A little known but potentially quite profitable lending niche is referred to as transactional funding. For investors with a Checkbook IRA or Solo 401(k) and the right network, this strategy can be very lucrative.
The concept of transactional funding is very well suited to a self-directed retirement plan and can be a good alternative for wholesaling or flipping, both of which are not really optimal for retirement funds.
What is Transactional Funding?
Simply put, transactional funding is the cash necessary for wholesalers and flippers to execute the quick acquisition and resale of a property. This is a commonly used creative real estate funding strategy.
Many wholesale or non-rehab flip transactions require a double-closing transaction and cannot simply be assigned. Examples would be foreclosures or short sales, where the controlling entity such as a bank or auction trustee requires a named purchaser to acquire the property and pay off any outstanding debt.
As a transactional lender, your self-directed IRA or Solo 401(k) is providing the cash to the wholesaler or flipper to purchase the property from the original seller, with the arrangement to resell the property to a qualified buyer in a short period of time.
Double-closings can often be done same day. Sometimes there may be a short delay such as a week or two between closings.
Because transactions are often very short term, most transactional loans charge a flat fee based on the amount borrowed in a range from 2% – 12%, depending on amount, risk factors, and expected time frame. For a $100,000 loan and a same day close, that might mean between $2,000 and $12,000 in return for one day. That is a pretty good rate of return.
Of course, with such short-term lending, it is challenging to keep money actively deployed. For every loan executed, you will likely have many days of idle capital between loans. That will reduce your overall rate of return.
If you plan to do transactional lending, you will want to develop a network of borrowers so you can fund deals with reasonable frequency.
Checkbook Control is a Must
Waiting 3-5 days for an IRA custodian to review and process an investment is simply not an option in the transactional lending space. Lenders need to be able to react quickly to opportunity and provide funds promptly.
The key benefit of checkbook control is the ability to execute contracts and fund transactions on-demand, without 3rd party paperwork, processing delays, or per-transaction fees.
Success in transaction lending comes from three things: network, network, and network. In order to keep your IRA money actively deployed you need to have multiple investors who flip or wholesale properties in your network that can look to you for rapid funding of their deals.
Being involved in local real estate clubs or meetups is one way to create connections with potential borrowers. If you have good relations with a handful of title agents or attorneys, they will often know who is active in these types of deals and looking for funding.
Direct Lending or Brokered Deals
If you can work directly with borrowers, you can have more control over who you work with, underwriting deals, and the terms of your loans. This equates to the maximum amount of control and investment return, but also requires a lot of work to develop relationships, ensure your lending documents are fully compliant with state laws, vet potential transactions, etc.
There are companies that broker transactional funding. For some IRA or 401(k) investors, it may be worth giving up a few percentage points of interest to be able to rely on seasoned professionals to put money to work.
With transactional lending, the property itself is the only security for the loan. Often times, your loan is covering the full cost of the purchase transaction. As such, you want to be sure the property is worth what is being paid.
Secondarily, you need to be sure the initial purchaser has lined up a buyer with appropriate funding to execute the secondary purchase. Not all lenders are willing to fund the 2nd half of a double-close transaction, so ensuring the final buyer’s funding is appropriate is a key factor to success.
If the final buyer fails to execute, you want to be sure your initial borrower has the ability to find another buyer for the property, or that your IRA is OK with taking over ownership of the property.
In many ways, thinking like a title agent is critical to good underwriting of transaction funding loans.
A Better Fit for an IRA
Many investors approach us with the idea of using a self-directed IRA to wholesale or flip properties. For a variety of reasons, neither of those approaches is well suited to an IRA.
Wholesaling requires a lot of hustle. The level of effort required to generate deals for your IRA could easily be viewed by the IRS as providing services to your IRA, which is a prohibited transaction.
Both wholesaling and flipping are considered dealer activities, or in IRA speak, trade or business activities. When an IRA engages in a trade or business on a regular or repeated basis, it is deemed to be competing with tax-paying enterprises and becomes subject to taxation on Unrelated Business Taxable Income (UBTI). The tax impact erodes profit margins to the point where such transactions are not typically beneficial in an IRA or 401(k) plan.
Transactional lending produces passive interest income, which is fully sheltered to a self-directed retirement plan.
While you would pay regular income tax rates on such loans personally, your IRA can collect interest on these short terms loans in an entirely tax-sheltered manner.
Short Term Minimizes Risk
Let’s face it. With COVID-19 ravaging the country, the short-term economic outlook is wildly variable and the mid-term and long-term are pure crystal ball territory. Who knows what will happen to demand for real estate in the next few months or years?
The beauty of transactional funding is that your IRA money is in and out of a deal in very short order. This minimizes the downside risk of potential drops in real estate values, extended vacancies, or tenants who are unable to pay rent that may come with other types of real estate investing in these uncertain times.
Short-term transactional lending can be very profitable and has minimal exposure to long-term risk factors that may impact various other investment classes in the age of Coronavirus.
Because such transactions require rapid decision making and funding, a self-directed IRA with checkbook control is a must.
The speed at which this space operates also requires that you really do your homework in advance. Engage title, lending, and legal professionals to help you craft a strategy with the highest likelihood of success.
Networking is key to creating transactional lending opportunities. You need to learn who in your community has the expertise to pull off wholesale transactions effectively, and make sure they can rely on you for on-demand funding when needed.
If the work required to develop relationships with borrowers and review opportunities is beyond your skills or available time bandwidth, working with a professional lender who brokers transactional funding opportunities might be a good choice.
As with any type of investing, working with experts who know how transactions work and intersect with IRS rules is key. Please feel free to contact us if you have an interest in learning more about how a self-directed IRA or Solo 401(k) can be used for short term transactional lending.