Valuing Private Notes in a Self-Directed IRA Roth Conversion: Second Mortgages and Life Settlements Explained

The taxable amount of a Roth conversion is the fair market value (FMV) of the assets on the conversion date, not the face amount of a note, the death benefit of a policy, or the price you paid. For a self-directed IRA holding a private note, a second mortgage, or a life settlement, no exchange quotes a price, so the number has to be built and documented. This guide explains how those three assets are valued, what an appraiser needs from you, and where the value shows up on your tax forms. If you are new to the account type itself, start with our guide to self-directed IRAs.

Our appraisers, whose credentials include designations from leading organizations such as the ASA and NACVA, prepare these valuations in accordance with USPAP, the standards published by The Appraisal Foundation. Our Roth IRA conversion appraisal work centers on exactly this problem: a defensible FMV for assets that do not trade.

What Value Does the IRS Expect on a Roth Conversion?

The expected value is FMV on the date of conversion. A conversion is taxed on the pre-tax portion of what moves into the Roth, so an overstated value creates tax you did not owe and an understated value creates exposure on audit.

The reporting chain works like this:

• Custodian: The custodian reports the December 31 FMV of the IRA and the amount converted on Form 5498.
• Taxpayer: You report the conversion on Form 8606, and the Form 8606 instructions explain how your basis in all traditional IRAs feeds the pro-rata calculation of the taxable share.
• Hard-to-value assets: Custodians typically rely on a value you supply or a third-party valuation for assets without a market price, which is why the quality of that value matters.

The IRS does not generally impose a charitable-style "qualified appraisal" requirement on Roth conversions. What it expects is a reasonable, supportable valuation. An independent, credentialed appraisal is much stronger evidence than an owner's estimate, particularly for large, related-party, delinquent, or subordinated notes. Our guide to Form 5498 fair market value rules covers the reporting side in more depth.

How Do You Value a Private Promissory Note?

A private note is valued by discounting its expected cash flows to present value, using a rate that reflects what comparable investors would demand today. The interest rate printed in the note is an input to the cash flows, not the discount rate.

The appraiser works through the following steps:

1. Project the contractual cash flows. Interest, amortization, balloon payment, and maturity date come from the note.
2. Probability-weight the outcomes. Full payment on schedule, delayed payment, partial recovery, foreclosure on collateral, and total loss each get a probability and a timeline.
3. Select a discount rate. The rate builds from a Treasury yield of similar duration, then adds comparable private lending rates, credit and default risk, collateral and expected recovery, illiquidity, and servicing burden.
4. Discount and sum. The present value of each weighted cash flow is added to reach an indicated value.
5. Test the conclusion. The result is reviewed against the payment history and the collateral, and sensitivity to the discount rate is checked.

Example: An IRA holds a $100,000 note paying 10% interest annually for 5 years, with the full principal due at maturity. If comparable investors would require 15% for an unsecured, illiquid note of this credit quality, the present value of the $10,000 annual interest payments is about $33,500, and the present value of the $100,000 balloon is about $49,700. The indicated value is roughly $83,200, not $100,000.

The reverse can also be true. A well-secured, performing note at a rate above the market yield may support a value near or above face. Neither conclusion is automatic, which is why the analysis has to be written down.

Watch out: Valuing a note at unpaid principal because "that is what the borrower owes" is the most common shortcut, and the easiest one to challenge. Delinquency, weak collateral, or a borrower who is a family member or business partner of the IRA owner all push the conclusion away from face value and raise the importance of independent support.

How Do You Value a Second Mortgage Held in an IRA?

A second mortgage is valued by what the junior lien can realistically recover, not by the property's gross value or the loan balance. The senior lien gets paid first, so the junior lender's real collateral is the equity left after the senior balance and the costs of getting to the money.

The appraiser reduces the collateral value for the following items:

• Senior liens: The current payoff of the first mortgage, including accrued interest and advances.
• Foreclosure and legal costs: Fees, taxes, insurance, and property preservation during enforcement.
• Time to recovery: Months of delay before cash arrives, which are then discounted.
• Property marketability: Condition, location, and the uncertainty in the underlying property value.

Example: A property is worth $400,000 and carries a $250,000 first mortgage. Foreclosure and selling costs are estimated at 10% of value, or $40,000. The net equity available to the second lien holder is $110,000. If the IRA holds a second mortgage with a $120,000 balance, its recovery in a foreclosure scenario is capped at about $110,000 before accounting for delay.

That figure is only one branch. If the borrower is current and likely to refinance, the cash flows look different, and the final value blends the performing and foreclosure scenarios by probability. A title or lien search and a current senior payoff statement are what make this analysis credible.

How Do You Value a Life Settlement in a Self-Directed IRA?

A life settlement is valued as the present value of the expected death benefit minus the present value of the expected premiums and charges needed to keep the policy in force. Time and probability drive the result.

The main inputs are:

• Life expectancy reports: Medical underwriting estimates of the insured's survival, ideally from more than one provider.
• Mortality dispersion: The reality that actual death can fall well before or after the expected date, which affects the range of outcomes.
• Premium schedule: What must be paid each year, and whether the policy is funded by cash value, a premium reserve, or ongoing contributions.
• Carrier strength: The financial health of the insurer that must ultimately pay the claim.
• Lapse and funding risk: The chance the policy lapses because premiums cannot be paid.
• Marketability: The limited pool of buyers and the transfer restrictions on these assets.

A longer life expectancy pushes the death benefit further away and adds years of premiums, which lowers value. A policy with a large face amount is not worth its face amount today. For an IRA, the appraiser also looks at what the IRA actually owns after policy loans, accrued interest, and servicing costs.

Valuation Approaches at a Glance

The three asset types share one framework, expected cash flows discounted at a market-based rate, but the drivers differ. The table below compares them.

Asset	Core Method	Key Drivers	Critical Documents
Private promissory note	Probability-weighted DCF	Borrower credit, collateral, discount rate vs. note rate, illiquidity	Note, payment history, collateral records
Second mortgage	DCF with collateral recovery analysis	Senior lien balance, foreclosure costs, time to recovery	Deed of trust, title/lien search, senior payoff
Life settlement	PV of death benefit less PV of premiums	Life expectancy, premiums, carrier strength, lapse risk	Policy, in-force illustration, life expectancy reports

Should Each Asset Be Valued on Its Own or as a Portfolio?

Each asset is valued on its own, and portfolio effects are considered only where they can be supported. A note secured by one property and a life settlement on a different insured have different risks and should not be averaged together or netted against each other.

Portfolio considerations do come up in specific situations:

• Life settlement pools: Several policies on different insureds diversify mortality risk, which can change how a buyer prices the group.
• Pooled or related notes: Notes to the same borrower or secured by the same collateral may share default risk, so they cannot be treated as independent.
• Reporting totals: The IRA's total FMV is the sum of individually supported asset values, not a blended percentage applied across holdings.

Any adjustment that treats assets as a group should be explained and tied to market evidence, not applied as a rule of thumb.

What Documents Does an Appraiser Need?

A complete file shortens the engagement and strengthens the conclusion. Our appraisers typically request the following items:

• For notes and second mortgages: The executed note, deed of trust or mortgage, payment history and ledger, modifications or extensions, borrower financial information, the title and lien search, the current senior lien balance, and a current property value indication.
• For life settlements: The policy, a recent in-force illustration, premium and loan history, life expectancy reports, and carrier information.
• For all assets: Custodian statements, the IRA ownership records, the planned or actual conversion date, and any related-party relationships.

The quality and completeness of these records, along with the number of assets and the depth of analysis needed, determine the scope of the engagement.

Why the Conversion Date Matters

The valuation date is the conversion date. A December 31 value on Form 5498 does not automatically fit a conversion that happened in March, and a note that was current in January may be delinquent by the time of conversion.

Pro tip: Decide the valuation date before the conversion instruction goes to the custodian, and confirm the custodian's process for accepting third-party valuations. The Form 8606 overview and its instructions explain how the converted amount interacts with your other IRAs, so your tax preparer should see the supported value early.

Transactions involving a disqualified person, such as a loan to a relative, raise separate prohibited transaction questions under IRS rules. A valuation does not cure those; they should be reviewed with a tax professional before conversion. Our overview of IRS penalties for converting without a qualified appraisal explains why careful support matters even where no formal appraisal rule applies.

Document the Value Before You Convert

The pattern is consistent across all three asset types: estimate expected cash flows, probability-weight the risks, discount at a market rate rather than the contract rate, and write down every assumption. A value that is supportable on the conversion date is the best protection against overpaying tax now or defending an understated figure later. No valuation can promise how a reviewing body will treat it, but one prepared in accordance with USPAP and built on source documents gives you a defensible record.

Our fee is a fixed fee quoted before work begins, after we scope the assets, the records, and the analysis required. To start, request an appraisal and send us the documents listed above.

This article is provided for general informational purposes only and does not constitute legal, tax, or financial advice. Readers should consult a qualified attorney or CPA regarding their specific circumstances.