Private Lending IRAs and Checkbook Control
Private lending is the ideal investment for an IRA…and less than ideal outside of an IRA.
Understanding why that’s the case – and why a checkbook control IRA is crucial to maximizing private lending investment returns – requires an understanding of tax and investment concepts. In this post we’ll cover the income tax treatment of private lending inside and outside of retirement accounts (IRAs, Solo 401k plans) and why a Self-Directed IRA with Checkbook Control is the IRA you need for private lending. Additionally, if you’re a real estate investor, you’ll learn how to get funding for deals by leveraging the IRAs of private lenders.
Key tax concepts to be aware when considering which investments are best for an SDIRA are: Unrelated Business Income Tax (UBIT, UBTI, UDFI) and ordinary income vs. long term-capital gains taxation.
What is Private Lending? Safety and High ROI (8%-20%)
Private lending is a broad term that encompasses all forms of for-profit lending by individuals and entities that are not licensed lending institutions. Private lending gives lenders very high returns for providing loans when banks are unable to meet a borrower’s needs. Your loan can be collateralized by all forms of real estate and personal property.
Hard money lending, in which your IRA’s loan is secured by real estate, is a great example of private lending that offers a high level of security and high returns. Banks and other traditional lenders that have regulatory constraints are unable to meet the needs of many real estate investors, which creates the opportunity for private lenders to profit by filling this void.
Your private lending IRA can win deals when competing with most other hard money lenders, who pool the funds of many investors to originate loans. Those hard money lenders need to provide a rate of returns to their investors, cover all the expenses of their operation, and earn a profit for themselves – requiring them to demand excessive interest rates from borrowers that your IRA can undercut.
How Are Non-IRA Investments Taxed? Ordinary Income vs. Long-Term Capital Gains
Income that you earn can be taxed as either (a) ordinary income or (b) capital gains. Ordinary income is taxed at the highest applicable tax rate at both the federal and state level, while long-term capital gains are taxed at much lower rates.
Ordinary income tax rates range between 10% – 39.6% at the federal level (prior to 2017 tax reform under the Tax Cuts and Jobs Act). Long-term capital gains are taxed at rates between 0% – 20%.
Private Lending Taxation and Why It Belongs in Your Retirement Account
Private lending presents very attractive returns in the form of interest income – a type of “ordinary income.” Therefore, to escape the large tax bite, private lending should be done within tax-advantaged accounts such as Traditional IRAs, Roth IRAs, Solo 401(k)s, or your regular 401k (if it were to be allowed by your plan).
Tax-Free Checkbook Control Private Lending IRAs
Maximizing investment returns requires being constantly invested and continuously deploying your capital, while minimizing transaction costs. With a checkbook control private lending IRA, you can directly manage your retirement funds cost-effectively and without administrative red tape. With checkbook control, IRA funds can be efficiently deployed by eliminating custodian processing and fees for your SDIRA private lending investments.
Private Lending IRA Taxation: Traditional vs. Roth or Tax-Deferral vs. Tax-Free
With a Traditional IRA, you get a current tax deduction for the amount contributed to the IRA and the IRA invests and earns interest on those funds tax-free, but taxes will be due when money is withdrawn from the IRA. The technical term for this is “tax-deferral,” as the tax is only deferred and will ultimately be due. However, you benefit from many years of tax-free compounding of returns, which will enable your funds to grow to many multiples of what they would otherwise be.
With a Private Lending Roth IRA, there’s no current tax deduction for contributions, but subsequent interest income is completely tax free. The interest income inside of a Self-Directed Roth IRA will never be taxed.
While some Self-Directed IRA investment income can be taxable as UBTI or UDFI, private lending is tax-free to retirement accounts and does not generate UBTI. As a passive investment that generates high returns, private lending belongs in your SDIRA.
If you’re a real estate investor looking for capital, you can find trillions of dollars in untapped liquidity within IRAs that can be leveraged for lender and investor benefit. Educate your private lenders about the advantages of providing secured private loans with their IRA to create a win-win for all.