Investing in mortgages with a self-directed IRA or Solo 401(k) is very popular. There is good reason for this popularity.

There is a wide availability of quality note investments that can generate solid returns. Your IRA can invest principal in a secure asset with stable value, and expect consistent and predictable returns every month.

With note investing, you can forget about the headache of opening a 401(k) statement after a particularly brutal news cycle. If being your own bank is an appealing investment strategy, here are a few things you should know about how this kind of investing works in a self-directed retirement plan.

Setup your Checkbook IRA or Solo 401(k) Plan

Yes, we say this for just about every type of investing. It’s simply the best way to ensure success.

It can take 3-5 weeks to establish and fund a Checkbook IRA or Solo 401(k). Once you’ve found a good lending opportunity, you generally will not have that long to get ready to act.

We recommend doing some research and analysis to see if there are good note opportunities that interest you, and build connections with the partners you may need along the way to source notes, record transactions, and provide servicing.

By vetting the strategy rather than looking for a specific opportunity, you can ensure that establishing a plan to pursue this type of investing makes sense.

Plans that offer Checkbook Control are generally much better suited to note investing than the services of a 3rd party IRA custodian. Note opportunities often need prompt action, and waiting for 3-5 business days for processing may not be an option.

Many notes — like to investors flipping property or building spec homes — are shorter term. The several buy/sell transactions that may occur each year can start to generate a lot of custodial fees. Meanwhile a checkbook plan will not incur any per-transaction fees.

Sourcing Notes

There are many ways you can find potential note investments. Some investors prefer using note brokers who find opportunities and perform diligence. Just getting the word out to local real estate investors, developers, realtors, or title companies can be a good way to network and turn up leads.

One thing you should avoid is creating your own marketing machine, such as a website or mailing campaign to originate note opportunities. This can create risk with IRS rules if you’re viewed as providing services to the IRA, or escalating what you’re doing to the level of a business rather than purely investments.

Passive interest income is fully sheltered to an IRA or 401(k), but trade or business activities may not be.

Perform Diligence

Whether you’re dealing directly with a borrower or working through a note broker, you’ll always want to be sure to perform diligence to ensure the minimum risk for your IRA.

Research the property and any outstanding title or debt issues, ensure the loan value is well secured by the property location and condition, and evaluate the borrower’s ability to pay. Having a property formally appraised may be appropriate as well.

Note Documents

If you’re working through a broker, the mortgage and deed of trust documents will generally be provided as part of the service. You’ll want to review the documents to ensure they accurately reflect the terms you have agreed to.

If you desire, your IRA or 401(k) plan can pay to have an independent attorney review these legal documents.

If you’re working directly with a borrower, you’ll need to have appropriate note documents created. A good place to start is with a title company or title attorney who may be able to generate documents or refer you to a reliable attorney who can.

In either case, a few of the following details are key:

• The IRA owned LLC or Solo 401(k) trust will be the lender
• You can sign on behalf of the entity in your role as LLC manager or 401(k) trustee
• The note instrument must comply with state lending laws with respect to terms and interest rates
• Any necessary borrower disclosures need to be included in the process
• Your plan can pay for legal and recording services or wrap these costs into loan fees paid by the borrower

Funding the Note

Once you have arranged for a lending transaction and have the necessary paperwork prepared, it’s time to act. With a Checkbook IRA LLC or Solo 401(k), you have signing authority and can execute the necessary documents and issue funds from your plan held account directly to the borrower or escrow.

No 3rd party review of paperwork or processing delays is necessary. The transaction can be funded by wire, cashier’s check, ACH or other means. The method of funding is not important, as long as all necessary funds are issued directly from your plan account.

Recording

Be sure to have your note instrument properly recorded as a lien against the property by the county recorder’s office. This is a critical step to ensure the enforceability of your plan’s claim in the event of a default.

If you’re working with a note broker, be sure to receive a recorded copy of the note for your records.

Collecting Payments

Once the loan is in place, your plan will receive the payments from the borrower. Be sure that funds are issued to the plan and not to you personally. The payments can be made by check or electronic deposit.

Of course, the payments of principal and interest are received into the plan on a tax-sheltered basis.

Compliance Considerations

Be sure to check with qualified counsel to ensure you operate according to state law when it comes to having your plan act as a lender. In some states, licensing may be required to originate loans depending on the type and frequency.

If licensing is required, you’ll have to utilize a 3rd party broker or note servicer who carries the appropriate licensing. Loans to commercial entities such as other real estate investors will often be less regulated than a mortgage issued to a homeowner living in a property.

You’ll also want to ensure that you provide any necessary reporting to your borrower as required by state law. As an example, issuing a 1098 to the borrower may be appropriate. An annual summary or regular statement may also be required.

Using a Note Servicer

While you can directly administer your plan’s lending transactions, there can be real benefits to using a professional note servicer.

From a plan perspective, you’re limited to basic administration. If your note investing becomes heavily involved or high volume, then the level of services you provide could become a potential risk factor with respect to self-dealing.

If you’re putting more than a few hours a week into the processing, you should consider hiring a 3rd party as a best practice. From a lending compliance viewpoint, leveraging the expertise of a professional can be valuable.

Laws related to disclosures and reporting, or the processes to remedy a payment deficiency can be complex and change over time. Working with a note servicing firm that has a clear understanding of the legal side of lending can make a real difference in the event a note transaction goes south.

In Summary

Having your self-directed plan be the bank and act as a lender is one of the most straightforward types of investment available. As with any investment, the real work comes on the front end in locating and evaluating notes.

Once you’ve identified a promising opportunity, the ability to execute directly with your self-directed IRA or Solo 401(k) makes for a pretty simple transaction. Then you can look forward to sitting back and watching payments roll into your IRA.

But like we mentioned earlier, to ensure good results when investing in notes, it’s important to do your homework first.

Discover 3 ways to acquire mortgage notes in your IRA, and the key factors to evaluate when considering note investments »