Note Investing: Passive Income & Taxes

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In another thread, @Chris Seveny and @Tracy Z. Rewey mentioned that investing for passive income in notes (performing notes/monthly cash flow) isn't great from a tax perspective, and you should use that in a tax deferred vehicle.

Personally, this is exactly my plan.  Grow my performing note portfolio to generate enough passive income to live off of.  In theory, it would be the only income (probably not in reality, as I love notes, but beach living and tiny umbrella drinks is potentially the life for me).

So how does one avoid losing too much of a return to the tax man?  Or do you just suck it up knowing that you're doing it for the cash flow and just add that to your calculation of how much passive income you need.

Interested in hearing people's strategies.  I'm not an accountant, but maybe buying everything through an s-corp and taking a salary?


@Alecia Bolton - I do the majority of my note transactions in my SDIRA for this exact purpose.  I have a full time job and pay what I consider to be a lot of taxes from my W2 income.  

If you have traditional rentals where depreciation (as April points out), etc could help offset the note interest income, that would be an idea to explore; however most note investors get into this area to avoid dealing with the tasks associated with traditional rentals.

There are pros and cons to doing S-corps as with anything and it will depend on your personal situation if it makes sense to do.  My input would be to talk with a CPA that is knowledgeable in the area of real estate. 

@Alecia Bolton Note investing IS tax advantaged to a small degree. Interest income is not subject to Social Security/ Medicare tax. If it was earned self employment income you would be taxed at 14% not including any income tax that might be due.

A way to save more tax is through a self directed retirement plan. A self directed IRA is one, but not the only option.

The S corp (or an LLC taxed as an S Corp) will not help you in this situation. The idea of an S corp is to convert some of you earned income to dividend income to save on Self employment tax (social security). Since interest income is not subject to Self Employment Tax income there is not advantage.

As always check with your legal and accounting professional.

@Alecia Bolton You know I love notes in SD IRAS! Also love the Self Directed HSA if you have a high deductible health insurance plan. At one of the Self Directed IRA events a colleague suggested I read this book:

The Power of Zero, Revised and Updated: How to Get to the 0% Tax Bracket and Transform Your Retirement by David McKnight. 

It is a very powerful concept.

We also do notes through our S corp and take a modest salary that meets the requirements and write off all allowable expenses.  If I am earning fee income rather than long term interest income I prefer to do those deals through the S corp.

These can be concepts to get the conversation going with your tax advisor.

P.S. Save me a beach chair and a drink with a tiny umbrella.  With Wifi and a laptop we can do notes from there!


@April Banda

Great question, not a CPA or accountant but in my business I know my book keeper keeps rentals different from notes and I think they are treated different for tax purposes on how / what form they go on.

Overall I recommend a diverse portfolio to include rentals and notes. As mentioned notes have a lot more benefit in a SDIRA versus rental since you do not get the advantages of depreciation. Like others mentioned, this is not a one size fits all and each persons situation is vastly different which is why its great to hear what people say but truth is do not take this advice and run with it. Review it with your CPA and ask the questions is best course of action as they know your situation better than someone posting on BP

I've been buying distressed and performing notes using Roth Solo 401K. All profit is tax free. The soloK is a great way to build up retirement income in tandem with transactions outside of your IRA. Uploaded is a general diagram of my cash flow where the lower half is tax free income and upper half is taxable. I transfer $26K/year of active income from some of my LLCs to add more funds to my soloK to invest in notes, JVs, lending and Bitcoin.

Yes, my "employee contribution" into the solo 401k is maxed out at the limit of 26,000 per year. Realize too, that this has to be from active income such as consulting, so passive income such as rental income cannot be used. This is why I have my first LLC on the upper left corner as the active income "bucket" which collects fee and come from the other LLCs and then I just do a contribution every month into my solo 401k.

@ Bob Malecki you realize you can charge a management fee to rentals right? Also you can make employer contributions if you have net profits from your business above and beyond the 26k you are contributing.