IRAs allow you to make tax-deferred investments while working, so you'll reap the rewards when you retire. A custodian typically puts your money in mutual funds, stocks and bonds.
The self-directed IRA allows you to bypass the custodian, take charge of your retirement savings, and put your money into a wide range of investments, including real estate and cryptocurrency. You can also use your self-directed IRA to invest in promissory notes, including mortgage notes and trust deeds.
Financial advisors will usually steer you away from alternative assets and towards Wall Street investments, but if you're a smart real estate investor, don't you want control over how your IRA is invested?
If you invest in promissory notes and other alternative assets using IRA funds, all income is tax-deferred until you choose to take a distribution. This keeps more money in the account and increases the effect of compounding. And with a Roth IRA, there will never be an income tax since contributions are taxed on their way into the account.
The self-directed IRA lets you put promissory notes to work for you. Let's take a closer look.
Good question! Promissory notes are legally-binding IOUs that borrowers sign when they take out loans. Essentially, it's a promise to pay back the lender.
Most promissory notes will list the terms of the loan, such as:
After a borrower issues a promissory note, the lender will keep it until the last payment is made. When the loan is entirely paid, the lender will mark the note "paid in full" and return it to the issuer.
Real estate or mortgage notes are promissory notes associated with real estate purchase loans and secured by the property. When a borrower takes out a home loan, the lending institution will typically require them to sign a promissory note and a mortgage agreement. It will be a deed of trust in some states rather than a mortgage, but they're pretty much the same thing (for our purposes, at least).
While promissory notes outline the terms of the loan, a mortgage or deed of trust secures the loan with the purchased real estate. After the loan is executed, the lender will record their lien on the property by filing the mortgage. Promissory notes don't get filed, so the lender will hold onto it until the loan's paid in full.
There are two categories of real estate notes you should know about: performing and non-performing. The distinction between the two types of promissory notes is relatively simple. If the borrower makes their payments on time, and the loan has never been in default, the note is "performing." When the loan is in default or the borrower is late on payments, the note is called "non-performing."
Both performing and non-performing promissory notes can be purchased, traded, sold, or transferred at any time before they are paid off. If you buy real estate notes, you will acquire the right to receive all future payments on the loan. In other words, you're investing in debt, not property.
The appeal of promissory notes varies with your investment strategy. People looking for a truly passive investment should consider performing real estate notes. Being a performing noteholder is basically just an upgrade from being a landlord. Since you own the debt, not the real estate, you don't have to handle tenants or repairs. Your only responsibility is to collect mortgage payments each month.
Investing in non-performing notes, on the other hand, can be a much wilder ride. While this route is not all that passive, you can make a lot of moolah through non-performing notes. Since the borrowers aren't paying, you can usually acquire these types of notes at a hefty discount, leaving plenty of room for profits.
While there are various strategies for investing in non-performing notes, the most common are:
No matter what strategy you choose, investing in real estate notes is an excellent way to diversify your retirement portfolio.
While investing in notes with your self-directed IRA may sound complicated, it's actually pretty straightforward.
I'm sure I don't have to tell you this, but, just in case, if you don't currently own a self-directed IRA, the first thing you need to do is get one.
Once you find a note you want to invest in, you'll use your IRA to purchase it. You can also create your own promissory notes by lending out funds from your IRA and collecting interest.
You'll need to fill out some paperwork and provide an original copy of the note to your bank. Take note — your IRA must be listed as the lender instead of you personally.
That's pretty much the entire investment process. Once you've secured the note and the bank has processed your paperwork, you're officially a promissory note investor!
As always, when investing with your self-directed IRA, some due diligence is required. You should always thoroughly review the existing legal documents, information on the property, and the borrower's financial background before investing in a note.
Once you have added notes to your IRA, you should also engage a third-party loan servicing company. Having a servicer deal with your loans eliminates the possibility of engaging in prohibited transactions by providing services to your retirement plan. While there may not be any issues with you handling certain aspects of servicing the loan yourself, hiring a third-party to manage your notes is your safest bet.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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