Choose an account type

Easy Tax-Advantaged Note Investing

October 7, 2019

When it comes to investing, everyone looks for an angle – a way to “beat the market” and get sizable returns with little risk.

Unfortunately, with publically traded stocks and bonds, there is never an opportunity to make a purchase at a discount, below market, or at wholesale.  Of the almost $7 trillion in IRAs, almost all investors chose to invest in lockstep based on advice from paid advisors, money managers, or through personal research.  The fact that you are interested in notes, purchased at a discount, provides a great deal of separation from the masses.

Buying notes in a tax-deferred account such as a self-directed IRA, or in special circumstances, within a 401(k), will likely accelerate your returns in ways that funds outside retirement accounts cannot.

Many are drawn to the attractiveness of the rather passive nature of note investments as contrasted with real estate investments such as rehabbing and rental management. However, unlike direct real estate purchases, tools for reducing taxes such as depreciation and capital gain tax treatments are not available to the note buyer.  The bottom line is that a 10% return can easily be reduced to 7% or less once ordinary income taxes are applied to the gains.

Let’s look at this example: An IRA holder purchased a mortgage-backed note with a principal balance of $110,000 at a discounted amount of $75,000. The remainder of the note was amortized over 12 years at an 8% rate. Total interest collected over the life of the loan was just over $61,000. All those funds were received without taxation to the individual or their IRA. In addition, if it had been done in a Roth IRA, there would be no taxation upon eligible distribution to them or their beneficiaries. Assuming the investor was in a 28% tax bracket, if the note was purchased outside their IRA, the returns would have triggered federal taxes of over $17,000, and worse yet, those funds would be unavailable to reinvest.

IRAs provide a unique way to ensure that all the gains are available to reinvest without taxes, eliminating the need to jump through the hoops of 1031 exchanges and exhaustive tax strategies. Within a self-directed IRA, notes are one of the fastest growing investment categories. Originating new notes, buying existing discounted notes, or buying partial notes are all possible within an IRA. Many buyers partner together on notes, either as tenants in common or within an LLC or other syndication.

Notes held in IRAs are not limited to those backed by real estate securities. As pointed out in other articles on this site, mortgages from other properties may be substituted as collateral for a loan, but so can automobile titles, liquor licenses, boats and other personal property.   

In order to access your IRA funds for note investing, you must open an account with a self-directed IRA administrator. The process is generally no different than opening an online trading account from a brokerage house. Once the funds are transferred from the current administrator, you can self-direct to fund a purchase of notes. The IRA holder can nominate a loan servicer, including themselves, to monitor the payments, send payment reminders, and review with the administrator the proper allocation of principal and interest for each payment.

All the revenues from the notes flow into the IRA, thus shielding that income from taxes until distribution (again, Roth distributions may be tax free). You have the freedom to use the funds as you wish, as long as you stay within the rules. 

For those that believe that their odds of beating the market lay with understanding their investment and taking control – notes may be a good choice. Within a self-directed IRA, that choice will likely be even better.

Glen Mather, NuView CEO