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The Basics of Private Lending In Your IRA

professionals passing contract exchange documents and closing instructions

What is a Private Mortgage?

Private Mortgages provide investors substantial returns at interest rates that are compounded several times annually. Still, they remain one of the most stable investment vehicles available. How is it possible for one investment vehicle to offer an investor high returns and stability without being too good to be true?

Home buyers traditionally seek a bank or mortgage company to finance the purchase of their new home. However, in this new era of sub-prime free lending, banks and mortgage companies are refusing more borrowers than ever. These home buyers are coming in droves to private lenders to find the private mortgage they need to buy a home.

It is completely legitimate for an individual to offer a private mortgage for a home purchase, giving a buyer a non-bank option for financing. All the lender needs is enough money to lend to a borrower looking to purchase and / or rehab a home. Private mortgages (also called hard money loans, trust notes, private notes, etc.) can be much safer than paper investments because they are secured by real property. In this way, if the mortgage is ever in default, the private mortgage lender sells the property in a quick sale to get their money out of the investment. The property is backed by the title insurance and hazard insurance as additional levels of protection, and the loan is additionally secured by the borrower’s personal guarantee. These multiple levels of protection cannot be found in any other investing instrument.

Why Would Someone Borrow From a Private Individual?

Banks are in the business of making money. They want to make long-term loans, and don’t want to deal in short-term or rehab lending. Ultimately, what a bank is looking for is a constant flow of money that lasts for years. This type of loan means the bank will have a regular income stream with little additional effort involved. It also means there are tons of hidden real estate gems for Hard Money companies to choose from.

As banks and mortgage companies turn down potential loans in ever increasing numbers, Hard Money companies are able to pick up some great deals on investment real estate and still make highly secure investments. Banks are also extremely slow to process loans. They have many channels and a lot of red tape to pass through before completing a loan application. Often, sellers are in a hurry to sell the property and prefer not to wait for processing of a bank mortgage. They would rather offer Hard Money companies a good deal on the property and get money in their hands immediately than wait for a lumbering bank to process their loan application. There are other reasons why a borrower might prefer the speed of working with Hard Money companies over the slow process of applying for bank financing. Sometimes, they just need some short-term financing. They may need to pay off some creditors to get their monthly expenditures under control. They might need to free up equity for family needs such as unexpected hospital bills. On the other hand, they might have an opportunity to move fat on the deal. Regardless, there are many reasons why a borrower might look to private lenders to provide financing.

Typical Rates of Return

Every mortgage is unique. The situation, property condition, and property location factor into the structure of the mortgage and affect the rate of return. Hard Money companies must, unfortunately, turn down many deals because they will never produce strong enough returns for hard money investors. However, those that do qualify for Hard Money loans present an excellent opportunity for an investor. Some of the other factors that play into the return an investor can get from a private mortgage are:

  • The term of the note
  • The Quality of the borrower’s credit
  • Loan-to-Value Ratio
  • The purpose of the loan
  • Exit strategy of the borrower
  • Direct lending or lending through a mortgage pool

The above factors make some deals better than others, but private mortgages offer considerably higher returns than traditional mortgages, and they have outperformed the stock market over the long-term. Conservatively speaking, private mortgages return anywhere from 9% to 14%. However, most private mortgages give investors an average return in the 12% to 15% range.

Lending From Your IRA

If you’re excited about the opportunity to invest in private mortgages but are concerned that you’re going to miss out on your chance because lack of cash-flow, there is good news. Investors can use their IRA to invest in private mortgages. Since most IRA administrators only allow you to hold investments that they sell, it is very likely that they will tell you that you are not allowed to invest in private mortgages with your IRA. The fact is, you can. It all depends on the administrator. That being said, to invest in private mortgages, you are going to need a Self-Directed IRA administrator. Midland can act as the IRA administrator that handles the private mortgage IRA investment.

What is a Self-Directed IRA?

Many people hear the term “Self-Directed” IRA and think that it is a special type of IRA. However, in reality, the IRS does not recognize a “Self-Directed” IRA as a type of IRA. Any IRA, whether it be a Traditional, Roth, SEP, or SIMPLE IRA can be “Self-Directed”. We use the term “Self-Directed” because our clients are making 100% of the investment decisions. The client directs Midland Trust (custodian) to make legal investments on behalf of their IRA.

Why do you need Midland’s services to invest in Private Mortgages?

Anyone who wants to take control of their retirement investments. Typical IRA custodians only allow you to invest in the products that they sell. Since Midland doesn’t sell any products or offer any financial advice, Midland does not limit our clients investment decisions. A Self-Directed retirement plan with Midland allows for IRA investments in a multitude of areas, such as Real Estate, Notes, Private Placements, Gold/Silver, or Futures/Forex Trading. Most people are just unaware that IRA’s can invest in such “non-traditional” assets. The main reason people are unaware is that the majority of the IRA custodians do not offer non-traditional assets as an option, so they do not promote it as a service.

The Advantages of Investing with IRA Funds There are Three Primary Reasons People Put Money in an IRA:

Building for Retirement

According to CNN Money (5/2006), Social Security will run out of money by 2040. Regardless of whether or not you believe that, I think it is safe to assume that most Americans do not want to rely on Social Security as their only income in retirement. Boomers only have $35,000 in median retirement savings and 69% will rely on at least working part-time for income in retirement. Hope is not a strategy.

All Earnings Grow Tax Free (Time Value of Money)

For you non-economists out there, the Time Value of Money simply states that at the present time, money is worth more than the same amount in the future. So why would you want to pay the IRS capital gain taxes after each investment sale, when you have the ability, through an IRA, to pay them later? The money you save in taxes can be invested to create even higher wealth. This is the primary reason clients use IRA accounts.

Tax Deductions for Contributions

Most IRA accounts give individuals the ability to write-off any contributions as a tax deduction. So in essence, Uncle Sam is funding part of your retirement savings. For example, if an individual is in the 25% income tax bracket, and contributes $4,000 to their IRA they save $1,000 in income taxes, meaning that they really only contributed $3,000 to their IRA and Uncle Sam contributed $1,000.

What IRA Plans are available for Self-Direction?

Traditional IRA

A traditional IRA is a tax-deferred retirement savings plan for individuals. Once the individual starts making withdrawals, the contributions and earnings are taxed.

ROTH IRA

A Roth IRA is a retirement savings plan for individuals but it isn’t tax-deferred. Once the individual starts making withdrawals, the earnings are tax free.

SEP IRA

A provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee’s name, instead of to a pension fund account in the company’s name.

SIMPLE IRA

A simplified employee pension plan that allows both employer and employee contributions, similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) admin

What other Savings plans are available for Self-Direction?

Qualified Plans

Qualified plans, such as employer 401(k), 403(b), profit sharing plans or Individual 401 (k)’s for the self employed can also be self-directed in many cases.

HSA (Health Savings Account)

A HSA is the ONLY type of savings plan that has three tax advantages; A deduction for contributions, tax-free earnings, and tax-free withdrawals (assuming the withdrawals are used for qualified medical expenses).

ESA (Educational Savings Account)

ESAs are savings accounts for your child’s higher education. The money you put into this IRA is taxed but the earnings are not taxed as long as the student withdraws the money to pay for qualified education expenses.

2014 Contribution Limits

Traditional/ROTH IRA

Under age 50: $5,500

Over ago 50: $6,000

SEP IRA

25% of Employee Salary; Max of $52,000

SIMPLE IRA

$12,000; $14,500 if over age 50

401K

Elective Deferrals $17,500; $23,000 if over age 50 plus 25% of earnings

Max of $52,000; $57,500 if over age 50

HSA

Individual: $3,300

Family: $6,550

Over age 55, add $1,000 catch-up

ESA

$2,000 per child

So What Next? Steps for a Self-Directed IRA Transaction

To invest in an LLC or Private Placement company with a Midland, clients must follow specific steps to ensure the investment is purchased correctly and safely.

Step 1: Open and fund Midland Trust (funding can be done via Transfer, Rollover, or Contribution).

Step 2: (Newly Formed LLC’s) Provide Midland with the LLC Operating Agreement with proper vesting: Midland Trust FBO Client Name IRA ##, Articles of Incorporation, and Funding Instructions (Pre-Existing LLC’s) Provide Midland with LLC Subscription Agreement or Assignment of Interest with Proper vesting.

Step 3: Provide Midland with Buy Direction Letter and Private Placement Disclaimer and Indemnity Agreement form (both forms provided by Midland)

Step 4: Provide Midland with LLC or Private Placement Check Writing or Bank Wire instructions.

Frequently Asked Questions

  1. How quickly can Midland fund my investment? Most of our clients have to transfer funds from their current IRA custodian, which generally takes about 2 weeks. If it is a newly established IRA, a transfer might not be necessary as the client is simply writing a check to Midland as an IRA contribution. As long as Midland has cleared funds, there is no delay.
  2. What are my fees? Midland has a one-time IRA set-up fee of $50, a one-time $95 fee to purchase the asset, and annual administration fees of $295 (see application fee disclosure for determination).
  3. How much can be invested? Midland has a required minimum balance of $250 to be left in the client’s money market account. All other funds may be invested.