For those who are looking for alternatives to the traditional stock and bond investments held in most IRA accounts, private debt can be a good option. This can be an option for investors who are looking to diversify their retirement plan holdings and who are knowledgeable about purchasing debt.
Types of private debt
Common examples of private debt instruments we often see in retirement portfolios include:
- Secured promissory notes
- Corporate debt offerings
- Convertible notes
- Mortgage notes and trust deeds
- Timber deeds
- Crowdfunding debt (consumer debt, real estate, alternative finance)
Promissory notes involve one party, the debtor, making a promise to pay the lender interest and principal over a specified time frame. The IRA account holder is the lender in this case and the interest payments are received within the IRA account on a tax-deferred basis.
Private corporate debt are instruments used by large corporations to borrow money. Through your IRA you can invest in private corporate debt, including convertible notes that can be converted into equity in the company. Interest is paid into the IRA and remains tax-deferred until funds are withdrawn.
Mortgage notes and trust deeds allow the self-directed IRA account holder to loan money secured by the mortgage or trust deed. The period payments of interest come into the IRA account and remain tax-deferred until withdrawn at a later date. Since these are financial instruments, the holder can resell them under the umbrella of the IRA and use the proceeds to make other investments inside the IRA account.
Timber deeds are similar to mortgage notes and trust deeds in many ways. When held in an IRA, investors in timber deeds can avoid the tax on dividends and capital gains resulting from land appreciation or the sale of cutting rights until a later date when money is withdrawn from the IRA.
Advantages of private debt
Private debt can offer a number of advantages for investors:
- It is largely uncorrelated to stocks, bonds and most other traditional investments.
- Unlike publicly traded bonds, the interest rate and return of principal is governed by the terms of loan agreement. The direction of interest rates does impact your return on investment. Interest payments will be made in line with the terms of the loan as will the repayment of principal.
- Private debt can entail its own set of risks and anyone contemplating investing or lending directly should perform proper due diligence before committing capital. That said, the added risk can help increase returns in the form of higher interest rates or perhaps a favorable conversion ratio into the firm’s equity on a convertible note.
Why use private debt in a self-directed IRA?
Private debt is a unique opportunity for investors to capitalize on debt that’s incurred by individuals, companies and corporations of varying sizes. What makes this opportunity so distinctive is that you have the ability to purchase the debt and collect the interest — all on a tax-advantaged basis if done within a self-directed IRA.
- The interest payments received will retain their tax-deferred status inside of the IRA account, allowing you to defer taxes on them until withdrawals commence in the future.
- These debt instruments will be at least somewhat illiquid, and this can mesh well into the long-term structure of a self-directed IRA.
Rules and restrictions
As with any type of investment made within an IRA structure, it’s important to avoid prohibited transactions. In the case of private debt, lending money to a disqualified person is a key rule to be aware of.
A disqualified person is generally defined as the account holder, their spouse, children and lineal descendants, account trustees, fiduciaries, investment managers/advisors and any entity in which the account holder holds at least a 50% ownership stake. For more on this check out Internal Revenue Code Section 4975.
As an IRA custodian, STRATA Trust does not process unsecured loans to individuals or loans secured by a vehicle title, foreign real estate or by personal property. Since the IRA custodian gets to determine the types of assets it will or won’t hold (including security collateral), you’ll want to discuss with your custodian before you begin an investment transaction.
An additional consideration is unrelated debt-financed income (UDFI) and/or unrelated business taxable income (UBTI). Either can arise in relation to a private debt investment inside an IRA and create income tax that the IRA must pay. To learn more, refer to IRS Publication 598.
When considering the use of private debt as an investment in your self-directed IRA, it is important to consult with a tax advisor and a financial advisor knowledgeable in these strategies.
An opportunity worth considering
Even with the rules and restrictions surrounding private debt transactions in a retirement account, private debt may provide an opportunity to diversify your retirement holdings with investments that offer the potential for solid returns. It’s not for every investor, but it can offer diversification and compelling returns for savvy investors that are risk tolerant.
STRATA Trust Company is a self-directed IRA custodian that specializes in holding alternative assets within IRAs.
I write about IRAs, alternative investments and retirement planning.
With over 30 years experience in the self-directed IRA and alternative investment space, I am passionate about educating investors on the many options for diversifying their retirement portfolio with alternative assets like real estate, private equity and more. I am President of STRATA Trust Company, and a board member of Retirement Industry Trust Association. In addition to writing for Forbes, my articles on self-directed retirement investing have also appeared in REALTOR®, Texas REALTOR® and INVEST magazines.