Investing in real estate notes with your IRA is one of the most popular self-directed IRA investment options available. With it becoming more and more difficult to qualify for a loan with a traditional lender, the need for private lenders is increasing. Private lending can be a great source of passive income and is accessible to everyone. But with this popularity comes common mistakes that investors make when lending their IRA (and non-IRA) money out secured by liens on real estate. Follow these 10 tips to avoid potentially costly mistakes when choosing a real estate investment note.
1) Never loan on an investment property you wouldn’t want your IRA to own. Many passive investors loan so they do not have to deal with all of the issues of owning a property, but remember that you may end up owning this physical property if your borrower defaults. While the potential risk of loaning your IRA investments toward real estate notes is matched by the reward (I routinely see yields from these loans at 12% and higher making it an attractive investment), borrowers can default and you may be left with the property in foreclosure. If you would be upset by the potential of taking over this property in foreclosure, you probably should not make the loan.
2) Do not advance IRA money for home repairs until the repairs are finished and inspected. This is one of the biggest mistakes that I see clients make with their IRAs. They fund the full loan amount expecting that the repairs will be done on the property, but the borrower will actually need a little more money on another. If the loan goes bad, the IRA could end up with a property that hasn’t had the necessary repairs.
3) Do not loan money to someone you would feel uncomfortable foreclosing on. William Shakespeare wrote in Hamlet, “Neither a borrower nor a lender be/ For loan oft loses both itself and friend/ And borrowing dulls the edge of husbandry.” For the most part, I cannot agree with this advice, because lending and borrowing money drives our economy and increases economic activity. However, the part about a loan losing a friend is absolutely correct, in my opinion. If foreclosing on your borrower would cause you heartache, it is better not to make the loan. I have seen friendships destroyed over a loan gone bad.
4) If the loan goes into default, take action immediately. No one wants to admit that he or she has made a mistake in an investment deal, but delaying action can be costly. You can always stop the foreclosure process once it has begun, but you cannot complete the process unless you start it. Always get good legal counsel to assist you with loan terms and documentation. Because the borrower traditionally pays for all expenses including legal fees, there is no reason not to have an attorney draw up loan documents, and you will be better protected if the loan defaults.
5) Collect interest monthly so you will know if the borrower is getting into trouble. Many borrowers, especially investors, would prefer to pay interest at the end of the loan. But this exposes the lender to additional risk. While it’s nice to have a passive monthly income, the main purpose of collecting payments monthly is to:
- Make sure the borrower remembers that he or she has to do something with that property in order to avoid the pain of the payment.
- Let you know if the borrower is in trouble because he or she starts missing payments.
Keep in mind that unless you have contracted for monthly payments, you may not be able to foreclose, even if you do discover that the borrower is in financial trouble, because the loan may not be in default. This has actually happened to some of my clients.
6) If you are unsure about how to evaluate the loan, hire a professional to help you. Although a hallmark of the self-directed IRA is that it is “self-directed” meaning that you make your own decisions and find your own investments most IRA owners either do not possess sufficient knowledge or, in my case, sufficient time, to properly evaluate a loan transaction. My solution is to hire a professional to help me with the deals. He checks out the borrower, coordinates with the title company, orders the appraisal and usually a survey, makes sure insurance is in place and generally evaluates the loan. Naturally, he charges a fee for this service, which is passed through to the borrower on top of any interest and fees that my retirement plan may charge. This increases the cost of the loan; but in this case, the non-Biblical version of the golden rule applies, which is “He who has the gold makes the rules.”
7) Get title insurance for the loan. The purpose of title insurance is to shift risk away from you and to the title company. In Texas, where my office is, the incremental cost of title insurance is very small when issued in conjunction with an owner’s title policy. Regardless of the cost, making sure that your IRA is protected from title flaws is important.
8) Verify that hazard and, if necessary, flood insurance is in place, naming your IRA as an additional insured. It is very easy to miss this issue when you are trying to get everything completed right before a closing. Borrowers may get insurance at the last moment and simply forget to add your IRA as an insured. But if something goes wrong, you will want to make sure your IRA is named on the check.
9) Insist that the borrower provides you with evidence of payment when property taxes and homeowners association fees become due. The same thing would apply to hazard and flood insurance premiums, although normally you would receive notice of cancellation for non-payment of those bills. Depending on where you live, property tax bills can increase quickly due to penalties and court costs, which reduces your equity position in the property.
10) Get a personal guarantee if lending to an entity or to an individual with some weakness. When things are going well, you might be tempted not to insist on a personal guarantee, and indeed many borrowers will resist this. However, as we all have discovered recently, circumstances do change, and a personal guarantee may be helpful in collecting the debt. I collected on a note once where the property had decreased substantially in value due to vandalism and market conditions. Instead of foreclosing, I had my lawyer send a letter explaining to the guarantor, who had a significant amount of assets, that he was personally liable on the debt and that if he were unable to satisfy the note, I would pursue legal action against him and the borrower. A week later, a cashier’s check showed up that satisfied the lien.
There’s more to know when considering real estate for your self-directed IRA. This list of suggestions is not meant to be exhaustive. Other issues you will need to understand include:
- Your lien position, which determines which lender gets paid first if the borrower defaults. (Personally, I only invest in 1st position liens.)
- State usury laws that might apply to the loan.
- A general idea of the foreclosure process is in your state, in case the loan goes into default.
Real estate note investing can be an excellent investment strategy with your retirement funds. It is relatively easy to do and, if done correctly, has a comparatively low risk. Getting to know successful real estate entrepreneurs who borrow your IRA money may also lead to other, intangible benefits as well. But before you take any action, be sure to educate yourself on the process of investing with your self-directed IRA. Quest provides two to three in-person and online educational events per week, and you can review our upcoming schedule and register at the link provided. If you would like more information about how to invest in real estate, promissory notes, or other alternative investments with your self-directed IRA, schedule a direct 1 on 1 consultation with a Quest IRA Specialist.