What Investors Should Know About the Tax Implications of Investing in Notes

by | BiggerPockets.com

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.

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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!

About Author

Dave Van Horn

Since 2007, Dave Van Horn has served as president and CEO of PPR The Note Co., a holding company that manages several funds that buy, sell, and hold residential mortgages nationwide. Dave’s expertise is derived from over 30 years of residential and commercial real estate experience as a licensed Realtor, a real estate investor, and a fundraiser. As the latter, Dave has raised over $100 million in both notes and commercial real estate. In addition to his investments and role as CEO, Dave’s biggest passion is to teach others how to share, build, and preserve wealth. He authored Real Estate Note Investing, an introduction to the note investing business, helping investors enter the “other side” of the real estate business.


  1. Jeffrey Mason

    Our LLC has some money in the PPR fund. Because the K-1 says that the money is “ordinary income” it ends up on line 4 of form 1065. There has been some confusion as to whether that money is subject to self-employment income. If it is, then a 10% return immediately becomes roughly an 8.5% return, which is obviously not desirable. Any comments? I know you are not a CPA, but could you ask the CPA for PPR?

  2. Chris LaSpada

    @JEFFREY MASON – I am the CPA for PPR. It depends what your LLC does. Typically the ordinary income earned from this investment is passive income which is not subject to self employment tax. Feel free to PM me to discuss further.

  3. The comment “I’d much rather be taxed like interest on a bank account than taxed like I am at my day job.” Last time I checked interest is taxed at the same rate as income. If not then I need to get back some of the I paid in tax last year.

    Please help me understand this. If truly a qualified dividend style rate, I may reconsidering looking at this investment. My first gander showed an expense structure that I could not understand, then again, I’ve been told I am below average intelligence, introverted and not creative.

    If the tax comment was to imply that making cashola passively is more better than being workin’ stiff, no argument there.


  4. Dave Van Horn

    Hi Joe,

    You’re right, your marginal tax rate is still the same but with interest income you don’t have FICA, social security tax, or any self employment tax (if you’re self employed) etc to pay.

    And like you said, it’s the passive cashflow that’s the big takeaway of the article.


  5. Linda Hastings

    Regarding the principal portion of an individual performing note you invest in, is it still considered return of capital (and not taxable income) even when you buy the note at a discount? Ie, even when the amount of principal you get paid back (over time) exceeds what you bought the note for?

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