Purchase Promissory Notes or Deeds of Trust with Solo 401k Funds

Just like fortune 500 businesses that invest their  401k plans and pensions in notes including deeds of trust, so can a self-employed business that sponsors a self-directed solo 401k plan. Putting together a promissory note investment is quite easy when done inside a solo 401k plan because the business owner is the trustee of the plan and can thus negotiate the note terms without permission from custodians or employees since a solo 401k is only for business owners. 

Defined - Promissory Note/Deed of Trust  

A promissory note is a written contract between a lender (also known as a beneficiary) and a borrower. 

It is considered a legal and enforceable contract. 

It obligates the borrower to repay the loan at a determined interest rate during a specified period of time. 

If the borrower fails to meet his or her promise to pay the note, the solo 401k trustee (generally the self-employed business owner) will have the right to foreclose on the property securing the note, and, ultimately, the solo 401k would take possession of the property if the borrower fails to pay.

The Note Terms

The note terms typically include the sum to be repaid to the Solo 401k, the interest rate to be paid on the  amount borrowed, and the length of the note (i.e., when the note requires full payment). Therefore, each of these variables affects the value of the note. The value of the note is also dependent on the borrower (i.e., the likelihood that the borrower will not default on the loan).

The Note Payment Amount

Before investing Solo 401k funds in a promissory note, you should determine the value of the property securing the note. For instance, if the note is secured by real estate, the loan-to-value ratio, or LTV should be determined. A note with a lower loan-to-value ratio—in other words, a note in which the amount of money borrowed is smaller in relation to the property's value --is a better deal than a loan with a higher ratio. An example would be property with a value of $100,000 and a loan of either $30,000 (30-percent LTV) or $70,000 (70-percent LTV). The 30-percent LTV is a much more secure investment. Since the borrower has greater equity in this case, the borrower has more to lose and, therefore, more incentive to pay the loan back. Further, should you have to foreclose, your Solo 401k will gain an additional $70,000 in equity, instead of the $30,000 the Solo 401k would receive with the $70,000 loan.

Note Interest Rate

The whole point of investing your solo 401k in promissory notes is to grow your nest egg. Therefore, it should be your goal to get the best interest rate of return for your solo 401k plan. There are two types of interest: simple and compound. Simple interest is interest that is paid on the principal, or the loan amount. For example, if your Solo 401k loaned $10,000 to a land developer for a year and charged a 10 percent interest, at the end of the year, the developer would pay the solo 401k plan $1,000 in interest plus the principal of $10,000, for a total payment of $11,000.The entire $11,000 would flow back into the solo 401k plan which can then be reinvested again. 

Compound interest is interest paid on both the principal and the accumulated interest of prior periods. If your solo 401k loaned your brother $400 for one year but charged him 1 percent interest each day--put differently, if the interest were compounded daily--he would owe you $404 at the end of the second day, and so on.

Secured vs Unsecured Promissory Note

Secured means the note is secured by real estate in the case of a deed of trust. Because the note is secured by real estate, if the borrower stops making note payments  and ends up not being able to make good on the note, the lender (Solo 401k) will take over the asset securing the loan ( in example this real estate) instead of receiving payments.

Unsecured--because the loan is not secured by collateral (e.g., real estate or equipment), and if the borrower stops making payments, your Solo 401k's only option in trying to enforce payments is to take legal action against the borrower.

Tips of Documenting A Self-Directed Solo 401k Promissory Note Investment

1. Draft the note or ask your solo 401k provider for a sample copy. Sometimes the borrower will take the lead in drafting the note so review it  to make sure it conforms to solo 401k investment regulations.

2. Review the note document to confirm  the lender reads your Solo 401k (it should read as follows, for example: Matt Smith, Trustee of Smith Solo 401k Trust)

3. Make sure both parties execute the promissory note document. The solo 401k trustee/owner sings on behalf of the solo 401k trust the borrower also signs. 

4. When processing the note funding, write a check from the solo 401k bank or brokerage account and make it payable in the name of the borrower listed on the promissory note. 

5.  Once the borrower starts making note payments, the check needs to be made payable in the name of the solo 401k for deposit into the solo 401k bank or brokerage account.

To read a complete promissory note investment procedure CLICK HERE.