The IRS doesn’t tell you how you can invest your IRA, but they do tell you which investments are not permitted.
The only things that you are prohibited from investing in through your IRA are collectibles and life insurance. Additionally, the IRS says that you cannot invest your IRA with disqualified parties, which include yourself and any lineal family members. These rules can be found in the Internal Revenue Code Sections 408 & 4975.
Investing your IRA in real estate, precious metals, private stock, and the stock market are all popular and acceptable ways to invest your retirement money, but today we’re going to talk about investing your IRA in loans.
Types of Self Directed IRA Loans
There are two types of allowed self directed IRA loans: secured and unsecured. An unsecured loan is any loan that is not backed by collateral, meaning that if the loan defaults you do not receive anything in place of the unpaid money. This is obviously the less common way of loaning money and is not advisable. You should only use an unsecured loan with someone very close to you, and even then, it’s not necessarily a good idea.
A secured loan, on the other hand, is a loan backed by collateral; usually real estate or some other tangible asset. With a secured loan, if the borrower fails to abide by the terms of the contract, they forfeit the collateral to the lender. A common example of a secured loan would be a mortgage. In this type of loan, the lender would receive the home instead of money should the loan default.
Now that we’ve defined secured and unsecured loans we can talk about how to loan money through your IRA.
Self Directed IRA Loans and Disqualified Parties
As we discussed earlier, the IRS prohibits you from investing your IRA with disqualified parties, which is defined as yourself and any lineal family members. This means that you are allowed to loan money to any person or entity that does not fall into that category.
Once you have found a borrower, I highly recommend speaking with an attorney to draw up the necessary paperwork. If you are loaning money to someone to purchase real estate, you will likely use a Note and Mortgage. The Note and Mortgage will define the terms of the contract, such as the loan amount, interest rate and term.
Keep in mind that it is not the IRA Custodian’s job to make sure payments are made promptly or assist in any way in the case of a default. If your borrower does not make payments or abide by the terms of the contract, it is the account holder’s responsibility to take action. Any attorney’s fees or other costs incurred from default proceedings MUST be paid out of the IRA. This process varies from state to state and often requires legal action. If your borrower fails to make payments or does not abide by the terms of the contract, it’s crucial for you speak with an attorney before proceeding.
Suitable IRA Loan Collateral
Should the borrower default, any collateral could become the possession of the IRA. When determining if a loan is a good idea or not you should always take the collateral into consideration. Ask yourself if it’s something that has value or you would want to own in your IRA if the borrower is unable to pay you back.
Loan collateral is often real estate, but other things can be used as collateral as long as they are permitted in an IRA. Earlier I mentioned that collectibles are not permitted in an IRA. This means that your buddy’s priceless baseball card collection would not be suitable collateral for an IRA loan. If you have questions about acceptable collateral for an IRA loan you should speak with a tax attorney.
Promissory Notes are another common way of loaning money through your IRA. Promissory Notes, like other types of loans, can be secured or unsecured. In my opinion, you should never use an Unsecured Promissory Note, but with that being said, I see people do it all the time.
It’s extremely important to do your due diligence when making any investment through your IRA. Ponzi Schemes often use Promissory Notes to steal money from individuals and IRAs. These notes are usually unsecured and make promises about huge profits or claim to be “guaranteed.” Use caution when lending money out of your IRA and always speak with an attorney or tax professional before making any investment decisions.