Self-Directed Loan Legalities

11 Replies

A friend of mine and I plan on rolling over old 401k's into self-directed IRA's.

We then plan to loan each other money, and use that money to flip houses.

So, I loan 80k to him, he loans 80k to me....we have 160k to buy and fix a house. Is this fair game, or are we missing something important here?

@Adam Johnson  

This would be a no-no. There can be no direct or indirect benefit between an IRA and a disqualified party - namely yourself. To utilize your associate in this way would be an indirect transaction between the IRS and yourself and if the IRS saw it, they would wipe out your IRA. Not worth the risk.

There are a lot of perfectly legitimate ways you can use your IRA to invest in real estate and generate good returns. It just has to be exclusively for the benefit of the IRA.

If you get caught both of your IRA accounts will be considered to be fully distributed. If you're SDIRA had, say, $150K in it and you make these $80K loans, then entire $150K would be distributed. You would owe taxes and penalties on the $150K.

The way @Adam Johnson  laid out the facts makes it sound sketchy, but my question to @Brian Eastman  & @Jon Holdman is: can his IRA and his friend's IRA each purchase a 50% stake in a property as long as the proceeds (upon sale) are to benefit the IRA?

This would avoid the situation entirely. Is that a prohibited transaction?

Lots of good info here, and good question from @Brandon Hall too.

To Brandon's question, I think your idea could work if I understand you correctly. My brother, father and I (disqualified parties, so tricky) all invest together in Buy-n-Hold Rentals, but you really need to know the rules. Our 3 way LLC (could be 2 way in original posters case) could also invest in flips. One of the big no-nos though is you can not do any of your own labor using SDIRA funds, which I am guessing might be the intent?

As to different SDIRAs loaning funds to other flippers...... Could that be done IF they were not investing JOINTLY.... basically each doing individual projects with NO 'mixed funds' so to speak? 

Dan Dietz

It's weird though, because in terms of my SDIRA, my investment is "loaning" my buddy money. So, I expect to earn interest from that, as far my IRA in concerned. It just so happens that he'd also me loaning money to me, and we are using that money to buy and flip a house.

You'd think that once the money is loaned out, what happens with that money doesn't matter, as far as the IRA is concerned.

@Adam Johnson  & @Brandon Hall  

Yes, Adam and his associate could effectively pool their IRA funds to joint venture into real estate transactions together. The idea is that it would be the IRA's doing the investing, and not Adam and his associate.

The returns would go to the IRA accounts. There is the additional limitation as @Daniel Dietz  points out, that they would only be allowed to "direct" the investments and could not participate with their own labor or the labor of parties disqualified to either IRA.

Flipping is something that can be done with IRA funds, but comes with exposure to taxation known as UBTI, as this is viewed as a business activity as opposed to a passive investment such as rental income or note payments received. Even with this tax, the IRA can potentially receive ROI that is favorable when compared to other investments one might make with an IRA.

An alternative approach for using an IRA with flip opportunities is to be the bank rather than the flipper. Lend money to someone flipping a house and that interest is deemed passive and therefore not subject to UBTI. Of course, Adam's IRA should not lend to his friend to flip, while his friend is at the at the same time using his IRA to lend to Adam to flip, as this would still be looked as an an indirect transaction between each parties IRA and themselves.

@Adam Johnson  

Your last post came in as I was writing the above. The issue is that, albeit indirectly, you are utilizing your IRA's capital in your own personal project. This is clearly prohibited.

You'd think that once the money is loaned out, what happens with that money doesn't matter, as far as the IRA is concerned.

ANY transaction that in any way benefits you personally would be a prohibited transaction. I was advised by an attorney to not even have my IRA purchase properties near properties I personally own lest that somehow be deemed to be benefiting me personally.

The IRS would look at the pair of tit-for-tat loans and view this as a structure that effectively results in your IRA loaning money to YOU, which is absolutely a prohibited transaction.

can his IRA and his friend's IRA each purchase a 50% stake in a property as long as the proceeds (upon sale) are to benefit the IRA? 

That certainly could be done.  In addition to the ugly UBIT tax @Brian Eastman mentions, they would not be allowed to do ANY of the work themselves.  If the plan is to buy a house together then put in the elbow grease to do the work, that plan will fall apart.  All the labor would have to be hired out.

Making loans from IRAs is, IMHO, a better business than fix and flipping. No UBIT. They just have to be arms length loans that do not in any way benefit the beneficary of the IRA or any other disqualified person.

@Brian Eastman instead of letting @Adam Johnson guess how to do this, then telling them NO. Why don't you tell them how it is done?

Or I could refer them to Carl Fisher of Cama Plan, PA who does this all day long.

@Mike Hurney  

A forum such as this is not appropriate for specific technical matters, and I do not have enough facts about @Adam Johnson  's situation to provide detailed recommendations. 

Sure, I could spend a bunch of time writing a long post listing 5 or 6 different approaches that nobody would read, but would it really fit Adam's goals?  Could I effectively illustrate the impact of UBTI and compare that to the option of being a hard money lender in a few sentences? Not really. 

Based on the thousands of investor conversations on the topic we've had over the years, we know that one-to-one consultations are the most effective means to educate. I mentioned that Adam is welcome to contact me directly, which would provide a vastly superior opportunity to learn about his options. Self directed IRA's are an area where generic one-size-fits-all approaches simply do not apply.

In the internet age, we all want instant gratification.  I get that.  But I also resist the temptation to meet that desire at the expense of quality information.  I participate in this forum to help where I can and encourage those who want to learn more to speak directly with a professional.  Whether that is our firm or someone else is up to them.

Originally posted by @Adam Johnson :

A friend of mine and I plan on rolling over old 401k's into self-directed IRA's.

We then plan to loan each other money, and use that money to flip houses.

So, I loan 80k to him, he loans 80k to me....we have 160k to buy and fix a house. Is this fair game, or are we missing something important here?

Another strategy that could work is to use self-directed Solo 401k, if you qualify (you need to have self-employment income). This plan allows to take personal loan from your retirement account up to $50K or 50% of the balance, whichever is less. The loan funds can be used in any way you wish. The loan has to be paid back in 5 years using amortized payments. 

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