When most investors think of investments they tend to focus on assets and asset classes that are relatively liquid. We’re talking about investments that you can trade in and out of relatively easily and at relatively low cost – things like stocks, mutual funds, banks CDs and the like. Liquidity means that your money is always available if you have an emergency or other pressing expense. (While it’s true that you may have to forfeit some of the interest you earned in order to liquidate a bank CD before maturation, the money is still there for you to use.)
For this reason, there’s sometimes a tendency to avoid investments that are illiquid. These investments include assets like real estate and investments in private companies. If you ever need to sell these investments, you might find that it takes a bit of time to actually “cash out.” Some investors are reluctant to have their funds tied up in this way.
Fortunately this type of illiquidity is perfectly consistent with the long-term investment timeframe of the self-directed IRA. Withdrawing money from a self-directed IRA before retirement generally incurs penalties (and in the case of a traditional account, taxes as well), so account holders are generally more comfortable with holding illiquid investments because they wouldn’t easily be able to use the underlying funds outside of the account anyway.
Real Estate. Real estate is a popular illiquid investment to hold in a self-directed IRA. Given the costs that are generally imposed on both the sellers and the buyers of any real estate transaction, most real estate investors tend to have a medium-term to long-term outlook, and rightly consider these investments to be illiquid.
Private Mortgages. Owning a piece of property outright is not the only way to invest in real estate. With a self-directed IRA you can lend money to others to enable them to purchase real estate. Many investors find that they can generate healthy returns by becoming active in lending markets that their local banks and mortgage companies don’t participate in.
This might mean commercial lending, or lending to first-time or high-risk lenders that may find difficulty in obtaining financing through traditional means. As you might expect, with higher risk comes a higher interest rate that you can charge.
Remember that as the originator of the private mortgage, you have to be prepared to carry the note to maturity. While a borrower can always choose to pay down their mortgage early, there’s no way for the lender to force early repayment. It’s possible to sell your mortgage note to another investor, but this secondary market is probably quite thin and potentially expensive to take advantage of.
Private Equity. By the same token, private equity investments are also highly illiquid, and therefore are well-suited for self-directed IRAs. It’s important to understand that the investment documents themselves may prohibit transferring the interest to third parties, so these may be the least liquid of any of the investment types we’ve discussed.
If you find an investment opportunity that’s going to tie up your money for a number of years, consider participating in it within your self-directed IRA.