Investor · Berkeley, CA · Member since 2016 · 45 posts · 43 votes
I have a self-directed IRA that I would like to use to invest in a third party's flip. In thinking about a promissory note that would avoid both a prohibited transaction problem and an Unrelated Business Income Tax ("UBIT") problem, I thought of these terms:
(1) The note will have no installment payments. It will have an interest rate of 12%, i.e., a "hard money" rate. Principal and interest will be payable in full at the end of 12 months.
(2) If the borrower sells the flip property prior to the 12-month payable-in-full due date, then the borrower will incur a pre-payment penalty. The amount of the pre-payment penalty will be equal to one-half the net proceeds of sale, minus the accrued interest. Of course accrued interest, and principal, will also be included in the payoff amount.
Does anyone see a prohibited transaction here, or a UBIT problem? Regarding UBIT, this would be the first investment that this SD-IRA has made, since being converted from a traditional IRA.
Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
9y
There is not enough info provided to determine if the transaction is prohibited or not but as long as the "borrower" is not a disqualified party, then you are fine there. Secondly, there is no UBIT when you lend from your IRA, only if your IRA becomes the owner or shares in "profits". So your prepayment penalty verbiage could be a problem there.
Lastly, if thevproperty is in CA, then you are limited to a maximum of 10% apr on your loan to stay within CA State usury limits. The way around that is to have a licensed loan broker facilitate the transaction which would provide an exemption.
From your borrowers position, I don't see why they would agree to such a stiff prepayment penalty either.
As long as the borrower is not a disqualified party (below are some examples), investing in notes via a self-directed IRA is a popular alternative investment type.
You
Your Spouse
Your natural parents and/or your adoptive parents
Your natural grandparents
Your natural children and/or your adopted children
The spouses of your natural children
Any fiduciary of your IRA
Any people providing services to your IRA–such as your IRA custodian