An Unsecured Promissory Note is a document that promises to repay a defined amount of money with interest bearing for a certain period. Unlike a Secured Promissory Note that is secured with an asset/collateral an Unsecured Promissory Note does not have a secured asset. So, if the borrower does not repay the Unsecured Promissory Note, your only recourse is to take legal action against the borrower for potential recovery.
There are reasons why you do not lend money to your relatives. The likelihood of them paying you back is 50/50. And then you must see them at every family gathering and pretend that the $50,000 you lent them that they have not paid back is not a big deal. It's a big deal!
So why do self-directed custodians allow this type of investment? Not all custodians do or many do with strict requirements. As a self-directed custodian, it is our responsibility to report and/or avoid suspicious behavior. Unsecured Promissory Notes historically have been mistreated to commit tax evasion. And since a self-directed custodian is governed by the rules and regulations of the IRS, it is frowned upon by "Captain Obvious." Tax evasion arises when the Unsecured Promissory Note does not have a term date or the custodian does not obtain a W-9 from the borrower. If a W-9 was not obtained at the time of the initial investment, the IRA account owner may be held responsible to pay the taxes as the custodian may consider the transaction a distribution.
At Preferred Trust, Unsecured Promissory Notes are allowed based on the following criteria being met: term of Unsecured Promissory Note cannot be longer than two years without the option of a provision for an extension; and the interest bearing on the loan must be industry standard (based on bank rates to hard money lending rates). At the end of the two-year period if the Unsecured Promissory Note is not repaid, Preferred Trust will report a 1099-C (Cancellation of Debt) with the IRS for the benefit of the borrower, which in turn will require the borrower to pay taxes on the outstanding amount of monies not repaid as promised. The IRA account balance for this asset will be reduced to zero to reflect the loss of capital.
The only circumstance in which Preferred Trust will allow an extension on an Unsecured Promissory Note is if legal action has been initiated with the intent to collect from the borrower. Communication with Preferred Trust is important during this period to document why Preferred Trust is not acting in the best interest of the IRS to identify a tax evasion circumstance.
Unsecured Promissory Notes are not a popular investment vehicle for a reason. Historically, less than 50 percent of Unsecured Promissory Note are repaid. Do your due diligence and know who you are lending to and their track record of repayment. Or better yet, make it a Secured Promissory Note and save yourself from showing up at the next family gathering knowing that someone at the table still owes you money!