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Start Investing with your Solo 401k: Promissory Notes

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In part 4 of our 7 Part Series,”Start Investing with your Solo 401k” we’ll cover Promissory Notes.

What is a promissory note?

A Solo 401k promissory note is simply a legal document outlining the terms of a private loan between a lender and a borrower. Information in a promissory note may vary. Most Solo 401k promissory notes include information such as the principal amount of the loan, interest rate, payment schedule, and final payment date. The note also lists lender and borrower names/titles/entities in the note terms. Promissory notes are often similar to a personal loan. However,  notable differences are that a personal loan may requires equal payment installments and is generally more detailed than a promissory loan. A promissory note also includes method of recourse should the borrower default on payments.

There are generally two types of promissory notes:

  1. Secured: Secured promissory notes are backed by real estate or other tangible assets. Normally the promissory note will outline the method of recourse if the borrower defaults on payments. Often this may include allowing the lender to take control of the asset backing the promissory note. In the case of a note secured by real property, a default could result in a foreclosure by the lender (Solo 401k trust).
  2. Unsecured: In the event of a default in payment, or if the note is not paid completely, there is no collateral for the lender to take possession. This makes unsecured notes more risky for the lender. However, sometimes the lender charges a higher interest rate to offset their risk.

Unsecured promissory notes are sometimes more common with the promissory note, whereas loans and mortgage notes most often are secured. Therefore a mortgage note is really a type of promissory note.

Disqualified persons

As with all Solo 401k investing, there are a handful of people that your Solo 401k cannot write a promissory note for or with.  Generally speaking, disqualified persons include grandparents, parents, spouse, children, grandchildren. Interestingly enough, siblings are not on the disqualified person list. It is acceptable to do deals with siblings, aunts, uncles, cousins, etc. However, if you’re thinking in terms of a family tree, anyone above or below you and your spouse are disqualified, but directly to either side is allowed (source).

Lending money to a disqualified person is what the IRS refers to as a prohibited transaction and the tax consequences are severe. The penalty for a prohibited transaction starts at 15% of the transaction. Unfortunately, the penalty can go all the way to 115% in certain scenarios. It’s better to be safe than sorry. Always run your Solo 401k promissory note investments by a capable CPA to ensure every part of the investment is compliant with IRS rules and regulations.

How do I get started?

There are a few different ways to create a promissory note for the Solo 401k:

  1. Find a friend who needs a loan. Decide if the note will be secured or unsecured. Set the loan repayment and interest terms. Have your attorney draw up the note paperwork for the Solo 401k as the lender.
  2. Buy a promissory note from a bank (smaller banks are worth considering as they may have a closer relationship with the borrower and may have better quality notes)
  3. Sign up on a website that facilitates promissory notes by connecting lenders and borrowers. Some of those sites include:
    Note Buyers of America
    Main Street Capital Partners
    Nationwide Secured Capital
    Reinvestment Fund

Note: The above list does not constitute an endorsement by Nabers Group. Always do your due diligence when opening an account or transacting with any facilitators.

Once you’ve found the note your Solo 401k will invest in, check out the following tips to ensure you’re compliantly buying the note with your Solo 401k

  • Always use your Solo 401k trust name and trust tax ID number
  • Buy the note using only Solo 401k trust funds
  • You will sign the Solo 401k promissory note as trustee
  • Never use personal and retirement funds when investing.
  • Payments from the note should go straight into your Solo 401k bank/brokerage account, never to your personal or business bank account.

Stay tuned for yet another tool you can use to invest with your Solo 401k!

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