Self-Direction and Real Estate Notes: Part 1
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Self-Directed retirement investors favor real estate over any other asset class.
It’s a familiar asset to homeowners, and it offers good opportunities to diversify your portfolio.
It can also offer strong return on investment (ROI). The latest Entrust report on real estate investment trends shows that clients realized an average 58% ROI in Florida, 23% in California, and 15% in Missouri.
However, real estate investing has disadvantages too. As the property owner, your IRA is responsible for all repairs and maintenance. You or your property manager must deal with tenant complaints and finding new tenants when someone moves out.
Investing in real estate notes offers many of the same advantages as investing in real estate, but without the disadvantages.
Let’s explore the fundamentals of notes and some of their advantages.
Definitions to Get You Started
A note, also known as a promissory note, is a promise to repay a specific sum of money, at a specific interest rate over a specific period of time.
A secured note is a loan that holds property owned by the borrower as collateral. In the event of non-payment, the note-holder can foreclose on the property.
Notes can also be unsecured, which we’ll cover in the next installment of this series.
When your IRA owns a secured note, the borrower makes payments directly to your IRA, which earns the interest on the note.
Home Ownership Vs. Note Ownership
Owning a rental property in your Self-Directed IRA means dealing with tenants.
There are many outstanding tenants who will care for your property as if it were their own, but there are also tenants who will fall short in that respect. Maintaining your property will cost more when you have less responsible tenants.
When you own a secured note, you deal only with the property owner.
Chances are, the owner will demonstrate significant interest in maintaining and improving the property. And, it is the owner—not you—who will be writing the checks to pay for improvements and maintenance. This translates to fewer expenses for your IRA to pay out over the years.
The property owner’s emotional investment in the property may motivate him or her to stay current on payments, which reduces the risk on your own investment.
Create an Income Stream
As with rental property, one of the advantages of owning notes is a steady income stream.
By definition, a note includes specific payments at specific intervals over a specific period of time. You can look forward to regular deposits into your Self-Directed IRA, where the income will grow tax-free (in a Roth IRA) or tax-deferred (in a Traditional IRA).
The income received from a note is truly passive. No need to worry about property taxes or property association fees, water or garbage bills.
Rely on Collateral and Benefit from Liquidity
If regular payments become irregular, the note gives you the right to foreclose on the underlying property. You are allowed to sell the property to recoup your investment.
Owning the note rather than the underlying property leaves you with a much more liquid investment. You can sell the note to another investor with relative ease (and speed), whereas offloading real estate takes considerable time, planning, and effort.