Using Your Self-Directed IRA to Buy Discounted Notes

Estimated reading time: 2 minutes

Discounted notes can be a great source of income inside a self-directed IRA.  However, it takes a lot of work and specialized knowledge to do it right.  In this article we use a real-life Entrust client situation to break down the process to explain how it all works.

The Situation

Three years ago, Terry, a real estate agent and Entrust client, completed the sale of a house and a small retail space to a client.  The house was financed for $100,000, and the commercial building for $115,000.  A local bank issued both mortgages.

A year later, the owner started having trouble making payments, first on the commercial building, then on both properties.  Just before both properties were about to go into foreclosure, an investor stepped in and purchased the obligations from the bank.  The private financing terms were at 15% for 30 years on both notes.

Two years later, the borrower had problems again, and the investor assigned the two loans to a collection agency.  The owner made payments, but too slowly for the investor, who wanted to sell out.  Terry knew the principals in the transaction and she knew the values of the properties in the event of foreclosure.

The Purchase

Terry’s SEP IRA had $180,000 in unvested funds.  She decided to make an offer to the investor: $50,000 for the $100,000 note on the house.  The owner accepted.  For the commercial property, the investor decided he wanted to retain some ownership, but agreed to sell Terry a 20% interest in the $115,000 note.  At $12,500, that was a bit more than Terry wanted to pay, but with a remaining $22,968 balance (20%), she believed it was still a good deal.

The Outcome

Six months later, the owner stopped making payments on the $115,000 note.  Terry and her fellow investor decided to foreclose.  The property owner gave them a deed in lieu of foreclosure.  Terry found a buyer for the property for an immediate cash sale of $110,000. This represented a loss of $4,844 from the face value of the note, but for Terry, it was a net gain of $95,500.  And, because her SEP-IRA owned the note, she paid no immediate tax on the gain.

And what about the $100,000 note?  The owner is making slow, but regular payments to Terry’s SEP-IRA.  Those payments are also tax-deferred.  Today, her SEP-IRA has grown by $38,000 from this transaction alone.

Buying notes at a discount using a tax-advantaged self-directed IRA is becoming more popular, in particular with real estate professionals, who realize this is a viable way to deal with problem loans or properties and generate income for their retirement. For more information about self-directed IRAs and your investment options, visit our Learning Center.