Note investing vs Turnkeys?

Question

Hi BP,

What are the advantages/disadvantages of buying a note versus buying a turnkey (or vice versa) in terms of cash on cash return, depreciation, deductions etc.? How much depreciation do I get from 1 property/year? Is the income on both taxed the same at the end of the year? The note would be at 10% annual return for 3 years and then I can buy a new one after that.

Thanks!
Anja

Paul Birkett · Answer

Hi Anja

Before getting into the advantages or disadvantages, I think you need to think about some questions:

1. What is your objective? Are you looking for a passive investment where you get a check in the mail or are you looking to learn a business. If its passive income, then notes or turnkey could work for you. Assuming you are comparing a performing note with a 10% coupon to a turnkey SFH with the same yield, there are probably some advantages to holding a turnkey as you get to depreciate the improvements to the raw land over 28.5 years. So, that generates a tax loss at least in the early years. Put very simply:

Value of Land: $5,000

Improvements: $50,000 (defined as anything not put on the land by nature)

Depreciation: $50,000/28.5 = $1754 depreciation per year (a non-cash loss)

You don't get to depreciate the note. Its a financial instrument (like a bond or stock).

2. What is your timeframe? Is this something you might hold for 5+ years or do you want to park some cash for a year or two.

If you are in for the long haul:  The turnkey may appreciate over time whereas the note will eventually be paid off leaving you with no residual value.

If its a shorter term horizon:  A performing note with a history of consistent payments should be pretty easy to sell. A turnkey may not sell for what you paid for it.

3. What is your tolerance for risk/hassle? Whether you are in real estate (turnkey) or finance (note), things go wrong. In the case of turnkey, its unexpected repairs, bad tenants, tax assessments etc. In the case of a note its borrower problems like not paying their taxes, not paying you, not keeping current on their insurance.

Given that some of these problems may come up from time to time...which type of problem would you like best!? I find that note problems can always be handled on the phone. Real estate problems usually require a visit.

4. Will you be using leverage to purchase the turnkey? If you can borrow you will have less cash in the deal and provided you can keep the place rented over time the returns should be higher. You typically cannot add leverage to a note purchase (certainly not your first few deals)

Whatever route you choose, its important to start with the end in mind. Where do you want to be in 10 years? It may be that you need a portfolio of performing notes for cashflow, some non-performing for scalability and some real estate for the leverage and tax benefits.

Larry Fried · Answer

@Anja Wehrmann

Hi Anja, I have both turnkey properties and notes (private lending).  I am not a tax adviser or accountant, so I will speak from my understanding, not as an "expert" or adviser.  When you own an investment property, the deduction is based on the improvements portion of your purchase price (ie: subtract the value of the land from purchase price).  The deduction is amortized over 27.5 years. So you divide that amount by 27.5 and that is one year's deduction.  Then there are also mortgage interest, property tax, and other deductions.

With a note you get no deductions what so ever.  The interest paid is taxed just like interest from a bank.  The advantage of a note is that it is totally passive, simple, and if you've done your  proper due diligence, can be low risk with a reliably high and consistent return.  It is short or shorter term, and somewhat more liquid.

Advantages of good turnkey or other buy and hold investment property over a note: the many deductions, equity growth via principal pay down (via rents paid) and appreciation, leveraging your money (with financing), control of the hard asset, wealth build up, which can be leveraged still further.  Then there other tax advantage strategies such as 1031 exchange at exit (sale) time that can really keep income in a very low or even tax free environment.

I hope that helps.

Mike Hartzog · Answer

@Larry Fried makes a good point regarding the differences in tax treatment between the two.  Personally I think owning both income producing real property and debt secured by real estate is a good strategy.  The built-in tax advantages of real estate make it ideal for holding outside of your SD IRA.  Depreciation should protect most or all of your returns.  Notes are great for holding in SD IRA accounts, using the tax advantaged status of the IRA account to protect the returns.

Ali Boone · Answer

Here's my vote! :)

http://www.biggerpockets.com/renewsblog/2015/01/24...

Anja Brey · Answer

Thank you, @Larry Fried @Mike Hartzog and @Paul Birkett for your valuable input!

Thomas Chang · Answer

Would note investing be a good way in increasing funds for future real estate purchases?  I am just starting out and don't have that much in the way of funds but am trying to figure out how I can increase it so that I can invest in maybe a turnkey one day.

Larry Fried · Answer

@Mike Hartzog reminds me that is suggested strategy is exactly where I am at now.  Just recently the only note I still hold is in my Self-Directed IRA, while all my properties are owned outside my IRA.  IRA owned properties do not have the same tax advantages or leveraging capabilities, and can in fact complicate your IRA tax liabilities a great deal, while notes are simple because they are passive investments.

Darren Eady · Answer

This has been my business solely for the last five years.  It would probably be best explained over the phone.  Please contact me through BP and we'll connect.  Thanks!

Note investing vs Turnkeys?

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