A self-directed IRA can lend money, and the interest flows back into the retirement account tax-deferred or tax-free depending on the account type. The self-directed IRA lending rules are strict on three points: the borrower cannot be a disqualified person, the loan must be funded and repaid entirely through the account’s custodian, and the terms have to look like what an unrelated commercial lender would offer. Miss any of these and the IRS can treat the entire account balance as a taxable distribution.
Who Your IRA Cannot Lend To
Federal law bars your SDIRA from lending to a “disqualified person.” For family, that means your spouse, any ancestor (parents, grandparents), any lineal descendant (children, grandchildren), and the spouse of any lineal descendant.1Office of the Law Revision Counsel. 26 USC 4975 – Tax on Prohibited Transactions Siblings, aunts, uncles, and cousins are not on the list. Your IRA can lend to them.
The restriction also reaches entities. If any combination of disqualified persons owns 50 percent or more of a corporation, partnership, or trust, that entity cannot borrow from your IRA either.1Office of the Law Revision Counsel. 26 USC 4975 – Tax on Prohibited Transactions If you and your spouse together own 60 percent of an LLC, that LLC is disqualified.
Separate from the borrower list, the law prohibits self-dealing: any arrangement where you personally benefit from the loan. Receiving a kickback from the borrower, using the loan to support a personal business deal, or having a family member draw a salary from an IRA-funded project all qualify. Even providing a personal guarantee on the loan is a prohibited transaction, because your personal creditworthiness would be supporting the IRA’s investment.1Office of the Law Revision Counsel. 26 USC 4975 – Tax on Prohibited Transactions
What a Prohibited Transaction Costs You
The penalty for IRAs is more severe than for employer-sponsored plans. If you or a beneficiary engages in a prohibited transaction, the account stops being an IRA as of January 1 of the tax year the transaction occurred. The entire fair market value of every asset in the account on that date is treated as a distribution to you.2Office of the Law Revision Counsel. 26 USC 408 – Individual Retirement Accounts
That deemed distribution goes into your gross income for the year. Depending on your total income, federal income tax rates can run up to 37 percent.3Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 If you are under 59½, a separate 10 percent early distribution penalty applies on top.4Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The custodian reports the event on Form 1099-R using distribution Code 5, which signals the account is no longer an IRA.5Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498
IRA owners are exempt from the excise taxes that apply to prohibited transactions inside employer plans. The trade-off is that a percentage penalty on the transaction is replaced by loss of tax-advantaged status on the entire account.1Office of the Law Revision Counsel. 26 USC 4975 – Tax on Prohibited Transactions
How the Loan Has to Be Structured
A formal promissory note is the core document. It names the borrower, states the principal, sets the interest rate, and lays out the repayment schedule and maturity date. Terms should reflect what an unrelated commercial lender would offer under similar circumstances. A below-market interest rate or unusually generous repayment terms can look like an indirect benefit to a disqualified person.
If the loan is secured by real property, add a deed of trust or mortgage document naming the collateral and record it with the local county recorder’s office to protect the IRA’s claim. For other collateral, such as business equipment, vehicles, or financial instruments, a security agreement does the same work.
Every document must be titled in the custodian’s name on behalf of the IRA, not in your personal name. The standard format looks like “XYZ Trust Company FBO [Your Name] IRA.” That titling makes clear the IRA is the lender. If the paperwork lists you personally, the IRS can treat the funds as a distribution to you rather than an investment.
How the Money Moves
Once the paperwork is ready, you submit a Direction of Investment form to your custodian telling it how much to send, where to send it, and which IRA account the funds come from. You direct the investment; the custodian executes it. After a short review for administrative compliance, the custodian sends funds directly to the borrower or a closing agent. The money never touches your personal bank account. Custodians typically charge a per-transaction processing fee and an annual asset-holding fee for alternative investments like private loans.
Repayments run the same route in reverse. Both principal and interest go directly to the custodian for deposit into the IRA. You cannot collect payments from the borrower personally, even temporarily. Routing a payment through your personal bank account with the intention of forwarding it to the IRA is treated as a distribution to you and triggers income tax and possible penalties.6Internal Revenue Service. Application Procedures for Nonbank Trustees and Custodians
Changing the loan terms after funding is allowed, but the modified terms still have to satisfy the prohibited transaction rules. Any change that shifts value from the IRA to a disqualified person can be treated as a new prohibited transaction.7Internal Revenue Service. Retirement Topics – Prohibited Transactions Reducing the interest rate to help a borrower who is also a business associate could look like an indirect personal benefit. Document the business justification for any modification and keep revised terms at market level.
If the Borrower Defaults
When a borrower stops paying, the IRA — not you personally — has the right to pursue remedies. On a secured real estate loan, that usually means foreclosure. You direct the custodian to start the process, and the custodian hires an attorney or trustee to run it. Costs come out of the IRA.
You cannot personally manage the foreclosure, negotiate with the borrower on your own behalf, or cover legal costs with personal funds. Any personal involvement beyond directing the custodian crosses into prohibited transaction territory. If the IRA takes title to the foreclosed property, that property becomes an IRA asset and has to be held, managed, and eventually sold through the custodian.
For unsecured loans, or where the collateral is worth less than the outstanding balance, the IRA may have to write off the uncollected amount as a loss inside the account. Because the loss occurs inside a tax-advantaged account, you generally cannot deduct it on your personal return. Due diligence on the borrower and the collateral before funding matters for that reason.
Tax Treatment of the Interest
Interest earned inside a traditional SDIRA grows tax-deferred, with withdrawals in retirement taxed as ordinary income. Interest inside a Roth SDIRA grows tax-free, and qualified withdrawals after age 59½ from an account open at least five years are also tax-free.
Passive interest income from private lending is generally excluded from unrelated business taxable income, so most SDIRA loans do not create a separate tax bill inside the account.8Internal Revenue Service. Publication 598 – Tax on Unrelated Business Income of Exempt Organizations One exception: if the IRA itself borrows money to fund a larger loan, the portion of interest attributable to borrowed funds can be treated as unrelated debt-financed income and require the IRA to file a return and pay tax.9Office of the Law Revision Counsel. 26 USC 514 – Unrelated Debt-Financed Income Most SDIRA loans are funded entirely from existing account cash, so this rarely comes up.
How Much Your IRA Can Lend
The annual IRA contribution limits — $7,500 for 2026, or $8,600 if you are 50 or older — apply to new money going into the account, not to the size of loans the IRA can make.10Internal Revenue Service. Retirement Topics – IRA Contribution Limits Your SDIRA can lend any amount up to its available cash balance, even if that balance is well above the annual contribution cap. A small-balance IRA has limited lending power, and tying up most of the account in a single illiquid loan leaves little room for diversification or for unexpected expenses like custodian fees and foreclosure costs.
Your custodian is required to report the fair market value of all IRA assets each year on Form 5498.11Internal Revenue Service. Form 5498 – IRA Contribution Information For a performing loan, that value is typically the outstanding principal balance. If the borrower has missed payments or the collateral has lost value, some custodians require a third-party appraisal or a written explanation of the reported value. Custodians must value trust assets at least once per calendar year.6Internal Revenue Service. Application Procedures for Nonbank Trustees and Custodians