You can give your prospective investors some good news – let your current and prospective investors know they can place their Self-Directed IRA funds into the potentially higher-yielding world of mortgage note investing.
Many Real Estate Investment Options
Did you know that the Internal Revenue Service allows individuals to buy real estate or lend money (secured by real estate) with the funds in Individual Retirement Accounts? Many people are just now beginning to tap into the benefits of holding real estate, mortgage notes, and trust deeds in their IRAs. The IRS code permits individuals to invest IRA funds in investment property such as single or multi-family dwellings, apartments, commercial buildings, raw land, vacation rental property, condominiums, mobile homes, and so on. Individuals can also lend money against these types of property. The IRS permits IRA funds to be invested in trust deeds, mortgage notes, and other interest-bearing notes purchased from private parties or note brokers. These can include back-ends of notes, real estate lease options, tax liens, and discounted notes. Individuals can also purchase or sell portions of mortgages within their IRAs. In these cases, the IRA account holds an interest in that portion of the note and receives the proportionate amount of income due under its terms.
There are some special considerations for mortgage notes and real estate transactions. For example, you cannot buy a property or invest in a secured loan, that involves yourself, a son, daughter, parent, or other disqualified party – such as a fiduciary or your sole proprietorship. However, this rule does not apply to siblings or any third party. An individual can hold the mortgage on his brother or sister’s home, or an unrelated third party. If the property is rented to any qualified party, all income and expenses must first flow back to the individual’s IRA. If the IRA owner decides to use some of the income produced, such distributions will always be subject to taxes and possibly penalties if they are received prior to the age of 59 1/2.
Seller Carry-Back: An Opportunity
Almost everyone knows someone who has sold a piece of property or home and held the note, or “carried back” paper on the sale. There are several reasons these types of mortgage notes and trust deeds are sold by the original lender. Many of these sellers are not in the banking business and don’t want the extra trouble of collecting late payments. Others would like to have the cash, rather than the income stream provided by the note, for other investments or personal reasons such as college tuition or medical bills. In any event, these sellers are willing to take a small discount from the face value of the mortgage or trust deed in order to have the cash.
For example, several years ago, Stan sold a commercial building for $100,000 and the purchaser paid $25,000 down when they bought it. Stan carried back a $75,000 loan at 9 percent interest with a repayment term of 25 years. The yield to Stan would be 9 percent if the note is paid as scheduled. However, Stan has a daughter entering college and needs money now to pay her tuition. Stan is looking to sell his mortgage note at a discount to get this cash.
Considering the payments made by the buyers since the beginning of the loan, the amount still owed on the property has now been reduced to approximately $72,000. Stan is willing to sell the note at a discount to obtain the cash now instead of over the remaining term of the note. You have an investor with a large sum of money in his IRA and who would like to earn a higher, more dependable return than he’s getting with his stock investments. This is an opportunity for you and your investor! Your investor rolls his IRA funds into a Self-Directed IRA account with a qualified special asset custodian, such as PENSCO Trust Company. He then uses those Self-Directed IRA funds to purchase Stan’s note for a negotiated sum of $62,000. Stan is losing $10,000 in principal and interest in the long run but is getting the cash he needs now. Your investor’s IRA is getting an effective 11 percent yield, since the buyers will continue to pay their originally negotiated monthly payments, except instead of mailing payments to Stan, they are now mailing their payments to your investor’s IRA account. You as the note broker negotiate the terms of the deal and your commission.
The investment made in the mortgage is secure because there is sufficient equity above the $62,000 paid for the note, and your investor’s IRA is holding the first position. If the property had not increased in value at all from the time it was sold until the time when your investor bought the note, he would still only have a loan equaling 62 percent of the value of the property. Should the buyers default on their payments, the IRA would take ownership of the commercial building. It could then be resold at a higher price, generating an even higher yield on the original IRA investment, or the IRA could retain ownership of the building and continue to rent out the commercial space, with the rental income flowing back to the IRA account.
What’s the catch?
While there is some paperwork involved, it is not much more than would be required if an individual were to purchase property or mortgage notes without IRA funds. There are also specific ways investments must be structured if both IRA and personal taxable funds are used to make a purchase. Investors should consult with a tax advisor to avoid complications later on. When purchasing any type of income-producing real estate note for a Self-Directed IRA, most custodians will request that a loan servicer be designated for the investment. They will need a copy of the loan servicing agreement between the IRA owner and the loan servicing company. If they are qualified, the IRA owner may service their own notes. In this case, most custodians will provide a standard loan servicing agreement that must be completed by the IRA owner.
A New Twist on an Old Strategy
As a member of the Cash Flow Industry, you know that the large number of privately held mortgages resulting from the real estate boom of the late 70’s and early 80’s started the cash flow industry. According to the American Cash Flow Institute, approximately 50% of the total business activity in the cash flow industry is comprised of the buying and selling of privately held real estate notes. Now you have an additional strategy to help individual investors to take part in this potentially lucrative investment arena: Self-Directed IRAs. Your investors don’t need cash out of pocket. They don’t need to “cash in” their IRAs or 401(k)s, which would result in paying taxes and penalties. They can invest in your mortgage notes using retirement funds within a Self-Directed IRA. You need to make this known to your current as well as potential investors! You’ll end up with more private funds available to you to broker more real estate notes and your investors will have the potential to maximize their IRA return on investment.
This article was modified from an article originally written by Tom Anderson and posted to this site on 2005/01/02.