Holding a Mortgage Note in Your IRA or 401k

By • on August 29, 2010 • Filed under: Articles of Interest, How-Tos, Plan Participants, Plan Sponsors

A lot of clients have asked me whether they can hold the mortgage on their house or a business property inside of their IRA or 401k plan.  This is an interesting question, especially in light of the ultra low interest rate that the Fed is forcing upon us to help bail out the housing industry.  It would be great to pay myself a 6% interest rate and then deduct the interest expense on my Schedule A of my annual tax return.

Unfortunately, in many cases this cannot be done but there is a way to do it safely which I will explain at the end of this article.

First we have to look at the rules set by the IRS regarding prohibited transactions. I will try to explain what I have learned regarding disqualified person(s), prohibited transaction(s), and the mistakes you should avoid when utilizing non generic investments inside of your self-directed IRA or 401(k) plan.

Basically, the IRS’s viewpoint is that the investment should benefit the IRA and not the IRA’s owner.  Furthermore, any transaction needs to be an “arms-length” transaction. What do I mean by “arms-length”? Basically it means a transaction that two willing parties would enter into. For example, extending a 50 year mortgage at a ½ of 1% interest rate to your IRA in an environment when 30 year mortgages are at 5% would not be considered “arms-length”.

Before we look at investing into specialized investments let’s talk about who a “Disqualified Person” is. A “Disqualified Person” is an entity with whom your retirement plan cannot do a transaction with. These include the following as defined by the IRS:

  1. A fiduciary of the plan.
  2. A person providing services to the plan.
  3. An employer, any of whose employees are covered by the plan.
  4. An employee organization, any of whose members are covered by the plan.
  5. Any direct or indirect owner of 50% or more of any of the following.
    1. The combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4).
    2. The capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4).
    3. The beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4).
  6. A member of the family of any individual described in (1), (2), (3), or (5). (A member of a family is the spouse, ancestor, lineal descendant, or any spouse of a lineal descendant.)
  7. A corporation, partnership, trust, or estate of which (or in which) any direct or indirect owner described in (1) through (5) holds 50% or more of any of the following.
    1. The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation.
    2. The capital interest or profits interest of a partnership.
    3. The beneficial interest of a trust or estate.
  8. An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in (3), (4), (5), or (7).
  9. A 10% or more (in capital or profits) partner or joint venturer of a person described in (3), (4), (5), or (7).
  10. Any disqualified person, as described in (1) through (9) above, who is a disqualified person with respect to any plan to which a section 501(c)(22) trust is permitted to make payments under section 4223 of ERISA.

Next, we need to look at “Prohibited Transaction”. These are transactions that cannot be done between a “Disqualified Person” and the retirement plan. Prohibited transactions generally include the following transactions.

  1. A transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person.
  2. Any act of a fiduciary by which he or she deals with plan income or assets in his or her own interest.
  3. The receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets.
  4. Any of the following acts between the plan and a disqualified person.
    1. Selling, exchanging, or leasing property.
    2. Lending money or extending credit.
    3. Furnishing goods, services, or facilities.

These are the common issues that Clients are looking to engage their retirement accounts which are considered prohibited transactions.

  • Taking Loans from a self-directed IRA (loans from 401k plans are fine)
  • Using an IRA as collateral for a loan
  • Transferring personal assets to your IRA
  • Personally using property invested within your IRA
  • Purchasing property from a Spouse, Child, etc.
  • Owning a mortgage on a disqualified person’s residence

Penalties

Generally the IRS can disallow the tax exempt status of the IRA and then make the entire account taxable to you as of the first of the year in which the prohibited transaction occurred.  This mean full taxation and penalties if you are under age 59 ½.

If you are considering making any investment that seems to cross the line, you should consult with a qualified tax advisor or CPA.  To become more familiar with the rules you can read IRS publication 560 located here: http://www.irs.gov/pub/irs-pdf/p560.pdf, Chapter 4, Prohibited Transactions.

So how can I get a decent return in my IRA or my 401k account and not be subject to the “Prohibited Transaction” rules. One way is to own the mortgage on your best friend’s house and have your best friend hold the mortgage on your home.

Comments

  1. I am so happy to read this. This is the kind of info that needs to be given and not the random misinformation that is at the other blogs. Appreciate your sharing this beneficial content.

  2. Rose Robison says:

    One of my best friends has a 401K that is earning little or nothing. I have need of refinancing my mortgage/home. I can pay between 5.5 and 6% interest and am doing so now. What we would like to do is have him buy my mortgage or take over the mortgage within his 401K account. I would then pay him what I pay my current mortgage company. I would assign him as the beneficiary on a life insurance policy equal to the amount I would owe him so he would be protected in case something happened to me. Meanwhile, I would be paying essentially the SAME as I do now…but he would benefit from the increased return on his money.
    Is this possible and if so, what would we need to do to make it happen?

    • jpodgorny says:

      This could be possible. However, you will need a very flexible 401k plan that allows outside investments to be held. Many of the generic plans like Principal, Fidelity, and so on will not allow this. Another option is to see if you have an in service withdrawal provision within your 401k. If so, then transfer the funds to a self-directed IRA that allows for outside investments, and have the custodian of that IRA hold the mortgage note.

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