Make Your IRA Work for What is Best for You
By Clay Malcolm
When it comes to private lending, or any other investment opportunity, investors are beginning to understand a fundamental truth: If I can do it personally, my IRA, 401(k), or health savings account (HSA) can likely do it as well. With a few exceptions regarding disqualified persons and titling considerations, most loans originated or purchased with personal funds are perfectly allowable within tax-advantaged retirement funds as well. For a borrower looking for a loan, this provides a new avenue for skipping the banks. Interest rates can be competitive (since the IRA holder and the borrower determine the rate, term, etc.) and funding times can be slashed from weeks to days with the right IRA provider. This structure allows lenders to double their investment power by putting their tax advantaged funds to work in addition to their personal capital.
Self-directed retirement accounts provide a degree of control that Wall Street retirement accounts, with only publicly-traded securities, typically cannot offer; yet there are a few key distinctions between personal investing and retirement account investing. It is important to understand your retirement account is a separate legal entity than you personally. Therefore, the separation of those moneys is absolutely critical; IRA income yielded through interest payments must return to the account until a distribution takes place. Conversely, any costs associated with establishing and servicing the loan would need to be covered by the account and could not be paid “out of pocket.” Fees associated with security documentation or legal services are potential expenses in this context. Even though you, as the lender and IRA holder, will interact with any applicable entities in completing such tasks, compensation for services would still have to come from your account.
In accordance with IRS regulations, parameters surrounding prohibited transactions must also be considered. Prohibited transactions most often occur when IRA-related business is carried out with disqualified persons. These disqualified individuals include certain immediate family members (parents, children, grandparents, grandchildren, their spouses, etc.), and any entities owned and/or controlled by disqualified persons, or fiduciaries to one’s retirement plan.
Non-lineal family members including siblings, aunts, uncles or cousins are non-disqualified, so one’s IRA could benefit from working with these people without IRS restrictions.
With these guidelines in mind, let’s examine common loan structures and address additional considerations involved with implementing these strategies within a self-directed retirement plan.
The tried and true method of granting a sum of money and charging interest is certainly available to IRA investors. Common structures like personal or automobile loans can be offered by a retirement plan as a secured or unsecured note. An IRA can help a borrower pay off student loans at a lower interest rate, it can be a second mortgage on a property, even act as a hard money lender for a fix and flip project.
IRA lenders apply the same investment principles they likely already use personally: conducting comprehensive due diligence, qualifying potential borrowers, and establishing agreeable terms to encourage successful loan fulfilment and a profit for the retirement account.
Potential lending activities in this regard include, but certainly are not limited to:
- Commercial or residential construction projects
- Bridge loans
- Fix & flip projects
- A new business in need of startup capital
- An ongoing business in need of operating capital
- And virtually any other loan variation
Lines of Credit
Your IRA, 401(k), or HSA can issue a line of credit, offering a loan sum on behalf of your plan and only collect interest on the actual cash your borrower requests. Although self-directed IRA investing requires the account holder to remain at arm’s length from IRA-owned assets, the IRS allows the account holder to determine the pertinent terms of the loan. It also alleviates any possible headaches from having to amend a note to request additional funds from the IRA custodian or third-party administrator. Depending on the policy of the IRA Company, requesting a withdrawal of funds to execute a loan could be a lengthy process. So be sure to do your due diligence; compare IRA companies and their processes for funding notes and lines of credit. Extending a line of credit provides flexibility to all applicable parties by requiring the borrower to only pay interest on money received and by authorizing additional IRA withdrawals when warranted.
When borrowers stop making payments on their loans, banks have historically responded by triggering security clauses to acquire collateral. In recent years, however, banks have begun selling non-performing loans to recoup a portion of their capital without the hassle of trying to collect. Although these loans can be difficult to acquire, IRA investors can pursue these opportunities in the same manner as personal investors. Like other methods of private lending, IRA holders can participate in acquisition and refinancing endeavors without violating the rules surrounding prohibited transactions. For instance, if your IRA purchases a non-performing home loan and you don’t want to foreclose on the family living there, you can personally determine and implement new, mutually-beneficial terms to create a solid economic opportunity for your plan while allowing the family to keep their home.
Equity in an Entity or Fund that Issues Loans
Can’t find a borrower or not sure you want the headache of a hands-on approach to the strategies discussed? This model may better suit individuals who don’t want to issue and service loans but still want to invest in the business of lending. Private lending companies are becoming commonplace as business owners pursue funding but don’t want the hassle of applying to a bank. These companies are always looking for capital they can use to lend to borrowers.
This mitigates the risk of losing your investment to a non-performing loan and may therefore suit investors with different risk tolerances. Of course, your investment still relies on the success of the investment company, but a series of failed loans may not be as likely as a single defaulted transaction into which you allocated a significant portion of your retirement plan.
Purchasing portions of larger loans has emerged as an increasingly popular means for investors to learn about the world of lending or participate, invest limited available capital, or diversify capital amongst multiple loans.
This lending model is often accomplished through online platforms, known as “fintech” or financial technology. Websites provide a single location for potential investors to review opportunities in real estate loans, small business loans, or other such transactions and contribute small sums toward the total capital requirement, all from the comfort of one’s living room or home office. Technology can promote a strong relationship between partial debt transactions and self-directed retirement plans as IRA providers develop analogous and compatible technology. This allows retirement investors to engage in business activities with a level of convenience that other investment models often don’t provide.
Loan to Another Retirement Plan
We have detailed several ways to use retirement funds as a lender. Another approach that includes all strategies discussed, is the borrower can be another IRA. As long as the borrowing retirement account does not belong to someone on your disqualified persons list, your IRA can serve as a lender, using any of the forms of lending we have covered, to another retirement plan. The loan can be secured but must be constructed as a non-recourse loan meaning that the account holder (or any other disqualified person/entity) cannot pledge any personal assets to secure the loan. The only recourse the lender has, should the loan default, is the property the loan is secured against. All retirement accounts can use non-recourse financing to purchase property, and many banks offer non-recourse loans, but the terms and process can often discourage investors. Using IRA funds creates new opportunities for both investors.
Financing for Real Estate
Your IRA can be someone’s mortgage lender. As leveraged real estate investing grows in popularity, IRA lenders can diversify their retirement portfolio by providing the financing for real estate purchases. Your IRA can be in a first lien position or come in as a second mortgage. The account holder does the due diligence on the borrower, and determines the terms for the note. The account holder also chooses how the loan is serviced, making sure payments are made in time to the IRA, HSA or solo 401(k) accounts. As traditional lenders have tightened guidelines for borrowers, private money lending creates a viable option for investors looking to diversify their retirement funds.
As you can see the lending-based opportunities for some IRA investors are broad. Many people are not aware of their ability to include their retirement accounts into their investment strategies; so, it can be important for all the parties involved in IRA investing to keep educating investors. Whether you are an individual investor or a business in the lending space, it is important to have easy access to IRA educational assets, and to choose an administrator that has the technological means to support your investment strategies.