Ask a self-directed investor how they got started using a self-directed IRA (SDIRA) for their retirement investing and you’ll hear the same answer time and again: real estate.
One of the things that self-directed investors love the most about being in control of their own retirement accounts is that they are not limited to “traditional” retirement investments like stocks, bonds, and mutual funds. Additionally, they can invest in “alternative” investments like real estate, certain precious metals, and just about anything else, with a few exclusions. One real estate-related asset that often tops the list right next to physical property is the private note, also called a promissory note by some investors.
Promissory notes are legally binding loans that work like any other loan except that instead of borrowing from a bank and paying that institution interest, the borrower borrows money from the self-directed investor. While promissory notes can be made on just about anything – business start-up money is a common example – most self-directed investors favor promissory notes with real estate collateral, or what is basically a private mortgage loan. Promissory notes are relatively easy to understand since most of us have taken out a car loan or a home loan in our lifetimes, but investors making them for the first time can make some pretty serious errors because the investment vehicle feels so familiar. Here are three self-directed investing pitfalls promissory notes investors never see coming that are easy to avoid if you just know where to look:
1. The legal eagles are not always on the lender's side
When you invest in a promissory note, you are entering into a legally binding agreement to loan the borrower a specific amount of money and receive repayment on that loan in a predetermined fashion and at a predetermined rate of interest. If you make a loan that involves collateral, you also must agree to a specific process that you will use to deal with late payments, delinquencies, and nonpayment in certain predetermined ways. If the terms of the note do not include details on this part of the process, then the borrower may not be obliged to forfeit the collateral as you anticipate in the event of nonpayment and, furthermore, you could find yourself tangled in a costly legal battle if the borrower fails to repay on time.
Solution: Work with a legal expert to make sure that your promissory note is fully legal and covers all the bases to protect you and your borrower from unpredictable and costly outcomes.
2. Real estate loans can be governed by public policy as well as legislation
Most private loans work out great for everyone involved. The private lender makes the loan, collects the interest and payments, and generates a healthy return for their self-directed account. The borrower gains access to the capital they need to do a deal or buy a property. Everyone wins! In most cases, even when things go badly for the borrower, the lender still is able to salvage the deal via repossession of the property. However, in some situations, outside forces intervene. For example, while the terms of your note may say one thing about foreclosure, the state in which your property is located may say something different. In this case, you must work with a legal expert to be sure that you are abiding by all legislation that protects consumers and borrowers in lending – even if that legislation does not protect you.
Solution: The best protection is to confirm before making the loan that all terms meet requirements for consumer protection.
3. Remember not all borrowers pay
It might seem like a silly reminder, but self-directed investors tend to need reminding that not all borrowers pay back their loans! Because many self-directed investors make private loans to people with whom they have personally interacted, they often find it hard to imagine that their borrowers might not repay the loans. In most cases, they like the individuals to whom they are loaning money and like the deals as well. However, not every borrower – even the best-intentioned – is going to be able to pay back a loan. If you will not feel comfortable foreclosing or taking other actions to recoup your money, then using a self-directed retirement account to make a private loan may not be the right move for you. Also, remember that your self-directed account cannot make loans to disqualified persons, defined by the IRS as “any person in a position to exercise substantial influence” on the account holder. This definition may be broader than you are used to, so make sure that you speak with a self-directed IRA expert before making any private loan.
Solution: Lend only to borrowers who meet your criteria for a successful transaction and who are eligible to borrow money from your self-directed account.
Self-Directed Promissory Note Investments Open Up New Opportunities
Now that you have read about these pitfalls, you might be thinking you would prefer to just steer clear of promissory note investments. Don’t react this way! Many self-directed investors are able to dramatically improve their returns in their self-directed accounts through wise note investment strategies. Just be sure to think every note all the way through to the end and evaluate how potential outcomes will “mesh” with your investment strategy. Then, if self-directed investments in promissory notes seems like a good fit, contact Mainstar Trust to help you set up the right self-directed retirement account for the job.
Always take the time to consult with trusted, professional advisors to ensure you understand tax, legal, and investment issues related to the use of IRA funds in LLCs.
Additional Resources:
IRS Retirement Topics (Prohibited Transactions)
Disqualified Persons – IRS