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Expanding Options: Notes and Your Self-Directed IRA


Buyers of secured notes in retirement accounts report receiving two important benefits: limited exposure to stock market uncertainty; and an income-producing asset.

Buyers of secured notes in retirement accounts report receiving two important benefits: limited exposure to stock market uncertainty; and an income-producing asset not linked to publicly-traded corporate or municipal debt. Most are also attracted to the increased diversification opportunity that trust deeds and mortgages provide.

A trust deed investment consists of a loan to a borrower that legally encumbers real property. The promissory note outlines the borrower’s terms and obligations to the investor, including, but not limited to, interest rate, payment date, default provision and a maturity date. The promissory note is secured by a mortgage or Deed of Trust against the property in favor of the investor. The deed is filed on record with the office of the County Recorder in which the property is located.

In the event of default of the terms set by the promissory note, the Deed of Trust secures the investor to the property, allowing foreclosure against the borrower. Foreclosure may result in investor ownership of the property, which can then be sold to recover investor funds. The investor’s position is further secured by title insurance. This protection ensures the investor’s interest in the property against loss due to title defects, liens, or other matters.

Growing interest

It should be no surprise that as the proliferation of alternative-asset investing becomes routine, notes secured by real estate are a fast-growing alternative investment category. Besides having tangible collateral, many are attracted to the overall protection that trust deeds and mortgages provide because property (typically) is not expected to lose all of its value. Even if a structure on a property burns down, investors typically will mitigate the risk with property insurance.

Important considerations

When comparing custodians to assist with one’s retirement account and the facilitation of the note investment, it is important to understand what each will allow, what they will not, and why. Each custodian is allowed the flexibility by the Internal Revenue code, with very few exceptions, to determine what assets they will custody. Many do not accept unsecured notes to entities, i.e., LLCs, LPs, or other private equity companies. With the increasing regulatory scrutiny cast over the financial system, provisions like Bank Secrecy, Anti-Money Laundering and the Patriot Act, etc. have identified notes to entities as potential high-risk places for illicit activity, fraud, or other actions that may be contrary to sound investment practices.

Additionally, to ensure the avoidance of engaging in a “prohibited transaction” the IRA cannot transact business with certain “disqualified” individuals as they relate to the IRA owner. A disqualified person is defined as:

• The accountholder owner

• The accountholder’s spouse

• Ancestral descendants (mother, father, grandparents)

• Lineal descendents (daughters, sons, grandchildren)

• Spouses of lineal descendents (son or daughter-in-law)

• Investment advisors

• Fiduciaries—those providing services to the plan

• Any business entity e.g., partnership, corporation, Trust or LLC in which any of the disqualified persons identified above has a 50% or greater interest.

Prohibited transactions include the following (A full list can be found at http://www.trustlynk.com/business/ca_promnote_loanserve.pdf ):

• The sale, exchange, or leasing of any property between a plan and a disqualified person

• The lending of money or other extension of credit between a plan and a disqualified person

• The furnishing of goods, services, or facilities between a plan and a disqualified person

• The receipt of any consideration for his/her own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan

A properly structured note should meet retirement plan guidelines by ensuring that the borrower is not a “disqualified person” according to IRC 4975 to avoid entering into any “prohibited transactions.” The self-directed IRA owner cannot have any affiliation with the underlying collateral or the IRA funds after disbursement from the account, and there must be a reasonable rate of return for any note investment. If the note is secured by anything other than real property, a UCC (Uniform Commercial Code laws regulating commercial transactions) filing is required.

Once you consult with an attorney, broker, note issuer, or anyone else qualified to determine if the note is properly structured (and record-able), vesting would be in the name of the IRA.

After the note is funded by the self-directed retirement account, the original note and original recorded deed should be returned to the custodian for safekeeping. The custodian will hold the originals until payoff, sale, or some other activity that would require surrendering the original. If a third-party loan-servicing agent is used, often they may keep the originals. In any case, custodians will require copies of the recorded documents to ensure that they have documented evidence of ownership.

As investors continue exploring alternatives to traditional investing methodology, a good advisor and custodial firm well versed in alternative investments may expose SDIRA owners to the process, simplifying mortgage, note or trust deed investment transactions.

Tommy Joe A. Valenzuela ("TJ") is vice president of sales and marketing for Trust Administration Services (www.trustlynk.com), a division of First Regional Bank. He has over 15 years experience in the financial services industry, implementing marketing strategies that educate and benefit real estate professionals, attorneys and other esteemed advisors and is a guest speaker at industry conferences, addressing topics, such as taxable investment strategies and retirement plan investing. His firm, a division of First Regional Bank, administers more than $1.3 billion in assets, including those invested in real estate, tax liens and private equities.

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