The Private Loan Source Perfect for Growing Your Real Estate Portfolio

by | BiggerPockets.com

Most investors I know are perpetually on the lookout for more capital. Whether they are seeking lenders or partners, real estate investors always need more capital to build their businesses. So, where should you look? Once you get comfortable presenting your business to a potential lender or partner, you will find that some sources of capital work better than others for your deals.

In my years of investing, I have found one particular source of capital to be the ultimate for both you and your money partner when doing a private loan. While this vehicle works best as a loan source, when it’s used properly, the investor can double their money quickly through real estate loans. The investor has tax advantages not available if their loan came from other sources, and they will most likely be OK with you paying interest when the loan is repaid, not during the loan term. Investors tend to invest over and over with you through this vehicle because it’s very hard for them to put the money in their own pocket or use it for something else. This investment even comes with a built-in third-party custodian who makes sure that your loan is compliant with regulations—and this custodian is paid by your lender, not you!

Related: How to Improve Your Odds of Scoring a Loan With a Private or Hard Money Lender

The Private Loan Source Perfect for Growing Your Real Estate Portfolio

In today’s video, I go into detail on the subject and tell you not only why this loan source is great but also how to find lenders with them. They are probably all around; you just don’t know it. Watch the video to learn more!

If you enjoyed today’s video, be sure to leave a comment here so we can get a good convo going.

Thanks for watching and have a great and profitable week!

About Author

Matt Faircloth

In 2005, Matt founded The DeRosa Group along with his wife, Elizabeth. At the time, the two person company owned and managed two assets – a single family home and a duplex. Over the last nine years, they have grown the company to a 12 person team owning and managing over five million dollars in residential and commercial assets throughout the central NJ and Philadelphia area. One of DeRosa’s mantras is “to make money while making a difference.”

38 Comments

  1. Brian H.

    Wow. Great video Matt. Thanks!

    Sad as this may sound, are there any other routes for a person to find people with SDIRA if they aren’t sure they would know anyone personally in a position to lend to them?

    Not really to that point yet, but just curious.

    Thanks again. I alway love your videos!

    • Matt Faircloth

      Hey Brian,
      Try expanding your network. Look at the community around you – your hobbies, church, school, etc… If you are not in the circles of anyone that has an IRA, consider joining new groups – networking groups, local real estate clubs, etc… to meet more people that could be potential lenders to you.
      Matt

  2. Cindy Larsen

    Matt,

    Great video as usual. A couple of additional things about lending/borrowing from retirement accounts.
    As I am sure you know, there are actually 3 types of retirement accounts you can do this with:
    1. SDIRA
    2. Self Directed 401k
    3. Self Directed ROTH IRA
    Of these, the BEST is the Self Directed ROTH IRA, because although all three types of retirement accounts grow tax free, the SDIRA and the Self Directed 401k Both get TAXED eventually.

    That happens when the retirement account owner takes the money out of the retirement account. They then have to pay both federal and state income taxes on the money, at their highest tax rate, since that retirement account money is additional to whatever other income they have that year. Once the account owner is 70.5 years old, the IRS FORCES them to take part of the money out each year, a larger percentage every year. That percentage starts at 4% of the balance and builds up to 50% of the balance each year, until the account is EMPTY. This is called RMDs or Required Minimum Distributions. Depending on your tax bracket in retirement you could pay between 25% to 39% or more of those retirement funds: and that tax is paid on the entire balance of the account, including all that phenonenal growth you were talking about. That happens whether the retirement account was self directed, or not, and regardless of whether it was invested in the stock market, or real estate, mortgage notes, gold, or whatever. RMD’s suck.

    The Self Directed ROTH IRA on the other hand, is funded with after-tax money, grows tax free, and is NEVER taxed, and you are NEVER forced to withdraw it. Of course if you need those funds in retirement, you can withdraw what you need, and that income is TAX FREE.

    Assuming that the investor becomes a sucessful real estate investor (which all of us here on BP are aiming for) and their tax bracket in retirement is the same or higher than it is now, with the Self Directed ROTH IRA, they will end up with LOTS more money.

    Let’s look at that investment of $100k, and assume that the average interest rate earned was just 7.2%. Then, whatever money is invested will double every 10 years. Lets assume the investor is 50’years old, and their marginal tax rate is 28%, both now, and in retirement.

    Investing via a SDIRA: after 20 years, the $100,000 investement is now $400,000, Awesome. EXcept that over the next 20 years, all of that money will be forced out of the tax free retiremnt account, and taxed at 28% or higher. Even though the money remaining in the account each year is still growing tax free, a higher pecentage of it must be withdrawn each year, so, soon the withdrawals are greater than the gains, and the account starts shrinking, faster, and faster untill it is empty. Of course the money that is withdrawn can be invested, but NOT tax free. So, not only do you eventually pay 28% or more on your $400,000, and on anything the account earns after the RMD’s begin, but you get taxed on the money that you reinvest.
    For example, the first year of RMD’s you only have to withdraw 4% of your account balance: $16,000, and pay 28% of that in taxes which leaves you 11,500 to reinvest. If that money also earns 7.2% interest each year, invested in a mortgage note, the interest will be taxed as ordinary income at 28%, which makes the effective interest rate 5.182%, which by the rule of 72 means that it will take that reinvested $11,500 13.89 years to double. NOT great.

    Investing via a Self Directed ROTH IRA: The Self Directed ROTH IRA never has to take RMDs, so the money can continue growing tax free throughout retirement and if some of money is withdrawn it is NOT taxed. Our investor could withdraw just part of the gains each year, or all of the gains, pay NO tax, and never touch the principle. So, suppose our investor had rolled over the $100,000 from his company 401k to a Self Directed ROTH IRA, and had paid 28% tax on the money, using retirement funds. He could also use non retirement funds to pay the $28,000 tax, and roll over the entire $100,000, but let’s assume worst case, that the retirement funds are reduced because of the conversion from 401k to Self Directed ROTH IRA. He would only have $72,000 as an initial investment, instead of $100,000. So, aftter 20 years, the money would have grown to only $288,000, instead of the $400,000 it would have grown to in the SDIRA account. Obviously not as good?

    Well, after another 20 years, if our investor takes no withdrawals, the Self Directed ROTH IRA will have $1,152,000, still growing tax free.
    The SDIRA will be nearly empty, it will have been taxed, and the after tax money will NOT have grown tax free, so it will have grown more slowly.

    Of course, everyone’s tax bracket is different, and we can only guess what it will be in retirement. But, the bottom line is that in the Self Directed ROTH IRA, your principle gets taxed before it grows, and with every other retirement vehicle, it gets taxed after it grows, and then the reinvested remainder grows more slowly. I’d rather be taxed sooner on a smaller amount than later on a much larger amount.

    So, I am converting as much as possible of my 401k money to my Self Directed ROTH IRA each year, carefully converting just enough to never pay more than 28% tax rate on the conversion, and paying as much of the tax as I can with out-of-pocket money instead of retirement funds. Someday, I’ll be living off of tax free income. I’ll also be able to will that tax free Self Directed ROTH IRA account to my kids. Then the IRS will make them take RMD’s on it. Oh well. Meanwhile I’ll encourage them, and all of you on BP, to max out your ROTH IRA contributions each year. It’s the best game in town.

    CJ

  3. Wilma E.

    Matt, thanks so much for enlightening us about SDIRAs. Cindy took it one notch up with a fabulous explanation of the merits of using a SDRothIRA. Thanks! How many people who leave jobs know to invest in a SDIRA or for that matter, a SDRothIRA? One’s returns could be juiced up prudently considering the array of investing vehicles. If I was educated about SDIRAs and/or SDRothIRAs when I left my job, I’d be first in line. Can a Roth IRA be converted to a SDRothIRA after all this time?

    • Cindy Larsen

      Wilma,

      Please see my reply to you under Linda’s coment below. I don’t know how I managed that, but I think I forgot to hit Post Comment on your post, and then read Linda’s post and hit reply, and it transfered my reply the post there. Weird.

      CJ

      • Wilma E.

        Cindy,

        Thanks for the thorough explanation. Very useful knowledge. The bull market has been generous to my Roth IRA so reluctant to convert now. I will, however open up a SD Roth, and seek to partner up with another investor’s Roth.

        • Cindy Larsen

          You can create an SD Roth IRA now, and rollover your regular Roth IRA whenever you want. That is not a conversion, just a simple rollover. (Unless you meant a regular IRA, not a Roth. That would be a conversion, and you’d have to pay taxes.)

          Since they are both Roth IRAs they are both the same from the IRS viewpoint: aftertax money in a Roth. The IRS sees all Roth IRAs as the same: it is the custodian who decides which types of transactions they are willing to allow. THere is no reason a brokerage company like Fidelity or Vanguard can’t do real estate transactions:’they just choose not to.

          AS for the bull market, yes, it has been great to my 401ks. i just hope I have time to roll them over to my solo 401k before the next crash. The problem is no one can predict when that will be, but my guess is sometime in the next year or two. I don’t want to roll my money over while is growing in the the stock market either, until I am ready with a real estate deal to invest it in. BUt I don’t want to take a huge loss like I did in the last two crashers either. that is the problem with the stock market: it is nondeterministic. Even when I studied it, I couldn’t figure out how to mitigate risks, except for the diversify and hope strategy, or the invest in index funds strategy. ANalysis can show that a stock or sector should do well, and then there is a rumor, and it crashes. The stock market is not for me.

    • Cindy Larsen

      Oscar. Be honest. The SD ROth IRA you want to borrow money from is someone’s retirement account. Quite possibly their life savings. Treat it like you would if it belonged to your Mom. If you are out of work, say so.

      Also, no one with any brains is going to loan money, especially from their most valuable source of tax free funds, the SD ROTH IRA, without you being able to present a good business case, and without you having skin in the game, and provable experience doing whatever you are planning to do with the money. Unless they know you really well, or have some other reason to trust you.

      Any investor is going to do due dilligence before investing, which means understanding and checking out every aspect of the deal, including any risks, including the person they are loaning the money to. Just like getting a bank loan, an investor is going to want to know about your income, your debts, your credit history, etc. I use smartmove.com to check out my tenants credit, criminal, evictions, bankruptcies, etc. why wouldn’t I do the sme kind of due diligence before loaning money or partnering with someone? A restate investor is also going to want to know everything about the deal, so they can assess the risks.
      CJ

      • Oscar Freiman

        What do you mean by be honest? I don’t want to mislead anyone, is this what you mean?

        This is why I asked the question, and presented my current situation. So, what are my alternatives? An asset based loan? What do you suggest?

        OHF

        • Matt Faircloth

          Hey Oscar,
          I think what Cindy is trying to say is that you need to show respect for the other person’s retirement funds. If you are clear with them, do the proper due diligence to make sure they are protected and use well-prepared loan documents so they have collateral, you are showing respect.
          I will say that it’s hard to get people to take you seriously when you are just getting started. If you haven’t done a deal yet, consider doing a joint venture with an investor that has a track record, so that you can get a few deals under your belt. That way you can show potential lenders that you have been around the business before, and aren’t going to have your first experience in real estate on their dime.

          Matt

    • Matt Faircloth

      Hey Oscar,
      I think that you should look to align yourself with a more seasoned investor to learn the ropes and use their track record to show experience. You may need to do that for a while to establish yourself, and pull off on your own in the future.

      Matt

  4. Zac Ferguson

    My thing is just finding these willing participants to loan me money for my deals. I don’t have that many connections with people who are financially savvy enough to own a SDIRA, or with the demeanor to want to loan to me regardless.

    • Matt Faircloth

      Hey Zac,
      Watch the video again. All you need to do is find people that had a job at a good company that would have offered a 401K program, and then moved to another job from there. it’s not about being savvy, it’s about showing them what’s right under their nose.
      Matt

      • Cindy Larsen

        Matt is right, there are hundreds of thousands of people with 401k accounts, who are mostly unclear on how their money is invested: it’s just in whatever funds were available in their 401k, whenever they set it up. Most of those people are not really comfortable with the stock market, and may be glad to invest their money in something real, as an equity investor, or for a guaranteed rate of return, as a lender. You just need to let them know that this is possible, and point them in the right direction: to a SD IRA, SD Roth IIA, or solo 401k custodian. THe custodian (or their website) will explain how investing from self directed retirement accounts works. You explain the risks and benefits of the deal you are proposing.

        Real estate is a lot easier to understand than the stock market, more deterministic, and more conducive to risk mitigation strategies. I bet if you took a poll of people with 401ks, you would find that most of them are not comfortable with how their retirement money is invested. They just don’t know that there are any other options.

        If you start someone down this path though, unless they are pretty savy, and willing to devote the time to understanding the IRS rules, I suggest that you steer them away from the checkbook control custodians. CHeckbook control is great for investos who are willing to spend the time to understand the rules and be careful to follow them. CHeckbook control gives quicker turnaround times, and less custodian fees, but you can shoot yourself in the foot. Anyone else should invest with a custodian who will provide that level of knowledge and care, and will only write the checks when they are sure the deal doesn’t violate IRS rules. Both types of custodians work well, but for different types of investors.

  5. Do you have any recommendations on finding a custodian to set up the SDIRA with? Or a way to do it yourself? When I checked into it, there seemed to be a lots of fees and paperwork.

    • Cindy Larsen

      WIlma,

      Yes, you can convert a regular IRA or a regular Roth IRA to a SD Roth IRA at any time. You can also convert a regular IRA to a Roth IRA that is not self selfmdirected. You can have a regular Roth IRA created at fidelity or vanguard, or scottrade, etc. Since your regular IRA contains pre-tax money, the rollover will be taxed, (and depending on your age, my be subject to early withdrawl penalty: I don’t know, I’m over 55, and haven’t researched that). When you create the new Roth, make sure that the money is transfered custodian to custodian and you never touch it, so you don’t invalidate the tax free status of the retirement money.

      Or you can go with an SD Roth IRA ( again custodian to custodian transfer) which is done as an LLC. There are two types of SD Roth IRA custodians: There is an initial fee for creating the SD Roth IRA and also yearly fees, which MUST be paid from the ROTH IRA funds, not your personal funds. One type of custodian gives you checkbook control of the Roth IRA, which invests its funds in the LLC, and you are owner/controller of both the SD Roth IRA and it’s LLC. THe LLC can, for example, buy real estate. WARNING: research prohibited transactions. Basically you cn’t do anything with ROTH IRA funds that directly benefits you, or your parents or kids. If you do, the tax free status of the Roth IRA is recinded by the IRS, just as though you withdrew all of the money: and they will immediatly tax it all as income that year. Educate yourself on the Roth IRA rules. If prohibied transactions still scare you, you can use the second type of SD Roth IRA custodian, who will (for a fee each time and with a small delay, usually days) check every transaction you want to do with your SD Roth IRA to make sure you are not doing a prohibited transaction. This type of custodian writes checks for you, instead of you having checkbook control.

      You can roll money from one of your Roth IRA accounts to another one whenever you want, as a custodian to custodian transfer, usually for free. So if a person was just starting out with a Roth IRA and was unable to convert IRA or 401k funds, they could create a regular (not self directed) Roth IRA, and invest in stock or bonds while they built up enough money in the account to be able to, from the SD ROth IRA: a) pay initial setup and yearly SD ROth IRA custodian fees, b) invest in real estate, and c) pay any expenses the real estate investment incurrs. Paying for anything associated with your SD ROth IRA out of pocket is a prohibited transaction called self dealing. Roth IRA money and personal money must always be separate.

      Since each person can only contribute $5,500/year to a Roth IRA ($6,500 if over 55), it can take a few years to have enough in the account to invest is real estate, except through crowdfunding real estate websites. I can’tcomment on those, I’m still researching.

      One way to invest a small amount of SD Roth IRA money is to partner with other people’s SD ROth IRAs to buy real estate. EAch SD ROth IRA must own a specified percentage of the property, and must pay that exact percentage of the expenses and recieve that exact percentage of the income. I believe the contract and the deed has to say that the property is owned as “tenants in common”. I haven’t done this yet, but I probably will in the future.

      Another way is have your SD ROth IRA be a hard money lender.

      SD ROth IRA Is a very powerful tool, but it takes a fair amount of research and care to make sure you don’t break any of the IRS rules. If you take the time and care to understand the rules, SD ROth IRA is awesome.

    • Cindy Larsen

      Linda,

      Yes, there are fees, which vary from one custodian to another. TANSTAAFL, an acronym coiled by Robert A Heinlein that means (There Ain’t No Such Thing As A Free Lunch). To paraphrase Heinlein, if sign in the hotel bar says Free Lunch, you can bet that the cost of the drinks is high enough to cover the food too.

      To make the fees worth while, you have to have enough money in the SD Roth IRA that the fees are just a business expense for the Roth. It isn’t getting taxed, so the fees are, with enough invested, not such a bad deal. You can open a Roth IRA that is not self directed and does not have SD Roth IRA fees, build up funds in there via contributions and returns on traditional stock market investments (which have fees for buying and selling stocks) and then roll it over to a SD Roth IRA. PLease see my reply to Wilma that got posted under your comment here, for more on this topic.

      There are 3 ways to get money into a Roth IRA:
      1. Contribute to the Roth each year $5,500 or $6,500 depending on your age. I WISH I had known about Roth IRA 20 years ago.
      2. Convert money from other retirement accounts, and pay the taxes on the conversion.
      3. Set up a side business that makes money, with you as a sole proprietor. Mine is tutoring math. That business can then create a retirement plan called a solo 401k
      (a self directed retirement account with the same custodian as your SD Roth IRA, and that also has setup fees and yearly fees, which again, have to be paid out of the retirement account, but you can rollover existing 401k money into the solo 401k account),
      which can have both a regular 401k(pretax money), and a Roth 401k(after-tax money, but subject to RMDs later). YOU are both employer/CEO of your business and employee of your business. You must pay yourself (the employee) a market wage, as W2 income, and pay FICA taxes, as both employee and employer, etc. As as employee, you can contribute up to the larger of either your before tax W2 earnings, or $55,000 to your business’s retirement accounts. After the business pays it’s expenses, including your wages, the business can make an employer matching contribution to your business’s regular 401k account. Any additional profits for the year are then applied as income to your personal tax return, as are your wages from the business. You can then roll all that new retirement money over to your SD Roth IRA. You have to pay taxes on the 401k rollover, but not on the Roth 401k to SD Roth IRA rollover, since they are both after-tax money.

      Example: My business might charge $30/hour, and pay me, as the employee $20/hour.
      if this side business makes $15,000/year, I have W-2 wages of $10,000, and after taxes, my pay checks add up to say $6,500. I can contribute $10,000 to my business’s retirement accounts, with pre tax income into 401k, or post tax into the Roth 401k. Yes, some of the $10,000 has to come from my day job, because myntakemhomempay from my business was only $6,500. IF my business was set up to do so, I can contibute an employer match to funds contributed to the 401k. Say my business expenses were $3,000. After wages, FICA taxes, and other expenses my business has left $2000 in profit that I can either pass though to the business owner (me as the owner/CEO) as profits, which I pay income taxes on, or I can use all or part of that profit as an employer match to the 401k funds that I as the employee contributed. IF my employer match was set up as “up 50% match, up to the total yearly profits” or legalese to that effect, then, I would, as the employee, put $4000 into the 401k, which would justify an employer match of $2,000, I could then put ($10,000-$4000 = $6000) into the Roth 401k. Then I could rollover both funds to my SD Roth IRA, paying taxes on the $6000 from the 401k, and no taxes on the $6000 from the Roth 401k, sincet that was contributed as after tax money.. Result: at least $10,000 into my SD Roth IRA. I haven’t done this yet, but I just licensed my tutoring business. Once I finish my current remodel and get the house on the market, and start tutoring, setting up my solo 401k is next. i have unitl december to set it up for this year’s taxes.

      Everything I know about retirement accounts is from reading the IRS website. I’m not a financial advisor just a real estate investor looking for the best ways to invest. MY only advice on which custodian to use to make sure they are approved by the IRS. Ask them to provide documentation.

      CJ

  6. Thomas C. Barrage

    Great explanation! I have a self-directed solo 401(k)… and as you said… have limitations on lending money to help move projects forward outside of my solo 401(k). Is there anybody in a similar situation in the Pittsburgh, PA area?

    Maybe I could help YOU move your personal real estate projects forward by loaning YOU $ from my solo 401(k)… while you help ME move my personal real estate projects forward by lending me money from your SDIRA / solo 401(k)…?

    Just a thought,
    Tom

    Thomas C. Barrage – House Flip Capital, LLC – Cranberry Township, PA

    • Matt Faircloth

      Hey Thomas,
      That’s a very creative idea! Good luck finding someone. Just make sure you know that the loan documents for loan # 1 can’t reference loan # 2. The loans need to be completely independent of each other.

      Matt

  7. Cindy Larsen

    Tom,

    Matt is 100% correct. Also make sure that you don’t do a prohibited transaction such as loaning money to a family member from yor retirement account and/ or borrowing from theirs.

    Another approach is to have your retirement account partner with one or more non-family member’s retirement accounts, with each partner owning a specific percentage of the property, based on how much they contribute. the property must be owned as tenants-in-common. Check with a lawyer,on how to do this, but, it can be very powerful. Imagine the deal where you need a $150,000 down payment to buy a $500,000 apartment building with 30% down. You could have one person’s retirement account contribute 15% ($15,00), three other’s contribute 20% ($30,000) each, and another contribute 30% ($45,000). SUddenly, a deal that no once could fund is possible. Of course, like any partnership, you need to put everything in writing as a contract specifying how decisions are made, deal exit criteria, and anything else you can think of. BUt if you can find one or more partners, it could be very mutually beneficial. As always, be careful that the deal only benefits your retirement account, not you in the short term.

    • Matt Faircloth

      Hi Michael,

      The Non recourse loan only kicks in if your self directed IRA is borrowing money to do a project by iteself. Meaning the SDIRA would buy the real estate, invest capital into it, and sell or refinance after.

      If it’s lending money to someone, the lender can get a personal guarantee from the borrower, no problem.

      Matt

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