Oftentimes when I’m asked about tax implications of investing in notes, I have to state that I’m not a CPA and that I’m not trying to give anyone accounting advice. But it is a common question that note newbies ask, as they like to compare it to other types of investments, such as real estate or stocks. Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free Investing in a Note Fund Most of the time when investing in a note fund, you’re investing in shares of an LLC (Limited Liability Company). Usually, this is taking place inside a private placement and is open to accredited (or high net worth) individuals and on occasion up to 35 “sophisticated investors” who still meet certain net worth and investment knowledge requirements. In these situations, the investor is usually investing at least a minimum amount (whatever that fund minimum is) for a certain period of time until maturity, per the private placement documents (PPM–Private Placement Memorandum). The good news is that your liability and your overall exposure is limited to the amount of money invested. You also get to share in overall fund expenses. In some funds (like PPR’s note funds, for example), you can even redeem shares to purchase notes upon availability. The other good news is that you can spread your risk around multiple notes, as opposed to an individual asset. Related: Wealth Building: Lessons Learned From Investing in Notes & Commercial Real Estate If you have one note and it goes bad, you have a 100% default rate, but if you have a hundred notes and one note defaults, you have a 1% default rate. From a tax perspective, when investing in a note fund as part of private placement, you should receive a K-1 at the end of the year, and in most circumstances those payments of return on your investment are taxed as “Ordinary Income.” Investing in Individual Notes When investing in an actual note that’s performing (or in other words, the borrower is current), most payments are part principal and part interest. The principal portion is really just a return of capital, and the interest portion is taxed as “Interest Income.” Usually your servicer will send you a 1099-INT, just as they should send a 1098 to the borrower as well. Depending on how long an investor owns an individual note and when he/she were to exit said deal, either by selling the note or cashing out in some way (for example, with a borrower refinance), the investor is taxed as either a short-term or long-term capital gain depending on if they had owned the asset for more than a year and a day. Unless you own the note in a tax-free or tax-deferred structure such as a self-directed IRA account, there are really no tax advantages like there is with depreciation when owning real estate. It’s similar with appreciation as well, since there’s no real, true appreciation while owning a note. The only way the amount that’s owed can increase is if the borrower had missed payments where interest and penalties were to continue accruing. Related: How to Get Started in Real Estate Notes: A Primer for Investor Newbies There may be instances of “phantom appreciation,” which can exist in a situation where a note was purchased at a discount because it had limited or partial equity, and due to improvements in the real estate market, the real estate values on the collateral behind a note increased, thus making the value of the note increase as well. Now that you know some of the tax implications of owning notes and mortgages, it’s easy to determine that it’s still a relatively passive form of income, and it’s taxed more favorably than earned income. I’d much rather be taxed like interest on a bank account than taxed like I am at my day job. Notes are just another tool that can be utilized on the road to financial freedom. Have any questions? What is your experience in real estate notes and taxes? Leave your comments below!