Fundamentals of SDIRA Private Lending
By: Jeffery S. Watson
If you’ve followed me for any length of time, you know that I’m a huge proponent of self-directed IRAs and using them for private lending. Let’s begin at the beginning…
“Private lending” is when an account-holder makes a loan from their self-directed retirement account (Roth IRA, solo 401k, HSA, etc.) in exchange for a well-documented, secured interest in a piece of appreciating real estate. When doing private lending, it’s important to have the right foundation for the process, and that starts with having a policy for lending and knowing what your lending criteria are.
The next step is to have a good process in place for doing the appropriate due diligence on the people, property and paperwork involved in the lending transactions. Thorough due diligence done correctly is foundational to a successful private lending transaction. If you fail to do things the correct way, you will find yourself lending money based on emotion or other human attributes to people who don’t have solid business plans, good collateral, good paperwork, or maybe all three. Having a specific, mapped-out process for doing due diligence on the people, property and paperwork is imperative.
Just looking at the collateral isn’t enough. I can tell you firsthand that a bad person can ruin a deal irrespective of how good the property is or how fantastic the paperwork for the deal is. A good person with acceptable paperwork can still have a bad result if the property is bad. All three factors – people, property, paperwork – must be right to result in a successful private lending transaction.
When it comes to private lending paperwork, the most important piece is the note because the note becomes the asset held by the IRA. The dollars in the account are being exchanged for the written IOU (promissory note) which is the asset. A properly-written note must lay out several key things, including, but not limited to:
- Who is the borrower?
- Who is the lender?
- How much is being lent and on what terms (interest rate, length of loan, etc.)?
- How will it be repaid?
- What collateral is being given to secure the note?
- What happens if a payment is late or missed?
- Is an extension permissible and what are the terms?
I have seen promissory notes less than a page long and others that are five pages long. I had a conversation with another attorney about a note that appeared to have been written by ChatGPT that was fundamentally flawed in two areas. If you are going to invest time and money into one area of your private lending business, please spend it on your paperwork, especially when it comes to the promissory note!
The note also needs to reflect any additional terms that might be involved in the deal, such as the percentage of the note owned by each lender in a co-lending situation, whether the note is in a first or second position, and whether the note is being wrapped by another note or if it is the note doing the wrapping. These things need to be clearly spelled out in language that an 8th grader can read and understand.
Using the term “security instrument” causes me to feel like I’m confusing people. When I use the term “security”, instead of thinking of it in terms of something that is an investment being bought, sold or traded, think of it as a written document that “secures” or ties the repayment of the note to a tangible, economic asset that is lost as a consequence of failing to pay. The “security instrument” could be a mortgage, a deed of trust, an assignment of rents, a UCC-1 filing, or a collateral pledge.
When it comes to which paperwork to use as a security instrument for a note, remember that not all states are the same. Some states use mortgages, and some use deeds of trust. I’m not going to get into the nuances of each, but there are material and substantial differences between a mortgage and a deed of trust. A comparison will show that a deed of trust gives the lender a lot more power, authority and control over the collateral than does a mortgage.
The most important thing to remember, no matter which of the above-listed security instruments you are using, is that it be drafted by design to fit the particular deal being negotiated. Yes, 90% of the document will be what we refer to as “boilerplate” language, but that other 10% needs to be carefully thought through and drafted deliberately to cover the specifics of the deal.
Now we come to the high point of the private lending process. We are ready to close the transaction. This is the time when things can get chaotic. If you are involved in private lending as a lender, you must be in control and be the clear, calm voice who provides clearly-written closing instructions to help the closing attorney or title company know exactly what steps need to be followed.
When I’m working with a private lender, we now do two sets of closing instructions. We have begun using a preliminary closing instruction letter outlining the things that need to happen at the outset of the deal, such as the title search being done and the commitment being prepared, and property and casualty insurance being obtained. These things take time, so we discuss them weeks before the closing.
Then, a few days before the closing, we deliver the dated documents along with specific instructions for how they are to be handled and signed. Those instructions also include what is to happen with the money. The closing instruction letter clearly states that those funds are not to be distributed until I have seen copies of the fully-executed documents and have reviewed the final closing statement. This means the lender in the transaction is the one driving the bus, and everyone else is following along.
The private loan has now matured, so one of two things should happen. There will either be a payoff, or the parties may agree to an extension.
The loan can be extended by doing a modification agreement whereby the parties agree to extend the maturity date and either change some of the terms (such as the interest rate or the loan amount) or agree to keep them the same as they have been. Payment of an extension fee or additional points is usually involved.
Typically, the maturity date is reached, and the loan is paid off. Payoffs are good things because the money invested by your self-directed account is coming back to it. It’s important to remember that all payments made during the term of the loan and the payoff need to go back to the same source or SDIRA account from which the loan originated.
Payoffs must be done according to written instructions which indicate how much is due and on what dates, and how much the interest is for every additional day. The same goes for loan extensions. Any extension needs to be documented in writing. That’s fundamental!
Jeffery S. Watson is an attorney who has had an active trial and hearing practice for more than 25 years. As a contingent fee trial lawyer, he has a unique perspective on investing and wealth protection. He has tried over 20 civil jury trials and has handled thousands of contested hearings. Jeff has changed the law in Ohio four times via litigation. Read more of his viewpoints at WatsonInvested.com.
