Yes, a self-directed IRA can loan money to third parties, and the interest the loan earns flows back into the account tax-deferred or tax-free depending on whether the IRA is traditional or Roth. The IRS doesn’t publish an approved investment list for IRAs; it prohibits only a narrow set of assets like collectibles and life insurance, which leaves private lending wide open.1Internal Revenue Service. Retirement Plan Investments FAQs The catch: every loan has to comply with prohibited transaction rules, be priced at arm’s length, and be documented so the IRA — not you personally — is the lender. Miss those, and the IRS can treat the entire account as distributed in a single year.
How the Lending Actually Works
Federal law defines an IRA as a trust held for the exclusive benefit of the account holder or their beneficiaries.2Office of the Law Revision Counsel. 26 U.S. Code 408 – Individual Retirement Accounts That exclusive-benefit requirement runs through every rule below. Your SDIRA custodian holds legal title to the assets, so when the IRA issues a private loan, the custodian is the lender of record. You identify the borrower, negotiate the terms, and do your own due diligence, but the money moves from the custodian to the borrower and back again without ever passing through your personal bank account.
The IRA itself carries the risk. If the borrower stops paying, you cannot cover the shortfall from personal funds without triggering a prohibited transaction. And if the loan generates a loss, there is no way to deduct that loss on your personal return while the funds stay inside the IRA.
Types of Loans an SDIRA Can Make
Most SDIRA lending falls into a few common shapes:
- Real estate-secured loans. The IRA holds a mortgage or deed of trust against a property. If the borrower defaults, the account has a legal claim to the collateral. These are the most popular SDIRA loans because the collateral gives the account a recovery path.
- Unsecured personal notes. The borrower signs a promissory note backed only by their promise to repay. Returns are often higher to compensate for the added risk, but recovery after a default is much harder.
- Bridge loans. Short-term financing for borrowers arranging permanent funding elsewhere. Terms usually run a few months to a year, at higher rates.
- Small business loans. Working capital or expansion financing for a company in exchange for interest over a set term. These can be secured by business assets or unsecured.
Every loan has to be a genuine investment that benefits the IRA. A loan with no realistic prospect of repayment, or one structured to route value to someone other than the account, will draw scrutiny.
Who Cannot Borrow From Your SDIRA
This is where most people get into trouble. IRC Section 4975 identifies a category of “disqualified persons” who are completely barred from borrowing money from your SDIRA or engaging in any financial transaction with it.3Office of the Law Revision Counsel. 26 USC 4975 – Tax on Prohibited Transactions The list includes:
- You and your spouse
- Your parents, grandparents, and other ancestors
- Your children, grandchildren, and other lineal descendants
- Spouses of your descendants (your son-in-law, daughter-in-law, and so on)
- Entities where disqualified persons own 50% or more of the voting power, capital interest, or beneficial interest3Office of the Law Revision Counsel. 26 USC 4975 – Tax on Prohibited Transactions
Notice who is missing: siblings, aunts, uncles, cousins, and friends. Those people can borrow from your SDIRA, as long as the terms are fair and the transaction genuinely benefits your retirement account.
Indirect Benefits Count Too
The prohibition is not limited to lending directly to a disqualified person. If you structure a loan so that you personally benefit from it, the IRS treats that as a prohibited transaction even when the borrower is an unrelated third party. Lending to a business partner on favorable terms that indirectly reduce your own business costs is the classic example. The test is whether the transaction is conducted solely for the benefit of the IRA.
What Happens If You Break the Rule
If you or a beneficiary engage in a prohibited transaction, the account stops being an IRA as of the first day of the year the violation occurred.4Office of the Law Revision Counsel. 26 U.S. Code 408 – Individual Retirement Accounts – Section 408(e)(2) The IRS treats the entire account balance as distributed to you at fair market value on that date.5Internal Revenue Service. Retirement Topics – Prohibited Transactions The full balance becomes taxable income in one year, potentially at the top 37% federal bracket for 2026.6Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 If you are under 59½, you also owe a 10% early distribution penalty on the entire amount.7Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section 72(t)
These penalties apply regardless of the loan amount. A $5,000 loan to your daughter can blow up a $500,000 IRA. Confirming that the borrower is not a disqualified person is the single most important compliance step in SDIRA lending.
Arm’s Length Terms Are Required
IRC Section 408(a) requires IRA assets to be managed for the exclusive benefit of the account holder, which means every loan the IRA makes has to reflect genuine market terms.8Office of the Law Revision Counsel. 26 U.S. Code 408 – Individual Retirement Accounts – Section 408(a) The interest rate, repayment schedule, and any fees should match what an unrelated lender would charge a similar borrower in a comparable transaction. A below-market rate raises a red flag because it suggests the loan benefits the borrower rather than the IRA.
There is no specific IRS formula for a “correct” rate. The practical approach is to research what private lenders, banks, or hard money lenders charge for similar loan types, set your rate within that range, and document the rationale. If the IRS questions the loan later, you want evidence that the terms were commercially reasonable.
Paperwork and How the Money Flows
Sloppy paperwork is the second most common way SDIRA loans go wrong, right after prohibited transactions. You will need several documents to satisfy both your custodian and federal requirements:
- Promissory note. The core contract specifying loan amount, interest rate, payment frequency, maturity date, and default provisions. This document creates the debt obligation.
- Security agreement or deed of trust. Required only for secured loans. For real estate-backed loans, the deed of trust or mortgage is recorded with the county.
- Direction of investment form. Your formal written instruction to the custodian authorizing the disbursement. The custodian will not move funds without it.
One detail that trips people up: every document must name the lender as the IRA, not you personally. The standard format is the custodian’s name followed by “FBO” (for benefit of), then your name and IRA designation. Getting this wrong can cloud the IRA’s legal ownership of the note.
After the borrower signs and you submit the full package, the custodian conducts its own compliance review. Once approved, the custodian sends the funds by wire or check directly to the borrower, or to a neutral third party such as a title company or attorney escrow account. You never touch the money. Payments come back the same way, going directly to the custodian for deposit into your IRA. If you personally receive a payment and then hand it to the IRA, you have taken constructive receipt of IRA funds, which can jeopardize the account’s tax-advantaged status.
How the Interest Is Taxed
Interest earned inside a traditional SDIRA grows tax-deferred, and you pay ordinary income tax when you eventually take distributions. Interest earned inside a Roth SDIRA grows tax-free, and qualified distributions in retirement are also tax-free. Either way, the interest is not reported on your annual return while it stays inside the IRA.
Straightforward interest income from a private loan is specifically excluded from unrelated business taxable income under IRC Section 512(b)(1), so most SDIRA lending generates no UBIT at all.9Office of the Law Revision Counsel. 26 U.S. Code 512 – Unrelated Business Taxable Income Things change when leverage enters the picture. If your SDIRA uses borrowed money to fund an investment, the portion of income attributable to the debt can become unrelated debt-financed income under IRC Section 514 and is subject to UBIT.10Office of the Law Revision Counsel. 26 U.S. Code 514 – Unrelated Debt-Financed Income If the IRA generates $1,000 or more in gross unrelated business income during the year, the custodian must file Form 990-T and the account owes tax at trust rates on the net amount, paid from IRA funds.11Internal Revenue Service. Instructions for Form 990-T
Risks Worth Knowing About
SDIRA lending can produce consistent returns that are not correlated with the stock market. It also carries risks that index funds do not.
Borrower default is the biggest one. If a borrower stops paying on a secured loan, the IRA may need to foreclose on the collateral. Foreclosure is slow, expensive, and there is no guarantee the property sells for enough to cover the balance, especially in a down market. For unsecured loans, recovery options are more limited still. All legal costs during foreclosure or collection must be paid from IRA funds.
Illiquidity is the other major concern. A promissory note cannot be sold on an exchange the way a stock can. If you need to access IRA funds before the loan matures, you are stuck waiting for the borrower to pay or trying to sell the note at a discount to another investor. That matters most if you are approaching the age when required minimum distributions begin.
Custodian fees for alternative assets are typically higher than what a brokerage charges for stocks and bonds. Expect annual recordkeeping fees plus per-transaction charges for each loan you fund or close. Fees vary widely between custodians, so compare schedules before opening an account. They are paid from IRA funds.
None of this makes SDIRA lending a bad strategy. It makes it one that rewards careful borrower vetting, conservative loan-to-value ratios on secured notes, and enough liquidity elsewhere in the IRA to handle a loan that goes sideways.