Most people in the U.S. are unaware that tax-advantaged accounts, like Traditional or Roth IRAs or old 401(k)s, can invest in “alternative” assets such as private loans. However, the IRS actually does allow “self-directed” accounts to invest in Private Lending investments, real estate, private placements, gold, and much more. For private lenders, this knowledge can create a new and very large source of capital.
It is not surprising that many individuals are not aware of the power self-direction offers. The most well-known bank and brokerage house retirement plan custodians restrict IRA holdings to assets they sell, which are typically stocks, bonds, and mutual funds.
The self-directed IRA custodians that handle alternative assets give individuals the ability to control their retirement account investment choices in a way that can mitigate (and possibly avoid altogether) the highs and lows of the stock market.
Individuals do not have to take money from their retirement plans to invest in alternatives. The assets are purchased by the IRA, titled in the name of the IRA, and thereby owned by the IRA. Investments such as private notes provide tax-advantaged growth that can exceed the ROI of typical stocks, bonds, or mutual funds.
Investing in Private Notes with a Self-Directed IRA
Self-directed plans can invest in tangible assets like real estate, as well as private notes that hold property as collateral. If property is used as collateral to back a note and the note goes into default, an IRA has the ability to take possession of the property. The IRA can rent or even sell the property to recoup the balance owed on the note. In the event of the sale of property, capital gains fall under the tax-sheltered status of the IRA. Depending on the type of plan—these gains are tax deferred (in a traditional IRA) or tax free (in a Roth IRA). That said, collateral is not required by the IRS, but is an oft preferred feature for IRA investors. The fact is, the IRA investor can participate in numerous lending options.
An IRA is a separate legal and financial entity from an individual’s personal money, but the individual controls the IRA’s investment activity. It is, therefore, helpful to recognize that an individual investor may have two (or more) sources of capital to invest: their personal funds and their IRA funds. When speaking to a potential investor, a lender who offers an investment opportunity is addressing one person but two investors—the person and the IRA.
IRA Investment possibilities in notes include:
- Originating or buying existing notes – whole or fractional
- Selling Notes – whole or fractional
- Investing in a debt-based fund
There are two key elements for an IRA to successfully engage in private lending investment strategies. First, the IRA holder must have their account’s funds with a custodian that handles private notes and/or funds. Moving funds to such a custodian can be accomplished without tax or penalty to the account. Second, because an IRA is a legal and financial entity, and because it is the entity making the investment, all investment documents need to use the name of the IRA, not the name of the IRA holder.
Let’s focus on two popular examples:
1. An IRA as a Note holder
These transactions involve an IRA holding a note (originated by the IRA holder or purchased by the IRA holder after origination) for a loan made to an individual, a company, or other entity. The borrower may have desired a mortgage loan, a bridge loan, construction loan, or cash for any number of other needs. The IRA grows by receiving the principle and interest payments.
The IRA owner is responsible for performing all due diligence including but not limited to vetting the borrower or existing note. The IRA owner also sets the terms of the loan and can deny funding to anyone as she/he deems necessary.
2. An IRA as an Investor in a Fund or Company
This private lending investment is characterized by the pooling of money from different sources under the umbrella of one fund/entity that extends loans to others. Here, the IRA is typically more passive, as all lending decisions are made by fund managers. The IRA is simply an investor in the fund or entity. Income earned on these investments is disbursed by the fund/entity and gets deposited into the IRA.
Keep IRAs in Mind
The Private Lending industry is a key part of our economic landscape. It allocates capital in a way that most large lending institutions don’t or can’t. The entrepreneurial spirit endemic to Private Lending professionals is similar to the mindset of self-directed IRA investors. Knowing the ability of IRAs to invest in private lending may provide a “win-win-win”. The Private Lender gets a source of capital, the borrower gets their loan, and an IRA holder grows their retirement savings.