Real estate can be a great investment. However, owning and managing properties can also be stressful and time-consuming. Managing a rental property means staying on top of maintenance costs and dealing with possible rental vacancies. It also means handling tenant complaints and needs.

What if there were a way to invest in real estate while bypassing all the stressful aspects of the investment?

You can set up a Self-Directed IRA (SDIRA) and use it to buy mortgage notes. This is an easy way to invest in real estate on a tax-free or tax-deferred basis.

Here’s how it works.

Model house, paperwork and cash money on a desktop: real estate, home loan and investments concept

A mortgage note, or deed of trust, allows an investor to lend money to a borrower using real estate as collateral. The deed of trust, or trust deed, legally secures the loan. The specific terms of the loan are set out in an accompanying promissory note. You can use funds from your SDIRA account to buy an existing note.

Your SDSDIRA will then receive monthly interest income based on the amount you paid for the note and term purchased. You can buy all or a portion of a note.

Doing Your Due Diligence

Before you invest in real estate, you should always do due diligence. This is just as important when you’re using your SDIRA to buy notes.

It’s a good idea to work with an experienced note investor/broker who specializes in mortgage notes. Be sure to carefully vet the investor/broker before you get started. Ask for references and take the time to check them out.

It’s also a good idea to ask if a Broker’s Price Opinion (BPO) has been recently prepared. You’ll want to know the property’s value to determine how much equity the borrower has in the property.

free quote and mortgage note analysis

IRS Regulations

The IRS imposes some restrictions on how you can use a SDIRA, so you’ll have to make sure that the note is compliant.

You can’t use your SDIRA to buy notes from yourself, for example. You also can’t use it to buy notes from family members, or from anyone who is named as a beneficiary of the SDIRA.

The basic rule is that, since your SDIRA will be buying the note, only the SDIRA can benefit from it.

Making a Wise Investment

Some investments have more risk than others. When you’re investing in real estate, it’s a good idea to stick to the tried and true.

In practical terms, that means that you should look for properties where there is a history of the owner making payments in a timely manner. This is another case in which you’ll have to do your due diligence.

Check to see that there’s a solid record of payments being made in full and on schedule. In most cases, that’s a reliable indicator that the borrower will continue to keep up with the loan.

What Happens If There’s a Default

Nothing in this life is absolutely certain. No matter how careful you are, there is always a slim chance that the borrower will default on their loan payments.

However, you can protect yourself and your finances, even in the case of a default.

If the borrower cannot keep up with the loan payments you have many alternatives. The first and easiest is to see if the terms of the note can be changed to work for both you and the borrower.  The borrower may be able to increase his payments for a short period to make up the amount owed. Or he could make payments that are somewhat less but over a longer period.  You could also sell the note to one of the many  investors who buy non-performing notes. You might be able to sell it for the remaining amount you are owed.  Last but not least you can foreclose and either rent or sell the property. If the note has been well underwritten, local rents will be higher than the interest payments and the property could be rented. You can also sell it outright. You are “the bank” and you can work with the borrower to make the situation good for both of you.  

Final Thoughts

Investing in real estate can be a great way to earn extra income towards your retirement or other long-term goals. It’s also a great way to help a new homeowner get started on the property ladder.

Done with care, using your SDIRA to buy notes is a safe, wise way to invest in real estate while avoiding the headaches that often accompany property management.