One section of the Professional Real Estate Investor class curriculum contains the concepts of using other people’s money (OPM). One of the greatest resources we have found for OPM is Self Directed IRA’s.
In this article we are going to look at some basic guidelines for lending money out of a SD IRA. This is important information whether you are the borrower or the lender.
First of all, money in a SD IRA can be loaned out to any person who is not a “disqualified person.” A disqualified person is defined as:
Individuals or entities between whom or which an IRA is prohibited (absent a special exception) from engaging in any direct or indirect sale or exchange or leasing of any property; lending of money or other extension of credit; furnishing goods, services or facilities; or transferring to or permitting the use of IRA income or assets.
- Fiduciaries (which in the case of a self-directed IRA includes you, as the IRA owner);
- The following family members of the IRA owner:
- Grandparents and Great-Grandparents
- Children (and their spouses)
- Grandchildren and Great-Grandchildren (and their spouses)
[NOTE: The term “disqualified person” under the Internal Revenue Code does not include siblings (brothers and sisters) or aunts, uncles and cousins of the IRA owner. Definition provided by Equity Trust Company.]
A loan made out of a SD IRA can be unsecured but most often it is secured by assets such as real estate, equipment, stock portfolios or anything of value.
From a borrower’s perspective it’s like creating your own “private bank”. How do you find individuals willing to loan money out of their retirement? You have to let people know that this is a possibility and then direct them to service providers that can setup an SD IRA for them and facilitate it.
Here are some guidelines:
1) Loan only on property that would be a good investment for the IRA. You need to always have a “plan B”. If property is used as collateral for the loan and if the buyer defaults then the IRA could end up being the owner of the property.
2) Make sure the borrower has some “skin” in the game. For example don’t lend money for the purchase and the repairs. Its best if the borrower escrows money for the repairs so that you can make sure the repairs get completed.
3) Don’t lend money to someone you would have a hard time foreclosing on.
4) It goes without saying that everything should always be in writing, with clear and defined late fees and default action steps.
5) If a loan goes into default, make sure to take action immediately. Delaying the process can be very costly. The foreclosure process can always be stopped once it has begun, but by taking immediate action it demonstrates to the borrower that you will keep to the letter of the contract.
6) The loan is best structured by having a payment due every month even if it is an interest only payment. There are two main purposes for collecting monthly payments; one to make sure the borrower is moving forward on the project and two because if there aren’t payments due on the loan, the loan can’t go into default making foreclosure not possible.
7) It’s important to hire a professional to help with the process. An IRA that is Self Directed, means the owner makes the finial decisions; however it doesn’t necessarily mean they possess the knowledge to properly evaluate the property, borrower and coordinate the process. A professional would investigate the borrower, coordinate with the title company, order the appraisal, and make sure insurance is in place as an example. These cost are usually passed on to the borrower as part of the up front loan cost.
8) Make sure a title insurance policy is part of the closing process.
9) Make sure that the hazard insurance for the property also names the IRA as additional insured.
10) Always ask for a personal guarantee. Remember plan B. If the property decreases in value then just foreclosing on the property might not be enough to satisfy the note.
11) Ideally a loan made from the IRA should always be in first position.
As the borrower, this can be an excellent way to finance your quick turn properties and have access to quick financing at a reasonable cost.
As the lender, this is an excellent way to invest your retirement money to achieve a high return with comparatively low risk.
If you want to learn more about a Self Direct IRA contact OTA Tax Services.