Notes vs. Rental Properties ?

7 Replies

I understand the basic concept of investing in note vs. rental properties - no headache with Tenent/Toilet etc while rental properties come with potential appreciation (house value, rent) and tax reduction. 

1. For Note investors out there (and I mean investor who buy and hold notes for passive income), Do you also own your PHYSICAL rental properties? How do you feel about the two?

2. Does it make sense to be in REI world with NOTES only?

Thank you so much

Hi Naphat,

I have both notes and rental in my portfolio. Although I'm not a big fan of tenants, trash/toilets, I think its a good idea to have rentals for the depreciation and tax savings. Notes are less of a hassle compared to rentals, but offer no substantial tax benefits. If IRS provided a tax deduction for notes comparable to rentals, I'd be 100% notes.


Borrow the money for your note.

You now have a tax deduction and better treatment than if you use your own money. (IRS rules are different on taxing profit.)

Then sell and 1031 the profit.

Think partial purchase as your returns can double.

Right, but I'm using my IRA and that would trigger UBIT which is around a 35% tax...

Originally posted by @Boyd McClean :

Borrow the money for your note.

You now have a tax deduction and better treatment than if you use your own money. (IRS rules are different on taxing profit.)

Then sell and 1031 the profit.

Think partial purchase as your returns can double.

Bob's points are good ones.  I would add that real estate provides an effective hedge against inflation, i.e., real property gains value with inflation, while the value of a note will decrease with inflation.

Another angle on this. Notes are great investments for self-directed retirement accounts, since they have no tax advantages on their own.  Real estate, on the other hand, is more difficult to own in these accounts due to the requirement that financing must be non-recourse.  In addition, you waste the tax advantages inherent with rental real estate when the asset is owned by the retirement account because the income produced is rendered tax free/deferred.

Given all of this, my view is that it is good to have some diversification, holding both rental real estate and notes in the investment portfolio, favoring ownership of notes in self-directed retirement accounts where possible.

@Bob Malecki  @Boyd McClean  @Mike Hartzog  

Thanks much for your inputs. Mike summarize it very well there. I do not have much in my retirement account (401k also with current employer which I can't convert to self-directed). 

I still like the concept of Notes and want to get involve somehow.

I like rentals because you get appreciation and return on investment. Yes you can also get tenant headaches. On the other hand I reduce my "headaches" by investing in class a real estate. So there are tons of options.

I like investing in buy and hold real estate when there is a economic downturn and you can get super deals with high cash flow with a big upside on appreciation (i.e. 2008-2012). But unless I can get a really good deal on a rental, I favor notes/hard money lending (I personally do HML, I do not buy existing notes at this time). Also when you live in expensive areas of the U.S. where the cash flow on rentals is poor (NYC, Boston, Coastal CA, DC, Seattle, etc..), and you can't find a good return on rentals in your backyard, I especially favor notes over rentals. I'm personally not a fan of buying rentals far away from where you live.

It's not just the tenants/toilets management part of owning rentals, I think it takes a lot more initial up front work to acquire good cash flowing buy and hold rentals then it does to lend on a hard money deal. When I bought rentals, it took months and months of driving out to look at properties that popped up, making offers, inspecting properties, fixing properties, screening tenants. This was all far more work then HML. With HML I do not leave my office. It rarely takes me more then an hour to evaluate if I want to fund a HML. There is also more liability being a landlord (getting sued for slip & fall, etc...) then owning the note. Also when you have to evict, you have to eat all the costs. When you foreclose on a note, all the back interest and foreclosure costs get tacked on the payoff on your note.

To me the tax advantages of owning rentals are a little over hyped.  The main tax advantage people are talking about with rentals is you can depreciate, this shelters a little of your cash flow.  This is the only "phantom loss".  But if you sell you have to re-capture that depreciation unless of course you 1031X.  And 1031X can be spotty, because you usually want to sell a rental at a market peak, and that means what you are likely to 1031X into is also at a market peak.  Everything else you can deduct you have to come out of pocket for (maintenance, repairs, etc...).   

If there is another downturn like 2008-2012 where I can get super deals on rentals in prime locations, I would go in again on rentals. But if not, for me it's much less hassle making 9-12% on HML's then finding and managing rentals.

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