Note investing vs turnkey rental properties - Tax perspectives

Tax Liens & Mortgage Notes
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Note investing vs turnkey rental properties - Tax perspectives

Daniel Torres
Investor · Hollywood, FL · Member since 2015 · 18 posts · 10 votes

Hi BP community,

I am an aspiring real estate investor yet to make my first investment and I wanted to get some thoughts on the two investments I am currently considering.  If my logic is terribly flawed please forgive me as I've been only looking into real-estate for two months.  I've been listening to Brandon and Josh at 1.5-2x speed commuting 4-5 hours a week (lol, it's true, people think I'm nuts when they hear me) and tackling a little bit of reading (as much as I can with a 20 month old and a 2 week old at home.)  

I am looking at turnkey rental properties vs performing note investing or hard money lending. A couple of assumptions. 1) I am looking at mostly passive for now as I have a 9-5 and a decent income. I would love to continue to learn and get into finding great deals, rehabbing and holding(BRRR) but my knowledge level and time keeps me from jumping in just yet. 2) I have a small business and a solo 401k, but for this discussion assume this is income outside of my 401k coming from after tax dollars and earnings will be taxed at applicable rate. 3.) My marginal tax rate is 33% and I am working off the fact that interest earnings will be taxed at this rate since it will be over and above my 9-5.

OK… Assume I have $100k in the bank

Scenario 1: $100k turnkey property in a "B" neighborhood getting $1000/month in rent. assuming 50% rule of expenses we are at $500 a month in NOI. This could either be with cash or 30k down (25% + closing costs). In cash scenario end up with cash on cash earnings of $6000/year or 6% return. In financed scenario with a $350 mortgage payment, we are at $1800/year, essentially also 6% and in theory i could get 3 properties instead of one. From my very limited understanding much of this income could be tax sheltered through depreciation of said property.

Scenario 2: $100k in either hard money lending (12% interest on investment property with 60% LTV , 3 years interest only with balloon payment at the end) OR in performing mortgage note (80% LTV, 100k note, 30 yr amortized with balloon due in 5 years, also 12% ROI )

The way I am seeing it, even if I get taxed at the 33% marginal rate the 12% turns into 8% after tax which beats out my 6% I am getting on real estate.  I know this doesn't account for amortization and appreciation long term, however I am cynical about counting on appreciation given the recent real estate bubble.

Please enlighten me.  Thanks in advance for the help.

Cheers and Happy New Year!

Danny

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Patrick Desjardins
Real Estate Investor · Amherst, VA · Member since 2015 · 386 posts · 400 votes
10y

There are a lot of components to your question. I like Gordon Moss' philosophy that real estate and notes complement each other.

It's not tax related but remember that note payments aren't adjusted for inflation. That means a $300payment now may be sweet but if they were to stay in their home long term, that $300 payment may be peanuts in 25 years. 

With rentals even if you can't count on appreciation it seems true nationwide that you can count on rent increases over that same period of time. In other words, rentals are a better protection against inflation than notes are.

You know how I'm personally solving this dilemma? I'm just buying notes and keeping REO as rental. Because of the discounts we get I don't need to be a genius landlord and we always have multiple exit strategies.

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  • Patrick Desjardins
    Real Estate Investor · Amherst, VA · Member since 2015 · 386 posts · 400 votes
    10y

    There are a lot of components to your question. I like Gordon Moss' philosophy that real estate and notes complement each other.

    It's not tax related but remember that note payments aren't adjusted for inflation. That means a $300payment now may be sweet but if they were to stay in their home long term, that $300 payment may be peanuts in 25 years. 

    With rentals even if you can't count on appreciation it seems true nationwide that you can count on rent increases over that same period of time. In other words, rentals are a better protection against inflation than notes are.

    You know how I'm personally solving this dilemma? I'm just buying notes and keeping REO as rental. Because of the discounts we get I don't need to be a genius landlord and we always have multiple exit strategies.

    3Reply
  • Daniel Torres
    OP
    Investor · Hollywood, FL · Member since 2015 · 18 posts · 10 votes
    10y

    Hey Patrick,

    Thanks for the advice.  Love the idea that rents tend to go up long term with inflation.  Definitely see the benefit to having both in a portfolio.  What type of notes are you investing in? 

    Thanks again!

    0Reply
  • Larry Fried
    Investor/RE Broker · Eugene, OR · Member since 2014 · 3k+ posts · 968 votes
    10y

    @Daniel Torres There are some assumptions in your comparisons that are naturally going to tip the balance toward notes.  The biggest of these is using the very general 50% expenses, which may or may not be true, depending on many factors.  A quality property in a decent area, done nicely that keeps tenants in place, and where taxes are reasonable is not likely to create that much expense.  In addition to tax benefits you also did not include principal pay down, if using leverage.  Even without depreciation this is increasing your equity very significantly over time.

    On the note side, I don't know where you are going to get a 30 year note at 12% and expect anyone to not refinance at a much lower rate closing out your note in relatively short time. I have done both lending (notes) and buy and hold investing, and I think notes are best for tax deferred retirement accounts like that solo 401k you mention. Just my 02 cents.

    2Reply
  • Rasheema Abduls-Salaam
    Real Estate Investor · Hilo, HI · Member since 2015 · 134 posts · 14 votes
    10y

    Great Scenario! Very valid questions. I am also comparing the similar options. Narrowing down my focus aka finding my niche. 

    Good Luck! 

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  • Matthew BrillPro Member
    Investor · Boca Raton, FL · Member since 2015 · 234 posts · 103 votes
    10y

    I recently met with an asset protection/estate planning lawyer (granted not a CPA but familiar with tax implications, and he also invests in RE). I asked him about his opinion on conventional loans utilizing 30 vs 15 year notes; being I have a substantial income and don't need cashflow now, going with 15 year note and getting more cashflow later (less interest/expenses to tax deduct) or go with the overall less cashflow in a 30 year note (more interest to tax deduct). I think his response is what applies to your situation: "Don't let the tax tail wag the investment dog." In other words, go with what you think is the better investment and don't let the tax implications  distract you. 

    Another thing to think about reading the lending; even though you won't be managing the actual real estate investment, you'll want to know that whom ever you are lending to has a good deal and will be able to make their payments to you. So you'll still need to be well enough versed in RE investing. Plus, in the event you have to foreclose you'll have to still have an out strategy for the property. You could look into  one of the crowdfunding RE sites to help counteract this. 

    Hope this helps. Best of luck!

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  • Ian IppolitoBusiness Member
    Investor · Tampa, FL · Member since 2015 · 1k+ posts · 1k+ votes
    10y

    I'm not a tax advisor, but I think your line of reasoning about the taxes is correct. I'm not sure the numbers you used are the complete picture, and plugging in some changes as suggested by others may affect the final number/conclusion. But the way you are thinking about the problem is correct. 

    Here are  a few more issues to consider that may affect your particular situation:

    1) Don't forget that in the scenario of the directly held real estate, there should also be some appreciation (increase in price of the property). This will depend on the neighborhood you buy in. But this can change the result of the equation considerably, and might tip the scales.

    2) Offsetting the above somewhat is that the "advantage" of deducting depreciation on directly held real estate is not a permanent advantage. It's not a free tax giveaway: when you sell the property, you have to pay back. So it's not correct to think of it as a tax savings. It's more of a tax deferment: postponing the need to pay taxes until the future.

     

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  • Daniel Torres
    OP
    Investor · Hollywood, FL · Member since 2015 · 18 posts · 10 votes
    10y

    Happy New Year all!   Thanks for all the great input.  Matthew you're the second person to advise me to understand RE well before venturing into note investing, I think that's great advice.  Ian, I like considering the depreciation as tax deferment.  Do you know if you do a 1031 down the line if you have to repay depreciation then or does it transfer to the next property?  Hope you all have a great day.

    0Reply
  • Daniel Torres
    OP
    Investor · Hollywood, FL · Member since 2015 · 18 posts · 10 votes
    10y

    Ian, just start reading some of the tutorials on your website, great stuff! Very big picture and easy to read.  Thanks for sharing

    0Reply
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    10y

    @Daniel Torres  I agree with the   " don't let tax tail wag the dog"  unless you have VERY SIGNIFICANT monies or abilities to buy multi million dollar type properties.  1031 generally works in HIGH appreciating markets or with properties one has owned for decades. you don't see much of it with lower end cash flow homes.. by lower end I mean anything at about 100k or under.

    the tax benefits at a few hundred grand in my mind are not even worth contemplating. I would much prefer write on's than write offs its about maximizing the return and spendable cash in my mind.

    If you want to try notes I would recommend finding a crowdfunding portal that allows both accredited and non accredited investors.. that way if your accredited you can partake and if your not you can also partake.. many of them are pretty much focusing on debt deals. IE loans of the short term nature.. you can many times invest as little as 5k.. and that would get you in the game with low exposure.. just do your home work make sure you like the asset and the company ...

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  • Ian IppolitoBusiness Member
    Investor · Tampa, FL · Member since 2015 · 1k+ posts · 1k+ votes
    10y

    @Daniel Torres, thanks so much. I was in the same situation as you, where I was trying to figure out what to invest in. So I took several months to do an in-depth investigation of all the sites, and when I was done I figured I would share it on the Internet. That's how the site got started. I'm glad it's useful to you.

    Yes, if you do a 1031 exchange then you get to defer both the capital gains and the depreciation recapture. So it can be used to extend the deferral to a longer period as possible. http://www.1031corp.com/exchanging-thoughts-blog/bid/90096/1031-Exchanges-Also-Defer-Depreciation-Recapture

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  • Ali Boone
    Real Estate Coach · Venice Beach, CA · Member since 2012 · 6k+ posts · 3k+ votes
    10y

    I wrote an article comparing the two options awhile ago...maybe it can help?

    https://www.biggerpockets.com/renewsblog/2015/01/2...

    1Reply
  • Don KonipolBusiness Member
    Investor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
    10y

    I don't believe it's necessarily an either/or option.  Jim Napier, an old time real estate and note guru (and one of the best) once told me to own notes for income and real property for appreciation and inflation protection.  In this low inflationary environment of the last 25 years it doesn't seem like much of a concern, but some of us elders do remember inflation at 14% per year with mortgage rates at 17%!

    If you are considering the INVESTMENT side of real estate - not the real estate BUSINESS - then here is the program I use.  I keep half my money in 12 month to 10 year trust deeds or mortgage notes - yielding an average of 16%.  Some were existing notes purchased at a discount, most were originated hard money loans, others were non performing restructured to become performing.  All are secured by commercial or multi family property. 

    The other half of my real estate portfolio is currently in high rise residential condos, small offices, and auto repair facilities, at an average of 50% debt leverage.  So theoretically having real estate valued at twice my notes (albeit leveraged 50%) makes my entire portfolio hedged 100% for inflation.  These properties net about 7% on an all cash basis, applying the leverage increases yield to about 9% cash on cash.

    So the overall yield on my holding of 50% notes 50% real property is 12.5% annually - not too bad with theoretical full inflation protection. I have not included in my analysis that I purchase properties only if they are available below market price or have an interesting kicker such as near term development prospects. I have found that well located commercial properties are very easy to manage, often tenants stay for 10 years or more! Further, I find high end condos much easier to manage than other residential rentals, since the condo association basically eliminates bad tenant behavior, and takes care of exterior maintenance. And I am willing to pay more in HOA dues (but save in not needing a property manager).

    The other important point that must be recognized is the difference between investing in real estate and being in the real estate business.  The line can get fuzzy in the middle; however some activities lend themselves easier to investment while others scream business.  If you are investing in notes a few hours a month, buying property managed for you, investing in syndicated deals, etc. you are investing.  If you are wholesaling houses, purchasing, rehabbing and selling properties, or self managing a portfolio of 200 rentals, you are in the rel estate business.  Knowing your goals will lead you to the right program.

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