You can use you individual retirement account to buy assets less familiar than stock shares and mutual funds. If you want to invest in real estate assets, you can open a self-directed IRA with a real estate custodian. Your IRA can then purchase real property and mortgage notes, which are subject to strict Internal Revenue Service rules that prohibit self-dealing.
A mortgage note is a promissory note that property owners sign when taking out a mortgage. It is a promise to pay the mortgage, under penalty of foreclosure should the borrower default. Often, mortgage lenders sell mortgage notes to security bundlers, such as Fannie Mae and Freddie Mac, that pool them with other notes and sell mortgage-backed securities to investors. However, private investors, including your IRA, can buy individual mortgage notes and receive monthly payments of principal and interest.
Mortgage Notes in IRAs
Your self-directed IRA can buy mortgage notes from several sources. You can approach a mortgage note broker or an online note marketplace. You can even make a deal with your neighbor to buy her note. The IRS does not allow your IRA to buy notes from yourself, family members or IRA beneficiaries. The IRA owns the note, so only the IRA can benefit from it. For example, you cannot use the note as collateral for a loan. You also cannot contribute a mortgage note to your IRA -- the IRA must buy the note.
Some mortgage notes are more attractive than others. Notes with higher interest rates provide greater income but might also have higher default risk. You might want to buy mortgages that have substantial down payments and that are “seasoned” -- the notes have a proven history of borrower payments that are on time and in the full amount. You also might want to shy away from mortgage notes that feature teaser rates or balloon payments due to fear of default once the new terms kick in. If the mortgage borrower uses an S corporation or limited liability company to buy the property, insist that the mortgage note contains a personal guarantee from the borrower. You normally obtain a lien on the property when you buy a mortgage note. This allows your IRA to seize the property in case of default.
If the borrower defaults on a mortgage, your IRA can obtain the underlying property through foreclosure. This can be costly and time-consuming, but ultimately the IRA should gain title to the property. Because of this possibility, your IRA should allow ownership of real estate, not just mortgage notes. Once the IRA receives the title, your custodian can have the property auctioned. Under the rule of “full credit bidding,” your IRA custodian can prevent the property from selling for less than the mortgage balance by entering a bid for that amount. If that is the high bid, the property will remain in the IRA.
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