Hard Money Lending as a business?

Question

Hi, I'm fairly new to RE investing. After reading and learning so much on BP, I'm considering starting out with passive RE investments (HML and mortgage notes). I read the threads on becoming a HML. I'm thinking of setting up a "business" to be eligible to transfer my traditional IRA into a Self Directed 401(k). Then I want to be able to do annual contributions to the SD 401(k) from the proceeds of a HML business. I want to do mortgage notes within the 401(k). So here are my questions for the experts:

1) I'm assuming HML is considered a "business" activity not an "investment" activity, correct? If yes, can it be set up as a sole proprietorship?
2) Does it make sense to start off HML with limited funds (25k) by investing in a pool? I came across one pool that accepts investor funds starting at 25k.
3) What do you think of this site? http://www.privatemoneylendingguide.com/investors/index.php

I would really like to hear from HML's @ Ann Bellamy, @ Jeff S and also the tax guy @ Steve Hamilton and @ David Beard about setting up the solo 401k correctly.

Thanks so much to everyone for sharing your invaluable advice!

Toby Johnston · Answer

A couple of points to clarify:

If you run this HML business as a sole proprietorship and it is truly a business, not just making periodic investment loans, then the interest income from the loans becomes ordinary subject to self-employment taxes.  This also allows you to make retirement contributions subject to certain limitations.  If you do the same thing, and it sounds like you won't, within your retirement account, then it would be subject to UBTI.  Bottom line is to distinguish between an investment activity which generates interest income and a business activity which generates ordinary income (just like bank).

Steven Hamilton II · Answer

Emma S.,

I think it is a great idea to run it through a sole proprietorship or corporation.  The advantages are the ability to contribute to the solo 401k and other various deductions.

To correct Toby Johnston's comment about UBIT. If you lend out of a solo 401k or SDIRA you Do NOT have to worry about it as interest earnings are exempt from UBIT.

Actually you can start the business and roll over to the Solo 401k before it ever even actually makes a dime.

A sole proprietorship would suffice. If you were investing higher sums I'd consider suggesting that you use a corporation; however, that would be overkill.

Feel free to ask if you have any questions.

Account Closed · Answer

Good comments.  One thing worth adding is that if you invest in a whole or fictionalized note and the deal goes sideways all your money is at risk whereas if you invest the same money in a pool only a small % of your money is at risk.

Jeff S. · Answer

Solo 401k = Self Directed 401K = SD 401k = Solo K = probably a lot of other names for exactly the same plan.  Sorry if this confused you.  There is no difference.  You also seemed confused about contributions.

An IRA, self-directed or not, is sponsored by you.  Depending upon your age, you can contribute around $5k or $6k to it each year using your earned income.  This can be in a Roth or Traditional IRA depending upon whether you pay the tax on this money in advance or not, along with a host of other requirements.

An SD 401k is sponsored by your company and it doesn’t matter if it’s a sole proprietorship or complicated corporation. These are for a husband and wife team or a single person, but with no other employees.  Here you and your company contribute on your behalf, up to approx. $50k each, based on the firm’s payroll.  Thus, there has to be a payroll to make these plans viable.  Which means the company has to have some operating income. Note that only the sponsoring company can contribute to its plan, though you can own many companies and have many plans if you’d like.

As I understand, you have no income from a business you own so you can’t have a payroll, except you also said, ”Then I want to be able to do annual contributions to the SD 401(k) from the proceeds of a HML business.”  Do you have some after tax money you will also use to lend and generate business income? If not, where will these annual SD 401k contributions come from? That is, stick to your SD IRA for now.

I’d argue that in spite of the title of this thread, you’re really not running a business with your retirement plan.  You’re just using it to invest in notes (to respond to Toby Johnston).   The same would be true with your after tax money, if any.  Depending upon your state, using a broker or HML will enable you to be a note or pool investor without having to become licensed -- an entirely different discussion but something you should consider.

Also, with regard to your question about investing locally, since you posted you have money to lend, if it hasn’t happened already, be careful of all the anonymous internet solicitations you’ll now receive from those happy to borrow it.  This is a relationship-based business.  Unless and until you get so big you couldn’t possible meet all your borrowers, my suggestion is you get to know them a little before you lend or invest and also physically look at everything you invest in, even if it’s part of a pool or fractionalized note. You’ll feel more comfortable and quickly get educated.  Obviously then, this has to be local.  In my view, that should be part of your lending/investment criteria.

Hope that answered everything for you, Emma.  Good luck.

Jeff

Jeff S. · Answer

Most Solo 401K’s have both a traditional and Roth component in them, John Thedford, and it’s extremely likely you could make Roth contributions right now and not know it.

I suggest you call the administrator you purchased your plan from as well as your CPA to see if it makes sense to change the form of your contributions.

Jeff

Ann Bellamy · Answer

And to follow up to what Raymond B. said, in order for it to work, you have to either already be colleagues with them, or they have to have already posted in the thread.  So usually just citing their name will summon them if they have key words set up.  Mine is set up for Bellamy.

So, Jeff S saved me a lot of typing, thanks Jeff.  I agree that $25K isn't enough to start lending.  And most of the time for most brokers or lending companies to take you seriously, you need more than 25K anyway.

So by all means move your IRA into a Self Directed IRA - I did a checkbook IRA with udirectira.com and they are excellent.  Equity Trust has the worst customer service on the planet, although they are the 800# gorilla.  I have two solo 401k's with ETC.  The only reason i dont' move the accounts is that it is a pain to move when you are already invested, and the investments are long term so I don't need to deal with them much.

You can move a great deal of money into a solo k like Jeff said, but you need to make money first from the business that forms the 401k, so 25K isn't going to be enough to produce much income.

So I would use the 25K for a pool if you don't want to actively try to find loans.

As to privatemoneylendingguide.com, they do have very good basic information.  I was listed in their directory for quite a while, and never got a single lead that amounted to anything.  There are lots of directories out there.  Bigger Pockets has one.  I may or may  not have gotten a deal from the BP hard money directory.  I certainly have done deals from being on BP, but can't differentiate whether it was because of the directory or my participation.  I suspect the latter.

Most of my deals come from local networking - so if you're not willing to actively market in your area, I'd put my 25K in a pool.

Jeff S. · Answer

They type of activity is irrelevant, Emma S.  You can run your business as a sole proprietorship and use it to form a solo 401k.  Transfer your IRA funds into the solo K and you can loan them out quickly with checkbook control. I see a few issues in your case though, and I think you might be overcomplicating things for yourself.

A 401k will allow you to shelter approximately $50k of outside business income.  In your case, it appears your only income will come from your loans or investments from within the plan.  Unless your sole proprietorship has other income and pays you a salary, you really don’t need the SD401k.

If it’s not already, convert your IRA into an SD IRA through a company like IRA Services, and loan the money out using them as the custodian.  You don’t really have enough to do 1st position loans and I wouldn't recommend anything subordinate to that.  I suggest you call a few of the larger hard money lenders in your area and ask if they run a pool or fractionalize their 1st position notes for you to invest in.

The website you cited is excellent and provides a great primer on lending.  I went through it quickly and it doesn’t look like they’re selling anything.  My only issue is the loan package they discuss on this page. By asking for “credit reports, tax returns for multiple years, financial statements, and bank and investment statements along with a variety of other documents” I think they are confusing conventional lending with asset based lending, which what hard and private money lenders do.  Beyond that, from my fast read, this appears to be an excellent site.

Jeff

Glenn N. · Answer

Is hard money lending a business eligible for the solo 401k.Emma S. ,From talking to these different companies HML lending even as a LLC is not enough to  start a solo401k .Which tells me its not a business different from what i was told before. They say you must have a separate self employed business and then you can only contribute to the solo from these other businesses not from the HML. I have a separate business Im starting but might not be enough income to make it worth it.

Taylor Green · Answer

I have been reading over this thread trying to get a grasp of how to lend money out of 401k. I originally planned on not using my 401k to use for lending money and planned to keep a mix of stocks and bonds. The returns and relatively 'low risk' lending offers just seems to crush that of what I could get in the stock/bond market.

I'm not sure if I can even make this happen because my 401k is sponsored by my employer that I'm still working for. I think it might put me in a different than a solo 401k, but I have no idea. Hope somebody could help me out, thanks!

Steven Hamilton II · Answer

Emma S.,

Yes, a sole proprietorship can be passive in nature.  So yes your income can be subject to SS and Medicare and then you contribute the first 100% of your business income up to 17,500 to your Solo 401k.

Profit sharing contributions can be comprised of 20% of net adjusted business income (So no, you cannot contribute other income).  "Net adjusted business profit is calculated by taking gross self employment income and then subtracting business expenses and then subtracting 1/2 of the self employment tax." -http://www.solo401kcalculator.com/

Yes, you can create and roll money into the solo 401k without ever earning a dime.  However, you cannot make contributions until it makes money.

You can do HML without a solo 401k by using a Self Directed IRA.  If it earns a couple grand a year that would still suffice and allow you to contribute a few more dollars to the account each year.

-Steven

Hard Money Lending as a business?

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