One of the lesser known investment assets enabled by a Self Directed IRA is the promissory note. Let’s break down how a promissory note works, how a Self Directed IRA can invest in one, and what are some of the pitfalls that should be avoided.
A promissory note is in its essence a bill of debt. The investor gives over funds to a company or individual, and the recipient in turn promises to pay back the money with a certain amount of interest. In some areas a promissory note can be referred to as a “note payable”. One of the key elements of its utility is that can secure funding without having to go through a standard financial institution.
Certain financial niches have grown to use promissory notes as their go-to financial instrument. Here are some of the most common:
There is no one right answer. It depends on the details of the deal and how this investment will fit into the greater scheme of your retirement investing. However, we can take a look at a fairly common scenario and make a determination for that given case.
Susan and Rick want to buy a house. They each have good paying jobs and have saved enough for a nice sized down payment. However, they are having trouble securing a mortgage because of a bankruptcy a few years back. After exploring different possibilities, Susan remembers that her cousin Kaye had offered to help with a loan. Kaye is amenable to the proposition and asks Susan and Rick to give her a few days for research. She heard that she might be able to use a Self Directed IRA for the loan and she wants to find out how the process works.
In Kaye’s research she finds that there are many ways to set up a Self Directed IRA but overall they provide two kinds of functionality. One is a custodian-based Self Directed IRA where all transactions go through the custodian. The second is a Checkbook Control Self Directed IRA where the IRA is set up with a checking account and the account holder can perform transactions on their own.
If Kaye were to call a Madison specialist, she would probably be told that in this specific case the custodian-based Self Directed IRA is the way to go. This is because as the investment stands now it will have very few transactions. There will just be the initial loan and the deposit of the monthly payment. A custodian-based Self Directed IRA offers very economical setup and, once it gets going, fairly hands off management.
What may change Kaye's mind is if she plans on making additional investments with this Self Directed IRA. In that case the monthly transactions may grow in number and Checkbook Control would be more economical. The setup fee is higher but it is quickly compensated for by possessing unlimited free transactions. Additionally multiple transactions are more easily handled via a checkbook then they are by going through a middleman custodian.
Once your Self Directed IRA is setup, there is a simple 3-step process for making a loan with a promissory note.
The documentation you need includes an Investment Authorization form, the promissory note itself, and a security document like a Deed of Trust. When the note has been repaid, you will submit a Satisfaction of Note form.
For more detailed instructions on investing in a promissory note, please visit our instructions page here.
In addition to private loans, a Self Directed IRA can also purchase company sponsored promissory notes. This kind of investment requires a tremendous amount of due diligence. There are some legitimate promissory note offerings, but most of them will be limited to top level accredited investors. If you would like to purchase a commercial promissory note, due your due diligence and find out the answers to the following questions.
Here are online sources that can help you research these kinds of offerings.
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