Diversifying your self-directed IRA (SDIRA) can help you hedge against market volatility. And one great way to do so? Promissory notes.

Promissory notes typically offer steady and predictable returns that aren’t based on market performance. Further, these notes can provide higher yields than traditional investments and stronger control over the lending terms.

However, like all alternative assets, promissory notes have unique rules, risks, and responsibilities. Understanding how promissory notes work in an SDIRA can help you determine if adding them to your portfolio is the right move for your retirement goals.

How Promissory Notes Work in a Self-Directed IRA

A promissory note is a legally binding document outlining the terms and conditions of a loan agreement between the borrower and the lender. When you invest in a promissory note, you can use your SDIRA to purchase an existing note or loan or use funds to issue loans to an individual or entity.

Once your IRA acquires or extends the promissory note, the borrower makes regular payments, including interest. Those payments are deposited back into your account, growing tax-deferred or tax-free, depending on the type of IRA you have — Traditional or Roth.

You can hold different types of promissory notes in your SDIRA, including

• Personal loans
• Mortgage loans
• Business loans
• Peer-to-peer loans
• Real estate or, “hard money” loans
• Treasury notes

Performing vs Non-performing promissory notes

Investors have a choice between performing and non-performing promissory notes, and each type has benefits and drawbacks.

• Performing notes are those in good standing, meaning the borrower is making payments. These are generally reliable and offer a steady income stream throughout the payment period.
• Non-performing notes are those that have fallen delinquent or are in default status. These are often sold at a discount and offer a potentially higher rate of return. However, they often generally have a higher risk of non-payment.

Secured vs Unsecured promissory notes

Promissory notes can be secured or unsecured.

• Secured notes often present lower overall risk—if the borrower fails to meet their repayment obligations, you can take possession of the collateral specified in the lending agreement, such as a vehicle, home, or piece of machinery or equipment.

• Unsecured notescan be riskier arrangements, but they often have higher interest rates and, therefore, the potential to be more lucrative. However, if the borrower fails to repay the loan, you have little recourse to recoup your losses.

Advantages of Investing in Promissory Notes

In addition to tax-free or tax-deferred growth, promissory notes provide a wealth of benefits that can make them worthy of a spot in your retirement portfolio.

Higher returns

Promissory notes often have higher rates of return than other assets, especially stocks, bonds, and mutual funds. This is particularly true when a borrower’s creditworthiness and lending conditions drive interest rates higher than typical.

Predictable returns

Unlike many other market-dependent investments, promissory notes typically have a fixed interest rate. As long as the lender meets its repayment obligations, you can expect the full repayment plus the interest as stated in the lending agreement.

Portfolio diversification

Adding promissory notes to your retirement portfolio allows for diversification. This can help hedge against market volatility, providing stability to your portfolio.

Control over investment terms

As the IRA holder, you can choose the borrower and set loan terms, such as interest rates, repayment periods, and collateral requirements. This can be extremely beneficial when evaluating the risk associated with specific borrowers or lending arrangements.

Risks and Challenges of Promissory Note Investments

While holding promissory notes in your IRA has plenty of benefits, there are potential risks worth considering.

Default risks

Your IRA may suffer if the borrowers fail to repay the loan for any reason. If the note is secured, you can generally take possession of the secured item, though that can lead to lengthy legal battles. However, your account can suffer a significant loss if the promissory note is unsecured.

Lack of liquidity

Unlike stocks or bonds, which you can quickly sell on the open market, promissory notes are not as liquid. You generally need to wait out the loan terms. That may not be problematic for a short-term loan, but your options may be limited if you have a long-term loan, like a mortgage.

Due diligence required

Like any SDIRA investment, you must complete due diligence before entering into a promissory agreement. This generally includes evaluating the borrower’s creditworthiness, available collateral, and, when applicable, their business plan.

Tax Implications and IRS Rules

Like other assets, investing in promissory notes comes with certain tax implications and rules. Failure to understand either can lead to penalties, losses, and potentially the loss of qualified retirement fund status.

Tax-advantages

Earnings from a promissory note are tax-advantaged. If you have a Traditional IRA, qualified withdrawals are subject to income tax. If you have a Roth IRA, taxes do not apply, as contributions are made with after-tax dollars.

Prohibited Transactions

SDIRAs open up a range of investment opportunities, but the IRS prohibits certain types of activity, with a central focus on “self-dealing,” or investments that will benefit you directly. The same is true for “disqualified persons,” which includes your spouse, direct relatives (parents, grandparents, children, etc.) and their spouses and service providers, like your custodian or a financial advisor.

For that reason, your SDIRA cannot hold a promissory note issued to you or a disqualified person or an entity in which you or a disqualified person are a stakeholder.

Fair Market Value Report

Each year, your custodian is required to report your SDIRA’s Fair Market Value (FMV), though you’re responsible for ensuring the accuracy of that report. The FMV for promissory notes is typically equal to the outstanding loan balance and any interest earned to date.

Unrelated Business Income Tax (UBIT)

Generally, promissory notes held in an SDIRA don’t trigger UBIT. However, there are some circumstances under which the account may be subject to UBIT. For instance, if the promissory note eventually converts to equity in a business, then you may owe taxes on the value of that equity.

FAQs

Are promissory notes a safe investment?

A promissory note can often be a low-risk investment that yields steady income for your SDIRA.  If safety is a primary consideration, a performing note is likely better than a non-performing note.

Performing notes are those in good standing, meaning the borrower is meeting their repayment obligations. Non-performing notes are not in good standing due to default or delinquency.

You can reduce the overall risk of a promissory note by performing due diligence, and analyzing the borrower’s creditworthiness, lending conditions and, if applicable, business plans.

What is the difference between secured and unsecured promissory notes?

Secured promissory notes require collateral, such as a vehicle, home, or business equipment that the borrower owns. If the borrower fails to meet their repayment obligations, the lender can take possession of the collateral.

Unsecured promissory notes are not secured by collateral and rely solely on the borrower’s creditworthiness. They often have higher interest rates than secured notes, but the lender takes on more risk in the absence of collateral.

How do I ensure my promissory note investment complies with IRS rules?

To keep your promissory note investment compliant, always work with an experienced custodian, avoid prohibited transactions, and file any required paperwork yearly.