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4 Ways to Invest in Promissory Notes with Your Self-Directed IRA

  |  By Chris Shanahan

At PENSCO, we make it possible for retirement investors to hold alternative assets in their self-directed IRAs. Owning alternative assets in an IRA gives account owners more choice and control over their tax-advantaged funds, and a way to broadly diversify their retirement portfolio beyond stocks and bonds.

Promissory notes, including mortgage notes and trust deeds, are popular investments among PENSCO clients. According to our annual client survey, a considerable number of clients intend to increase their holding of promissory notes in the next five years.

In simple terms, a promissory note is an investment that represents a legally binding contract between a lender and a borrower. By signing a note, the borrower agrees to repay a sum to the lender within a specific period of time. Failure to make payments results in a default. You can think of a promissory note as a legal obligation between your IRA and a borrower.

Beyond their ability to offer portfolio diversification, promissory notes also may appeal to investors who are seeking the potential of reliable cash flow. Rather than relying on the fluctuating returns generated by the stock market, notes typically come with a predetermined payment amount and interest rate.

Here are 4 types of promissory notes that can be held in a PENSCO self-directed IRA:

1. Notes Secured by Real Property: Secured notes, such as mortgage notes and trust deeds, are promissory notes that are backed by the borrower's collateral—in this case, real property. In the event of default, the lender is entitled to the underlying collateral. Repayment terms are outlined within the promissory note. Examples of repayment options include fixed principal and interest payments amortized over a specified time period; a balloon payment of interest and principal; or interest-only payments for a set period with a final balloon principal payment.

2. Notes Secured by Non-Real Estate: These are secured promissory notes where the borrower pledges non-real estate items to the lender. Some of the pledged collateral PENSCO has seen includes factory or farm equipment, company stocks, or even manufactured homes. Again, the repayment of the note is determined by the terms within the promissory note.

3. Unsecured Notes: Unsecured notes are promissory notes where the borrower does not pledge any collateral to the lender. The loan is made to the borrower based purely on the merit of the borrower’s ability to repay. This results in a riskier investment, and lenders typically require a higher interest rate to compensate for higher required risk. (Please note that PENSCO does not custody unsecured notes with a repayment term longer than 10 years.)

4. Note Participation Agreements: Note participation agreements are structured differently than the three types of notes listed above. Their structure can vary widely as can their type of financing—which can be debt or equity. As a result of their broad range, it is best to seek information from a professional related to the underlying asset for further information.

In one scenario of debt-based participation agreements, a lead lender may originate a loan with a borrower and take responsibility for servicing the loan and dealing directly with the borrower. Multiple lenders, such as your IRA, can then sign a separate contract, called a participation agreement, to purchase an interest in the loan. However, the lead lender may be the only party with a direct contractual relationship with the borrower, and participants are not considered "creditors" of the borrower under bankruptcy law.[1] As a participant, your IRA should ensure the participation agreement clearly outlines your rights as well as the responsibilities of the lead lender, such as notifying participants as to whether the loan is good standing.

Investing in promissory notes does not come without risk. Results of a survey conducted by the North American Securities Administrators Association found that promissory notes are the most frequently identified source of investor complaints or investigations.

As a self-directed investor, you are responsible for evaluating the merits and suitability of all investments you are considering as well as investigating the individuals who may be selling or recommending those investments—including promissory notes. Before investing in note using your IRA, be sure to conduct ample due diligence and familiarize yourself with the rules and regulations of owning a promissory note in your self-directed IRA.

To learn more about owning notes in your self-directed IRA, including the need to avoid prohibited transactions, please download our investor guide, "Investing in Promissory Notes With Your IRA".

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.

PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.


[1] "Loan Participations: Proceed with caution," Banking Exchange, 1/19/2017