Secured or Unsecured Promissory Notes and Private Lending

Secured or Unsecured Promissory Notes: Due Diligence and Private Investing

If you’re looking to use your self-directed IRA to invest in a private lending opportunity, it’s important to understand the difference between a secured and an unsecured promissory note before sealing the deal.

Patricia McCrystal

July 10th, 2015

Your best friend from college, a stay at home dad, has decided to pick up a new hobby that will help him generate additional income for his growing family. After he and his wife remodeled and sold their first home for a sizable profit, your friend has decided to try his hand as a novice real estate fix-and-flipper. You've talked to your friend in the past about wanting to invest your self-directed IRA account into an alternative asset - something more concrete than just stocks and bonds. Now he’s approached you to ask if you’d be willing to invest in his next real estate fix-and-flip project. He already owns the house, but he’s asking you to finance the remodeling of the property.

Before you agree to use your self-directed IRA account to loan him the money, you have to decide whether to request a secured or unsecured promissory note from your friend. A promissory note is a written, signed, and dated contract that establishes the rights and duties of the parties involved in the loan agreement. The loan recipient agrees to pay a certain amount of money either on demand, at a specified time, or in installments to the lender. The amount due may include interest on the note’s unpaid principal amount.

A secured note is any debt secured by real property. This could include a first deed of trust, a vehicle title, or a certificate of deposit. An unsecured note is any note that is uncollateralized. You trust your friend will repay the loan; you’ve known him a long time and don’t think he would take advantage of your generosity. You don’t want to undermine your relationship by requesting a secured note.

However, your friend does have some outstanding student loans from college that he still hasn’t paid off; not to mention his wife is expecting another baby before the end of the year. You’re afraid that without some form of collateral, he may run into financial trouble, and you’ll have to accept a loss on the loan.

When considering a private lending opportunity with self-directed IRA account, every investor should exercise two types of due diligence. First, is the investment viable? Meaning, what will be the estimated rate of return, and does the investment make financial sense? Will this investment produce a significant cash flow for your IRA account? Secondly, is this investment a scam? Is it being proposed by a reputable and non-fraudulent source? Although you want to expand your IRA’s investment opportunities and you want to help your friend with his fix-and-flip project, it’s important to acknowledge possible drawbacks and faulty dealings with every investment opportunity.

Before extending a private loan, every investor should “do the numbers” for the deal. Understand how to determine whether you are about to engage in a good or bad investment. How does the estimated cash flow of this investment compare with other opportunities? What is your personal risk tolerance?

With real estate, factors to evaluate may include physical inspections of the property, title company and insurance (make sure the person selling the property is the full legal owner), quality of neighbors, cost of utilities, HOA fees, property insurance, rental history & market rents (including surrounding properties), generating your own expenses (time and energy spent doing research on the property), among many other factors.

Due diligence is not a perfect formula. You may exercise extreme vigilance before evaluating an investment opportunity and still get taken advantage of – by a scam artist, or a well-meaning friend. Determining whether you want a secured or unsecured note from your loan recipient is completely up to you. However, a secured promissory note guarantees you won’t be left completely empty handed if your loan recipient gets himself into financial trouble – or if his wife has twins!

Expenses to Pay? Make Sure it Stays in Your IRA

Patricia McCrystal
June 25th 2015

If you're the type of active investor who prefers to stay engaged with the oversight of your investments, you are likely already well-versed in the wide array of investment opportunities available through a self-directed Individual Retirement Arrangement. Contrary to common belief, your IRA account has almost limitless investing potential - providing the asset and your management methodology align with IRS guidelines.

Despite your investment savvy, when it comes time to pay the piper for your IRA expenses, including custodial services for those assets, you may have a few questions about what the process looks like. Can you as the IRA account holder finance the expenses of your retirement plan with your own personal funds? What about collecting income – do you as the IRA owner get to handle any of your hard-earned capital gain?

The fact of the matter is, your IRA is a completely separate legal entity from you, the IRA account owner. Consequently, financing the expenses of your IRA account and collecting income from your IRA’s investments must all be done through your IRA, not through the account of any disqualified persons – yourself included.

Nick Snapp, Client Representative at New Direction IRA, explains that the details of this process are fairly intuitive, as long as you understand the basic tenants of an IRA, “Although an IRA may be owned by a client, it’s helpful to look at it as a sovereign entity. The reason IRA administrators like New Direction exist is because the IRS wants to keep IRA owners at an arm’s length from their IRA investments.”

“Because an IRA is its own legal entity, any money that is earned through its investments or owed for its expenses must flow through IRA funds themselves. As far as making this process as painless as possible, New Direction has a leg up on its competitors because of our Online Bill Pay.”

New Direction IRA is paving the way in technologically advanced payment processes for self-directed IRA administrators. NDIRA has created an online bill payment environment that saves clients time and money. This unique feature allows clients to submit expense payments through myDirection.com, and reduce processing time down to only one business day. There are also no additional check fees to this process.

“Another benefit of the Online Bill Pay feature is clients’ ability to view their payment throughout the entire process. The feature works kind of like a bank account. Clients also have direct access to their funds. They can request a check for emergencies and receive it between 1 and 3 business days.”

To learn more about New Direction’s quick and efficient Online Bill Pay feature, click here. 

Remember, you and your IRA account are friends, not carbon copies. Your IRA’s profits and expenses must be managed through your IRA alone – a provision that allows you to bask in the tax benefits that IRA accounts have to offer!

Think of Your IRA When Planning For Higher Education Expenses

Careful planning for future education expenses is becoming more common as the national average for college tuition costs continue to rise. Many savers are already familiar with tax-advantaged vehicles such as the 529 Plan or Coverdell Savings Account but did you know that all IRA account structures offer certain incentives for educational expenses as well? This article explores IRS Publication 970 and the exception to additional tax on early IRA distributions for qualified education expenses.

SOURCE: U.S. Department of Education, National Center for Education Statistics. (2013)

When it comes to taking IRA distributions an additional 10% penalty is imposed for withdrawing funds before the designated retirement age of 59 ½. This additional tax applies to the Traditional IRA account structure but also includes SEP IRAs, SIMPLE IRAs, and Roth IRAs. Note that early distribution penalties may be as high as 25% for SIMPLE IRAs.

If you decide to withdraw from an IRA to pay for higher education expenses for either yourself or others, you may be able to avoid the 10% penalty that would normally be imposed. Let’s take a closer look at the eligibility requirements below.

Who is eligible for the exception? 

This exception applies to: yourself as the IRA owner, your spouse, or your or your spouse’s child, foster child, adopted child, or descendant of any of them. 

What is considered an eligible education institution? 

Eligible institutions include: any college, university, vocational school, or other postsecondary school eligible to participate in a student aid program administrated by the U.S. Department of Education. 

What types of expenses are considered ‘qualified’ education expenses (QEE)?

• Tuition
• Fees
• Books
• Supplies
• Equipment required for enrollment or attendance.
• Services for special needs students in connection with their enrollment or attendance. 
• Room and board if the student is enrolled at least half-time. Half-time status is determined under the standards provided by each individual institution.
• See Publication 970 for specific details on room and board.

Be sure to review IRS Publication 970 for additional details, considerations, and examples. The information provided in this article is for educational purposes only and is not guaranteed to be reliable. Always see a qualified tax professional who can offer advice and guidance. New Direction IRA does not offer tax, legal, or investment advice.

2014 IRA Contribution and Distribution Rules

People in the accumulation phase of their working lives are often concerned about “maxing” out individual retirement account (IRA) contributions while retirees are concerned about annual required minimum distributions (RMD). Whether contributing or withdrawing, the amounts change almost annually due to inflation protections and life expectancy tables. Below is a discussion on 2014 traditional IRA rules.

2014 IRA Contribution Considerations

A traditional IRA is a fantastic retirement tool that allows tax deductions for those contributing and tax-deferred growth on investments. IRA rules also allow those investors nearing retirement age (50 years and older) to contribute more to their IRA plans than someone younger. If you are engaged in 2014 retirement planning, below are the IRA contribution limits for 2014:

• $5,500 for those below age 50
• $6,500 for those above age 50
• Anyone age 70 ½ + cannot contribute to a traditional IRA 

In order to contribute to an individual retirement plan, one must earn a taxable income. In other words, in order to contribute $5,500, for example, a person must have made at least $5,500 in taxable income.

2014 IRA Distribution Considerations

If you are a retired traditional IRA investor over age 70 ½ or you have inherited a traditional IRA, you are probably considering your 2014 required minimum distribution (RMD) amount. While investment growth of a traditional IRA is tax-deferred, withdrawals are considered ordinary income. A required minimum distribution is calculated based on the total IRA account balance and your life expectancy or the life expectancy of who you inherited it from. Please keep in mind a few other IRA withdrawal considerations outside of retirement and inheritance:

• As a broad rule, taking a distribution from a traditional IRA account before age 59 ½ will result in a 10% IRS penalty. Consult your tax expert for more specifics on penalty exclusions. 
• ROTH IRA accounts do not have required minimum distributions.
• The penalty for missing your 2014 RMD is 50% of the difference between what should have been distributed and what actually was. 
• There is no penalty for withdrawing more than your required minimum distribution. 

While it may feel like 2014 is almost over, IRA contributions can be made until April 15^th 2015. This allows anyone planning for retirement to consult with his or her tax advisor to choose the most tax-advantaged amount of contribution or withdrawal based on concrete 2014 taxable income calculations. 

I Want my IRA to Invest in “Green” Energy

Energy consumption is on the rise, both nationally and globally, and many new energy companies are popping up to fulfill the increased demand. Growth in the alternative energy industry has increased the number of wind turbines and solar panels that provide power to our homes. The oil and natural gas industry is also still booming, with technological advances in shale extraction leading to more opportunities for expansion. All this growth has caused many of our self-directed IRA holders to ask us how they can take advantage of this emerging industry as part of their retirement portfolio.

Whether the energy industry is something you have previous experience with or it is a new interest you have developed, the IRS allows SDIRA holders to pursue their interests and use their personal agenda or strategy when investing. Your IRA can invest in energy in a number of ways, including lending funds to an energy start-up through promissory notes, purchasing shares of private stock, or forming a limited partnership.

As the price of fossil fuels has increased, the popularity of renewable energy sources has soared. Wind and solar energy are becoming major players in the energy game, presenting investors with the opportunity to not only take advantage of an emerging industry, but also to invest in “green” energy sources. Those SDIRA holders who are concerned about making socially responsible investments can utilize these environmentally-friendly energy sources for their retirement portfolio.

Increases in the demand for energy are creating an emerging industry that could create an investment opportunity for self-directed IRA holders. As the account holder, it is important for you to perform thorough due diligence when choosing a new investment. Doing so will help you protect your retirement and allow you to find the right investment for you.

Retirement Plan Integration with Self Directed IRAs

Whether you’re getting close to retirement age or you’re just beginning to look into retirement planning, it is important to understand how each type of retirement account fits into your overall retirement plan. Common retirement accounts, such as the Traditional IRA, Roth IRA, and HSA, each play their own role in a well-rounded retirement strategy. Knowing how to utilize each type of account will allow you to develop the best retirement plan for your personal retirement goals.

Each plan type offers a different tax advantage. Traditional IRAs are traditionally thought of as providing tax advantages when funds are placed in the account, and Roth IRAs delay the advantages until funds are removed from the account. While this is generally true, there are many factors that can affect the personal advantages of any particular account. These factors can include the age at which you plan to retire, your current tax bracket, the tax bracket you will be in post-retirement, the cost of living where you plan to retire, and the performance of other investments outside of your retirement accounts. A study of each account’s tax advantages and how those advantages will interact with the factors above may help you to create a personalized retirement plan.

For self directed IRA account holders, determining which accounts will best suit your retirement goals can seem complex. Just because you have a self-directed account does not mean you are alone on your retirement journey. SDIRA account holders can utilize the services of Certified Public Accountants (CPAs), Certified Financial Planners (CFPs), RIAs, trusted friends, and others to form a financial team. This team can help you discover the right combination of retirement accounts for your goals while you maintain the independence that comes with self-direction.

One account to consider for your well-rounded retirement plan is a Health Savings Account. An HSA can help you plan for those medical bills that may be incurred after you retire, allowing you to use your IRA funds to pay for other things. Not only can your HSA help you save for future medical costs, but you may also invest your funds to help grow your account’s value. The HSA also provides another advantage. After the account is opened, any medical costs incurred and paid out-of-pocket may be reimbursed from the HSA at any time in the future. Your financial team can help you determine how best to utilize a HSA as part of your plan.

New Direction IRA is proud to be a part of your personalized retirement plan. The self directed IRAs and HSAs we provide allow you to diversify your retirement investments, use your personal expertise to invest in what you know, and adjust to changing market conditions. We offer education to account holders and non-account holders alike, as well as providing continuing education to CPAs, CFPs, and other members of your financial team so you can make the best decisions possible for your self-directed retirement plan.

IRS Explains Unrelated Business Income Tax (UBIT) and Unrelated Debt Financed Income (UDFI)

At New Direction IRA, a self-directed IRA and HSA provider, we hear a lot of questions about UBIT, or Unrelated Business Income Tax.

Many investors are afraid of acting on money-making opportunities because they think UBIT is a penalty or an excessive tax. However, UBIT typically means that—in the case of retirement accounts—the account is making money. It is not a penalty, just a way to even the playing field between tax-exempt and tax-deferred entities like a retirement account and other entities/people.

To get a basic understanding of UBIT and Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI), that two types of income that may be assessed UBIT, let’s go straight to the source: the IRS. The IRS Publication 598 outlines what these tax consequences are and how you’ll incur them.

Below are some excerpts from the IRS that may help an IRA holder to understand the parameters.

Unrelated business income - Unrelated business income is the income from a trade or business regularly conducted by an exempt organization and not substantially related to the performance by the organization of its exempt purpose or function, except that the organization uses the profits derived from this activity.

Income - Generally, unrelated business income is taxable, but there are exclusions and special rules that must be considered when figuring the income.

Exclusions  - The following types of income (and deductions directly connected with the income) are generally excluded when figuring unrelated business taxable income.

• Dividends, interest, annuities and other investment income - All dividends, interest, annuities, payments with respect to securities loans, income from notional principal contracts, and other income from an exempt organization's ordinary and routine investments that the IRS determines are substantially similar to these types of income are excluded in computing unrelated business taxable income.
• Royalties - Royalties, including overriding royalties, are excluded in computing unrelated business taxable income.
• Rents - Rents from real property, including elevators and escalators, are excluded in computing unrelated business taxable income.
• Exception for rents based on net profit - The exclusion for rents does not apply if the amount of the rent depends on the income or profits derived by any person from the leased property, other than an amount based on a fixed percentage of the gross receipts or sales.

Gains and losses from disposition of property - Also excluded from unrelated business taxable income are gains or losses from the sale, exchange, or other disposition of property.

Unrelated Debt-Finance Income

Income From Debt-Financed Property

Investment income that would otherwise be excluded from an exempt organization's unrelated business taxable income (see Exclusions under Income earlier) must be included to the extent it is derived from debt-financed property. The amount of income included is proportionate to the debt on the property.

Debt-Financed Property

In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property's disposal, if it was disposed of during the tax year). It includes rental real estate, tangible personal property, and corporate stock.

If you have any questions about UBIT, UBTI or UDFI, feel free to contact us at NDIRA by visiting www.ndira.com and giving us a call, email or chatting online with an IRA expert.

(Information provided by the IRS publication 598.)