Loading resource...
A recent call with a financial advisor in California is representative of a common question on self-directed Solo 401(k) investments.
Welcome to the Retirement Learning Center's (RLC's) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security, and Medicare. This is where we highlight the most relevant topics affecting your business.
“My client is self-employed and has a Solo 401(k). She wants to invest in a loan secured by a first deed of trust. Can she do that with her plan?”
Potentially yes, but it is not a given. There are several concerns to address. Your client should seek experienced tax and/or ERISA counsel before proceeding.
A first trust deed investment is a loan made by a Solo 401(k) to a borrower, secured by a recorded first-priority lien on real estate, with principal and interest paid back to the plan. “First” matters because it means the Solo 401(k)’s lien is in the senior position—paid before second mortgages or junior lienholders if the property is foreclosed or sold after default.
Before serving as a plan investment, there are at least five hurdles for a first-trust deed to overcome: Plan document language, provider limitations, prohibited transaction rules, proper documentation and processing, and standard investment due diligence. A 401(k) covering rank-and-file employees has additional ERISA fiduciary, prudence, diversification, custody, valuation, disclosure, and operational concerns that make a private first deed-of-trust investment much harder to justify.
Confirm that the basic plan document, adoption agreement, trust agreement, and any custodial or brokerage agreement allow private notes, deeds of trust, mortgages, or other nontraditional investments.
Determine whether the brokerage platform will custody and process private notes/deeds of trust. Some restrict investments to assets the provider makes available, such as mutual funds, exchange-traded funds (ETFs), stocks, bonds, certificates of deposit (CDs), and other marketable securities.
The prohibited transaction (PT) rules are potentially the most dangerous trap [IRC §4975(c)]. A plan generally cannot lend money or extend credit to a disqualified person, and plan assets cannot be used directly or indirectly for the benefit of a disqualified person [IRC §4975(e)(2)]. In a Solo 401(k) context, that means the business owner, spouse, ancestors, lineal descendants, entities controlled by those persons, plan fiduciaries, and service providers to the plan. An unrelated borrower is not automatically disqualified, but the transaction can still be problematic if the borrower, guarantor, broker, seller, loan servicer, or any compensated party has a disqualified-person relationship with the plan or creates an indirect benefit for the owner. A disqualified person must pay an initial tax on a PT of 15 percent of the amount involved for each year (or part of a year) in the taxable period. If the disqualified person does not correct the transaction within the taxable period, there is an additional tax of 100 percent of the amount involved (See Form 5330).
The paperwork should show the retirement plan as the investor. The borrower's payments should go back to the Solo 401(k), not to the owner personally. Closing statements, title instructions, servicing records, insurance, property tax monitoring, valuation support, and default notices should all be handled consistently with the plan as the lender. Important steps:
· Name the plan, not the individual, as lender or beneficiary;
· Verify the deed of trust is recorded;
· Confirm there is no personal guarantee by the plan participant; and
· Document that any fees paid by the plan are reasonable and not paid to a disqualified person.
"First" means the deed of trust is intended to be senior to junior liens, but it does not mean risk-free. It would be prudent for your client to obtain an independent title report, confirm lien priority, review the property value and loan-to-value ratio, understand the borrower's repayment source, document the interest rate, maturity date, payment schedule, default interest, late charges, insurance requirements, tax escrows, and foreclosure remedies, and consider independent loan servicing.
This is also a valuation and reporting issue. A Solo 401(k) with sufficient assets may have Form 5500-EZ filing obligations, and nonmarketable assets require careful year-end valuation support. The client should consult with their CPA.
Clean example: A review reveals that the plan document, trustee/custodian, and recordkeeper accommodate first trust deeds. The Solo 401(k) lends $100,000 to an unrelated borrower. The borrower signs a promissory note with commercially reasonable terms. A first deed of trust is recorded on the borrower's investment property. The title report supports a first lien position. The Solo 401(k) plan is listed as the lender/beneficiary, the borrower's payments go directly back to the plan, and no disqualified person receives a side benefit.
Problem example #1: The Solo 401(k) lends $100,000 to the owner’s LLC or to the owner’s child. That raises PT concerns because the borrower is related to the owner or controlled by the owner.
Problem example #2: The Solo 401(k) lends to an unrelated borrower, but the borrower pays the owner a personal consulting, finder’s, or origination fee. That raises self-dealing and personal-benefit concerns.
A first deed-of-trust investment is not automatically off limits as an investment for a Solo 401(k), but it should be approached carefully. Your client should seek experienced tax and/or ERISA counsel before proceeding.