisticated investors can buy privately placed mortgage notes and reap monthly inflows of interest and principal. Sources of mortgage notes include broker/dealers and online person-to-person (P2P) portals.

Of course, not all notes are created equal, and some are more attractive than others. For example, you might be interested in high-interest notes, but keep in mind that these may also bear higher default risk. To lower your risk exposure, you might want to purchase notes on seasoned mortgages with a proven track record. Higher risk is also associated with special-feature mortgages, such as ones that are interest-only, or adjustable rate ones with balloon-payment requirements. Another strategy is buy new notes in which the underlying property contains substantial equity – that is, the borrowers put up a substantial down-payment, a feature of so-called “hard-money” loans. Secured notes, often available at a deep discount, can provide predictable payments backed by ground leases, rents, option contracts and/or general account funding.

Secured-note/mortgage-note managed funds provide the benefit of professional management and instant diversification. They also allow investors to enter this market with a smaller minimum investment.

In general, unsecured notes expose your IRA to higher risk but also potentially higher returns. Unsecured notes are often scrutinized by regulators for possible money-laundering activity.

Self-Directed IRAs

A self-directed IRA is administered by a custodian willing and able to trade alternative assets on behalf of the IRA owner. You can own multiple self-directed IRAs devoted to different asset classes, such as real estate and precious metals, but your maximum total annual contribution remains the same. In 2017, the limit is $5,500, or $6,500 if you are age 50 or older.

Purchasing secured notes and mortgages offers IRA owners several benefits, including:

• Diversification: Many investors create retirement portfolios composed only of stocks, bonds and mutual funds/exchange-traded funds. While these assets certainly are fundamental to any retirement plan, they do not provide the full benefits of diversification afforded by alternative asset types, such as private real estate debt. By diversifying into alternative assets, you increase the likelihood that one asset class will zig when the other one zags, thereby reducing the portfolio’s overall volatility. The returns from private mortgage/secured loan debt is likely to have a limited correlation with other asset classes, such as stock, municipal bonds and corporate debt.
• Tax benefits: IRAs are tax-sheltered accounts. Traditional IRAs allow you to deduct your annual contributions from your taxable income and defer taxes on any gains or income. Instead, you add any withdrawals from your traditional IRA to your ordinary income for the year. Withdrawals from Roth IRAs are tax-free if you follow the rules. With a traditional IRA, you can stretch your withdrawals over your lifetime, starting no later than age 70 ½. This allows you to shelter the remainder of your IRA balance for as long as possible. If you predecease your spouse, the IRA moves to the spouse without tax consequences. Non-spousal beneficiaries can also stretch out their withdrawals, usually for a period of not less than five years. Roth IRAs do not require withdrawals in the original owner’s lifetime, and beneficiary withdrawals are tax-free.
• Freedom from UBIT: Normally, IRAs that own debt-financed real estate are subject to Unrelated Business Income Tax (UBIT). Fortunately, UBIT does not apply to interest income from secured notes and mortgages, because you own only the debt, not the underlying real estate. In other words, you are a creditor, not a debtor, and you are not using leverage to buy real estate.
• Creditor protections: In most states, the first $1 million in a traditional IRA is protected from creditors seeking to attach your wealth in a bankruptcy proceeding. Laws concerning Roth IRAs are less protective in some states.

Self-Dealing Rules

IRS self-dealing rules prohibit your IRA from buying notes from yourself, family members, fiduciaries or IRA beneficiaries. The IRA is the note-owner, so only the IRA can benefit from the ownership. For instance, are not allowed to use the note as loan collateral. You can’t contribute an existing note to your IRA – the IRA must purchase the note directly.

Foreclosures

Should the borrower default on the loan, your IRA can foreclose and gain title to the underlying property. While this secures the note, it requires money and time to complete a foreclosure, at which time your IRA becomes an owner of real estate. Therefore, the custodian of your self-directed IRA must be prepared to manage real property, not just secured notes. Your custodian can auction the property once the IRA takes title. The auction terms may invoke “full-credit bidding,” preventing the property’s sale for less than the debt amount, in which case the property remains in the IRA.

Alternatively, an IRA might choose to sell a distressed note before foreclosure, although this inevitably results in a loss.

If your IRA invests in a managed fund, the fund is responsible for handling defaults and foreclosures, a significant benefit.

Authored by Tracy Stein – CEO & President of Prime Pinnacle Investments

Toll Free: 855-387-7463

Email: TracyStein@PrimePinnacle.com