What is a promissory note?

Created July 21, 2021 20:44

A promissory note is a legal document by one party to issue and pay another a sum of money, similar to a loan, for which the second party follows the note's instructions for repayment.

How Does the Checkbook IRA Structure work?

This is a common way for two parties to transact in a loan agreement privately without having to rely on a bank's lending restrictions. You can "become your own lender" to lend money, write mortgages, finance a business, or even fund a promising student's loan without dealing with a bank.

There are many varieties of these private debt agreements, often collateralized by real property, like a mortgage or deed of trust. Others are issued to businesses or to finance specific projects.

Many firms specialize in packing and offering debt products in a fund structure. Taking the sourcing, underwriting, and servicing out of your hands. This is a popular passive income strategy that can fit well within a retirement portfolio.

Popular Promissory Note Uses

Mortgages and real estate purchases (seller financing)
Short-term business financing
Student loans

What should I keep in mind when exploring a note?

You can loan money to non-disqualified persons, but not disqualified persons
Be careful of UBIT taxes if your IRA is participating in the profits of the loan.
The interest rate you charge must be commercially reasonable in an IRA. You also must not give extreme discounts or violate the exclusive benefits rule (by excessively exceeding the current market rate). This means no excessive rates or heavy loan discounts.
You can write an unsecured loan, which can be risky, as your only path to repayment is the courts and hopes of seizing assets. Normally, someone would secure it to real estate or another asset, and only do unsecured lending with parties they have an extreme level of trust and long-standing business relationship. Be clear about your IRA's positions within the debt structure of the borrower & whether there are any existing liens on the collateralized assets. Ensure that you have a clear path to pursue the borrower in case of a default.
You will want to tie the interest rate to the Index of Applicable Rates. Pick a rate that matches your timeframe. The applicable federal rate (AFR) is the minimum interest rate that the Internal Revenue Service (IRS) allows for private loans. Each month the IRS publishes a set of interest rates that the agency considers the minimum market rate for loans.
A lender instruction letter lays out terms before the other party can have funds released. It is often a best practice to enlist the services of a private lending attorney or broker, helping you execute the transaction to fully account for any particular state & county laws that may be applicable.
You should store and title all documents in the name of your IRA LLC/Trust in a safe place. If you need to, you can pay for a safety deposit box from your IRA bank account.

Can I set up an agreement for the possibility of interest-only payments?

You can as long as you again follow the Index of Applicable Rates. Assuming the promissory note is secured by real property, you have several repayment options including fixed principal and interest payments amortized over a specified time period; a balloon payment of interest and principal; or interest-only payments for a set period with a final balloon principal payment.