Private lending from your Solo 401k

[Richard Howell]

Can anyone offer advice or feedback on their experience on how they utilize their Solo 401k to lend money to real estate investors?  I would like to begin doing this with my Solo 401k cash.  Your reply is greatly appreciated.

[Michael Plaks]

@Richard Howell

You got very solid advice to your question. I hope to not offend you by dropping the conversation to a more basic level than the other professionals who responded. I want to talk about the very concept of private lending.

Visualize who your likely borrower is. A brand new investor seduced by "make millions in flipping" seminars or, worse, HGTV ridiculous shows. He has no idea what he is doing, he has no experience and no capital - but he expects to make a fat profit on his first deal. You're the one who will fund his new "business." 

Six months into project, when your loan is due, he is still in the middle of rehab, which by now is way over budget, and he has no way to refinance to pay you back. He is still in denial and hopes for a miracle, such as eventually selling it much higher than the market supports.

You have two options at this juncture: extend your loan for a longer period or foreclose. Hard to say which one is worse for you. If you extend the loan - yes, you can add the hefty penalties and extension fees, however - what's the end? The end is that your hapless investor will not be able to sell the property to recover his money - or maybe not even enough to recover yours. Some of them will simply walk away, leaving you the property that YOU now have to sell and hopefully get your money back. Sometimes, the property is not sellable, and you will have to finish his job. Ouch.

If you foreclose on him - you receive an unfinished property, and you now become the rehabber. The property may come with contractors' liens if he did not pay them, with poorly done work that has to be redone, with code violations and who knows what else. You adopt someone's poorly raised and neglected child. Good luck to get your money back.

If you do this out of your 401k - it becomes twice more difficult, because you also have to watch for the IRS rules that prohibit you from directly participating in the projects owned by your retirement plan.

If you think I'm imagining doom and gloom - unfortunately no. For 20 years, I have been doing taxes for investors, including hundreds of lenders and borrowers, and I have seen these scenarios too many times.

You need to protect yourself in four areas, not necessarily in order of importance:

1. Legal compliance, as mentioned by previous commenters.

2. Properly secure your investment with the property you're lending on - i.e. use an attorney specializing in private lending.

3. Lend only to proven experienced investors who know what they are doing. The risk is too high with newbies.  

4. Never lend more money than the property is worth in its current condition - in case you have to foreclose. A deadly mistake is to lend based on what the property should be worth after rehab. Always obtain your own reliable number - from an investor-friendly inspector or appraiser or from an experienced investor. Never ever trust the borrower's numbers!

Your best bets are either lending to the "big dogs" in your area or investing in a professionally managed fund like @Dmitriy Fomichenko suggested. The third option is lending to your local "hard money" lenders instead of to individual investors. All 3 options will return less % on your money than you could request by lending directly, but in return you get a degree of safety. Until you yourself become an experienced lender.

Warning: just because someone teaches a class on flipping or posts pictures of his fat checks on Facebook - does not mean he is actually a successful investor who can be a safe borrower.