Promissory Note Investing: What it is and Real-Life Examples
While the options for investments in a self-directed retirement account are nearly endless, there is one asset class that some Equity Trust clients prefer because it can be passive and offers an added diversification to their overall investment strategy. Promissory notes, or private debt investing, can offer investors a low-maintenance way to grow their wealth.
Here we answer the question, “How do promissory notes work?” and provide examples of how investors use them to grow their retirement accounts.
Promissory note: defined
A promissory note is simply a financial document containing a written promise to repay a specified sum borrowed, as well as the terms of repayment, any collateral, etc.
The term promissory note is a catch-all that could refer to a variety of different types of notes, including:
Mortgage notes/deeds of trust
Private loans
Corporate debt
There are two basic types of notes:
Performing: The borrower is making regular payments on the loan
Non-performing: The borrower is not making payments on the loan
Self-directed note investing in action: real estate note
An IRA can hold a promissory note. The webinar provides a look at a real estate note investment Equity Trust client Joe in Minnesota completed with his retirement account. Here’s a summary:
Joe’s promissory note investment
Joe’s Roth IRA purchased a performing note on a single family residence in the form of a double-wide trailer in Florida. The market value of the property was $42,000.
There was a little over $31,000 left on the note when his IRA purchased it. The terms of the note were as follows:
10-percent interest
Monthly payments of $318
203 monthly payments (just over 16 years) remained
Joe’s Roth IRA purchased the note at a discount for $24,425.
Due to the unique rules associated with investments inside of self-directed accounts, the note payments must be made a certain way. The borrower makes the checks payable to Joe’s Roth IRA, and the payments are sent to Equity Trust to be deposited into Joe’s account.
In accordance with the amortization schedule, if all payments are completed, Joe’s Roth IRA will receive a total of $64,554. Joe’s Roth IRA would potentially see a profit of over $40,000, which amounts to a 14.19-percent yield.
Due to the tax advantages of a Roth IRA, if all rules are followed, it’s possible the profits will return to Joe’s account tax-free.
Learn more about promissory notes: free 15-minute guide
Am I restricted to only purchasing residential property with my IRA?
You are not limited to residential real estate. Your IRA can hold various investment properties such as commercial buildings, vacant land, condominiums, mobile homes and apartment buildings, in addition to residential property.
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What are prohibited transactions in an IRA?
According to the IRS, a prohibited transaction is improper use of an IRA account or annuity by the IRA owner, his or her beneficiary or any disqualified person. Examples of prohibited transactions with an IRA are borrowing money from it, selling property to it, using it as security for a loan and buying property for personal use (present or future) with IRA funds.
Case studies are provided for illustrative purposes only. Past performance is not indicative of future results. Investing involves risk including possible loss of principal. Information included in the above case study was provided by the investor and included with permission. Equity Trust Company does not independently verify all information provided by third parties.
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