Are Unsecured Notes Worth the Risk?
Investors with self-directed IRA and Solo 401(k) plans are always looking for ways to put their tax-sheltered savings to work that can produce better than average returns.
Investing in notes is a popular choice. When done well, note investing can be a great way to diversify a portfolio, generate solid returns, minimize volatility, and have more control over the investment lifecycle.
When a note is backed by a secure asset such as real estate, there is also a certain amount of protection that comes with the investment. In the event of a default by the borrower, the lender can foreclose and take possession of the property.
Some notes are not directly secured by an asset, however. These are referred to as unsecured notes. While the promised return on investment can often be quite appealing, there are some significant risks to be considered when investing in unsecured notes.
What are Unsecured Notes?
An unsecured note is simply an agreement between a lender and a borrower where money is lent for an agreed upon purpose. The borrower promises to repay the loan, but does not offer any specific tangible asset as collateral for the loan.
A lender can agree to make the loan, but they are solely reliant on the willingness and ability of the borrower to repay the loan. If the borrower defaults, there is no asset that can be claimed by the lender in lieu of payment.
Because there is more risk in an unsecured note, the interest rates are typically higher, which is why some investors are drawn to such opportunities.
What are Some Common Types of Unsecured Notes
A loan for most any type of transaction can be offered on a secured or unsecured basis. The only difference is whether the loan is securitized by collateral of real value.
Unsecured notes are common in certain type of real estate transactions, especially where there is a shorter timeframe involved.
Flip transactions are one of the more common areas where a real estate investor may seek an unsecured loan.
While they could have a note secured by the property being flipped, there is a cost in terms of time, paperwork, and recording. If the investor can get a lender to trust that they will perform and repay the note when the flip is completed, they can move more quickly and spend more time doing deals and overseeing rehabs than sitting in title offices signing documents with an unsecured note.
Some real estate investors seek unsecured notes to their flipping business such as a LLC. The argument here is that they turn properties over quickly, and will be able to keep a lender’s money more actively deployed if they do not have to open and close an individual secured note for each property.
Unsecured notes are also common in mezzanine financing and transactional lending situations.
What are Some Advantages of Unsecured Notes?
Borrowers benefit from unsecured notes in several ways.
Unsecured notes are typically simpler to issue and manage than secured notes, as they do not require the creation and management of a security or collateral.
Issuing unsecured notes may be less expensive than issuing secured notes, as there are fewer costs associated with the creation and management of a security or collateral.
Unsecured notes can provide greater flexibility for borrowers, as they are not tied to specific assets or collateral. This can make it easier for borrowers to obtain financing for a wide range of real estate projects.
The main advantage for lenders is the potential for higher returns. Unsecured notes can offer higher returns compared to traditional investments, such as savings accounts or bonds, due to the higher interest rates they can command.
What are the Key Risk Factors?
The main concern with unsecured notes is the risk of default. If a borrower cannot pay, the lender does not have collateral they can foreclose upon.
There are other risks as well, including lack of liquidity. With a secured note, it is often possible to resell the note to another investor if you find you need to apply your capital to a different purpose. Not many investors will buy an unsecured note at resale for anything close to its original value.
But the main risk in our opinion is fraud.
What is the Fraud Risk?
Unsecured notes, like any other financial instrument, can be subject to fraud. While there are certainly many legitimate unsecured note transactions out there, they do provide greater opportunities for unscrupulous parties to defraud investors.
When you invest in a secure note, you can request a copy of a recorded deed and see the actual asset that is pledged as collateral.
With an unsecured note, you really only have a promise on the part of the borrower to pay.
Well, what if the borrower says they are going to flip a house and pay your IRA 18% interest, but they then take the money and spend it on a trip to the casinos or that new Lamborghini they have been hankering for? Sure, you can call the state attorney general, and that person may end up in an orange jumpsuit, but your IRA will probably not see the invested money again.
How to Mitigate Risk?
It is important to be aware of red flags or warning signs that may indicate a potential fraud, such as guaranteed high returns with no risk, pressure to invest quickly, or a borrower asking for a higher dollar amount than you may be comfortable with.
Requests for personal or financial information can also indicate predatory practices.
The best thing to do in these situations is slow down and ask someone you trust, preferably someone who has investing experience, if the deal sounds right.
To reduce the risk of fraud, it is crucial to thoroughly research the borrower, including their background, experience, and track record. It is also wise to work with a trusted financial advisor or investment professional.
In conclusion, while unsecured notes may offer higher returns compared to traditional investments, they come with significant risks. It is essential to weigh the potential benefits against the risks, and to conduct due diligence before investing in unsecured notes. Investors should consider working with a trusted professional to minimize the risks associated with unsecured notes and to ensure that their investments are in line with their financial goals and risk tolerance.
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Quick answers to common questions
We’ll take you through a simple, step by step process designed to put your investment future into your own hands…immediately. Everything is handled on a turn-key basis. You take 100% control of your Retirement funds legally and without a taxable distribution.
YES! In 1974, Congress passed the Employee Retirement Income Security Act (ERISA) making IRA, 401(k) and other retirement plans possible. Only two types of investments are excluded under ERISA and IRS Codes: Life Insurance Contracts and Collectibles (art, jewelry, etc.). Everything else is fair game. IRS CodeSec. 401 IRC 408(a) (3)
It’s actually pretty simple. Early on, regulators let the securities industry take the lead in educating the public about retirement accounts. Naturally, brokers and banks promoted stocks, bonds, and mutual funds—giving the impression that those were the only allowed investments. That was never true... and still isn’t. You can probably guess why they kept the rest under wraps.
It is possible to use funds from most types of retirement accounts:
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
- Keogh
- 401(k)
- 403(b)
- Profit Sharing Plans
- Qualified Annuities
- Money Purchase Plans
- and many more.
It must be noted that most employer sponsored plans such as a 401(k) will not allow you to roll youraccount into a new Self-Directed IRA plan while you are still employed. However, some employers will allow you to roll a portion of your funds. The only way to be completely sure whether your funds are eligible for a rollover is by contacting your current 401(k) provider.
A Solo 401(k) requires a sponsoring employer in the format of an owner-only business. If you have a for-profit business activity – whether as your main income or as a side venture – and have no full-time employees other than potentially your spouse, your business may qualify. The business may be a sole-proprietorship, LLC, corporation or other entity type.
A self-directed retirement plan is a type of IRA or 401(k) that gives you greater control over how your retirement funds are invested. Unlike traditional accounts held at banks or brokerage firms that limit you to stocks, bonds, and mutual funds, self-directed plans allow you to invest in a wide range of alternative assets including real estate, private businesses, precious metals, cryptocurrency, and more.
These plans still follow the same IRS rules and maintain the same tax-deferred or tax-free benefits as conventional retirement accounts. The difference is simply in how and where you choose to invest.
No. Moving to a self-directed IRA or Solo 401(k) does not trigger any taxes, as long as your funds are eligible for rollover.
Self-directed retirement plans maintain the same tax-advantaged status as traditional plans offered by banks or brokerage firms. The key difference is flexibility—our plans are designed to give you greater control and allow for a wider range of alternative investments beyond stocks, bonds, and mutual funds.
A prohibited transaction is any action between your retirement plan and a disqualified person that violates IRS rules and can lead to serious tax consequences. Under IRS Code 4975(c)(1), prohibited transactions include:
- Selling or leasing property between your plan and a disqualified person Example: Your IRA cannot purchase a property you already own.
- Lending money or extending credit between the plan and a disqualified person Example: You cannot personally guarantee a loan your IRA uses to buy real estate.
- Providing goods or services between your plan and a disqualified person Example: You can’t use your personal furniture to furnish a rental property owned by your IRA.
- Using plan income or assets for the benefit of a disqualified person Example: Your IRA cannot buy a vacation home that you or your family use.
- Self-dealing by a fiduciary (using plan assets for their own benefit) Example: Your CPA shouldn't loan your IRA money if they’re advising the plan.
- Receiving personal benefit from a deal involving your IRA's assets Example: You can’t pay yourself from profits your IRA earns on a rental.
If a transaction doesn’t clearly fall within the allowed guidelines, the IRS or Department of Labor may review the situation to determine if it qualifies as a prohibited transaction.
Disqualified persons are individuals or entities that are prohibited from engaging in certain transactions with your IRA or 401(k). Doing so could trigger a prohibited transaction, which may result in taxes and penalties.
Here’s who is considered a disqualified person:
- You (the account holder)
- Your spouse
- Your parents, grandparents, and other ancestors
- Your children, grandchildren, and their spouses
- Any advisor or fiduciary to the plan
- Any business or entity owned 50% or more by you or another disqualified person, or where you have decision-making authority
These rules exist to prevent self-dealing and ensure your retirement plan remains in compliance with IRS regulations.
(Reference: IRC 4975)
Understanding and following these rules can be tricky, but it’s very doable. The best way to stay compliant is to work with professionals who specialize in self-directed retirement plans. They can help you navigate IRS guidelines and avoid prohibited transactions.
If an IRA holder is found to have engaged in a prohibited transaction with IRA funds, it will result in a distribution of the IRA. The taxes and penalties are severe and are applicable to all of the IRA’s assets on the first day of the year in which the prohibited transaction occurred.
Yes. While self-directed retirement plans allow for a wide range of investments, there are a few important restrictions.
You cannot invest in collectibles or life insurance contracts, and you must avoid prohibited transactions—activities that benefit you personally rather than the retirement plan. These include things like buying or selling property to yourself or family members, using plan assets for personal gain, or self-dealing in any way.
Violating these rules could cause your entire IRA to lose its tax-advantaged status. To protect your account, it’s essential to work with professionals who understand IRS regulations and can help you stay compliant.
This is a common misconception. In many cases, professionals may simply be unfamiliar with self-directed retirement plans, as they fall outside their usual scope of work. CPAs and tax preparers are trained to file taxes, not necessarily to advise on alternative retirement strategies. Financial advisors and brokers often work for firms that focus on traditional investments like stocks and mutual funds—and may not benefit from or support alternative options like real estate or private lending.
Self-directed retirement investing is legal under IRS rules—but like any specialized area, it requires working with professionals who understand how it works.
The IRS has rules in place to make sure your IRA is used only for the exclusive benefit of the retirement account—not for personal gain or to help family members. These rules can get complicated because there are many ways a conflict of interest can occur, even unintentionally.
For example, if your IRA buys a house and rents it to your mother, you might be reluctant to evict her if she stops paying rent. That emotional connection creates a conflict between what’s best for your IRA and your personal relationships, something the IRS aims to prevent.
These rules help ensure your retirement account stays compliant and protected. (See IRC 408)
Yes. Most tax-deferred retirement accounts—such as Traditional IRAs, old 401(k)s, 403(b)s, and TSPs—can be rolled over into a self-directed IRA or Solo 401(k), depending on your eligibility. Roth IRAs cannot be rolled into these accounts.
You can contribute directly from earned income, subject to annual IRS contribution limits. The method and amount depend on the type of plan you have (e.g., Solo 401(k) vs. IRA).
To take a distribution, you'll request funds through your custodian or plan administrator. Distributions may be taxable depending on your account type and age. Early withdrawals may be subject to penalties.
For 2025, the Solo 401(k) max contribution limit is $81,250 if age 60-63, $77,500 if age 50-59 or 69+, and $70,000 if under 50. Traditional and Roth IRAs have a limit of $7,000 ($8,000 if age 50+). Limits are subject to IRS adjustments.
Yes. IRA contributions are typically due by your personal tax filing deadline (e.g., April 15). Solo 401(k) contributions follow your business tax filing deadline, including extensions.
IRS reporting requirements vary depending on the type of self-directed retirement plan you have. Here’s a quick breakdown of what you need to know
Please note: Our team can help you understand what’s required for your specific account, but we don’t provide tax or legal advice. We always recommend working with a qualified tax professional to ensure full IRS compliance.
Self-Directed IRA (Traditional or Roth)
- Form 5498 – Filed by your custodian each year to report contributions, rollovers, and the fair market value (FMV) of your account.
- Form 1099-R – Issued if you take a distribution or move funds out of your IRA.
- Annual Valuation – You'll need to provide updated FMV for any alternative assets held in the account, such as real estate or private placements.
Solo 401(k)
- Form 5500-EZ – Required if your plan assets exceed $250,000 as of year-end. Must be filed annually by the plan participant.
- Form 1099-R – Required if you take a distribution or roll funds out of the plan.
- Contribution Tracking – Keep records of employee and employer contributions. These are not filed with the IRS but may be needed for tax reporting or audits.
SEP IRA
- Form 5498 – Filed by your custodian to report contributions and FMV.
- Form 1099-R – Filed by your custodian. Issued for any distributions.
- Employer Contributions – Must be reported on your business tax return (and on employee W-2s, if applicable).
Health Savings Account (HSA)
- Form 5498-SA – Filed by your HSA custodian to report contributions.
- Form 1099-SA – Filed by your HAS custodian. Issued for any distributions.
- Form 8889 – Must be included with your personal tax return to report contributions, distributions, and how funds were used.
