From a Tax Perspective, Is it Better to Invest in Notes or Rentals?

by | BiggerPockets.com

Choosing your preferred method of investing can be daunting. With so many investment vehicles available, investors often find themselves stressed out when deciding what to choose. A common question that I get time and time again is whether it is better to invest in notes or rentals. While both can generate a steady amount of income, they also have some unique upsides and downsides from a tax perspective. Let’s take a look.

Income & Expenses

Notes generate interest income that is taxed at your ordinary tax rate. They generally have very few expenses, and so as long as your payee keeps paying, it can often be a hassle-free investment. Not having expenses is great for your bottom line, but not as great when it comes to deductions for reducing taxable income. If you own a rental property, it may be reasonable to deduct some car, travel, and repair expenses. As a note investor, you generally will not have much in those types of expenses. After all, who drives every week to look at a property that is simply securing their note investment?

For those small expenses that you may have related to notes, they are usually considered “investment expenses.” These are not as ideal as rental expenses since they are generally taken as an itemized deduction and are subject to income threshold limitations. Therefore, unless you have a decent amount of these types of investment expenses, they may not provide you with any significant tax savings.

Related: It Gets Stranger: How Trump’s Tax Plan Impacts Homeowners & Real Estate Investors

When it comes to rental properties, net rental income is also taxed at the normal tax rate, but there are tons of expenses that you can use to lower your income. Besides legitimate car, travel, home office expenses, one of the best deductions that rentals offers is depreciation. Depreciation generates paper losses that can help lower taxes on your rental income. For example, if you have a $4,000 net rental profit and depreciation expense of $4,000, you get to pay zero taxes on your rental income for that year. This is true whether you pay cash or have leverage on the property. Whether you put a $10k payment down or a call cash payment to buy a $100k property, depreciation is calculated based on the purchase price of $100k in both scenarios. In other words, depreciation allows you to take a deduction on leveraged portions of your rental properties.

tax-changes

Losses on Investments

No one likes to think about losing money on an investment, but the reality is that it can happen from time to time. Just like many things in the tax world, losses are not treated equally from investment to investment.

With notes, it is possible that your borrower suddenly stops paying their note. With a rental property, longer term vacancy or a non-paying tenant can eat quickly into your bottom line.

Notes investments may have some limitations when it comes to taxes. Losses on notes are generally considered capital losses. The downside of this treatment is that capital losses generally only offset capital income. Any excess capital losses are limited to $3,000 per year, which can be used to offset other sources of income. Anything greater than that carries forward to the next year. Theoretically, if you had a $9k note investment that became uncollectible, it could take up to three years to use the losses if you had no other capital gains.

This does bring up a great planning opportunity. If you are going to have a $9k capital loss, then it may be a great time to sell stocks with large gains. That way, your $9k gain on stocks can be offset by this $9k note loss all in one year, instead of spreading out the loss over several years.

Rentals also have some limitations when it comes to losses. For example, if your income is less than $150k, you may be limited to a $25k loss per year to offset other non-rental income (i.e. W-2 income). If you make over $150k, then you generally cannot use rental losses to offset non-rental income at all. In situations where rental losses are limited, the excess losses are carried forward into future years and can be used to offset other passive income (such as rentals or investment K-1s) or when you sell the property.

These pitfalls can be avoided if you or your spouse can meet real estate professional status. If you qualify as a real estate professional, then current year losses are not limited, and you can generally take the full amount of losses to offset all types of income.

Tax Reporting

Note investments can be much easier to report on your taxes at the end of the year. Generally, you will just report interest income, except in the case of an uncollectible loan, which is a simple capital loss. Either way, it is fairly easy to report.

On the other hand, rentals need their own specific schedule for reporting and can be much more complex. If you hold your rentals in your personal name, you generally need to complete Schedule E for your taxes and also include depreciation schedules to calculate your annual depreciation. If you purchase or sell a property, you may need to figure out your basis, selling costs, and accumulated depreciation to know your gain or loss on the property. Since rentals can be much harder to report, many investors turn to a CPA or tax preparer to do their returns.

IRA Investing

If you are investing with a retirement account such as a self-directed IRA, notes can be one of the easiest investments.

Related: What Investors Should Know About Qualifying As a “Real Estate Professional” For Tax Purposes

Since there are few expenses, they make for a very low maintenance investment. As a lender on a property, you generally would not be involved in fixing toilets or broken windows, so this helps to ensure that you do not stumble into a prohibited transaction within your retirement account. Since interest income is generally tax-free or tax-deferred within the retirement account, tax returns for the retirement account are typically not required for note investments.

Rentals, on the other hand, can be a little trickier. If the property is purchased with all cash, then your retirement account generally would not be required to file a tax return. However, if you leverage the property, then you may need to file returns each year if taxes are due on the leveraged portion of the income. For example, if your IRA financed 50% of a property and made $10k of taxable income, then $5k of that income may be subject to Unrelated Debt Financing Taxes. This may be avoided if you make your leveraged investment out of a 401K instead of an IRA.

Another drawback for rentals in an IRA is that everything must be paid out of the IRA account. This includes all closing costs, mortgage interest, taxes, repairs, and all other expenses. Personal funds cannot be used for anything related to the rentals owned within the retirement account. Therefore, you need to make sure that you have enough funds in your retirement account to pay for all rental-related expenses. Otherwise, those expenses will need to be paid with your annual contributions into the retirement account.

Conclusion

So, which one is better? It depends what kind of investor you are. If you want big returns and don’t mind the stress involved with upkeep and higher risk, then rentals may be up your alley. However, if you are OK with smaller returns for less involvement and risk, then notes may be more ideal for you. Tax-wise, if you are investing personally or through an LLC, rentals make more sense due to their unique depreciation deduction and capital gains. If you are investing with an IRA, then notes may be better tax-wise. Remember, though, that it is important to make decisions based on all aspects of your financial situation: cost, risk-appetite, time, etc. Whatever you choose, make sure it makes sense for you, your lifestyle, and your finances.

Investors: Which do you prefer and why?

Leave your questions and comments below!

About Author

Amanda Han

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

18 Comments

  1. I respectfully suggest consideration of an exit strategy including a IRS 721 exchange or a IRS 1031 deferral of
    taxes plan is important specially if your planning to invest in any multi-family assets from duplexes to multi-plexes.

  2. Cindy Larsen

    Great post as usual. Thanks Amanda.

    My personal preference is investing in small multifamily (1-4) units real estate, mostly because I understand it well, and can mitigate the risks by informed decisions I make myself (well researched tenants, for example). Also leveraging small multifamily is more profitable than commercial apartment buildings (whic means anything with more than 4 units)
    Small multifamily: lower insterst rates, 80-95% LTV, 30 year term
    Multifamily: higher interest rates, 60 – 70% LTV, 25 year term

    I looked into notes, and may invest in some of the crowdfunded notes from my Roth IRA at some point, but, not only do notes have lower ROI than real estate, but, I find notes risky because,
    1) you are depending on someone elses assessment that the borrower will not default. WIth a renter, It is my assessment.
    2) the costs of foreclosing on a defaulted note can be as high as 25% of the outstanding principal (can’t remember where I read that, but I found it scary)
    3) The foreclosure process takes many months, during which you are earning 0% on your principle invested
    4) After you succeed in foreclosing, you are likely to be in possession of a house that has not been well maintained and/or has been trashed. So there are more costs involved in getting the property ready for sale, before you get your principle back. And, it is unlikely to be located near you. And, while you are getting it fixed up, you are getting 0% return on your principle, and incurring additional costs such as property taxes.
    5) There is complicated law stuff about the borrower who defaulted possibly getting some equity back when you sell the place. There was something I read about tax liens getting paid before the first mortgage. I obviously need to do more research.
    6) There are more issues that I haven’t researched yet.

    Notes seem to be a good investment, as long as the borrower keeps paying. But, bad stuff in life happens to even well intentioned people with good jobs and good credit ratings who qualify for loans.
    If that person is a tenant in one of my rentals, the downside is late payments, and possible eviction. Well understood, short term, relatively small costs. If it is the borrower on my note, the downside seems much worse: a much longer term, much more expensive nightmare.

    CJ

  3. Dave Van Horn

    Great article Amanda!

    As someone who has done a lot of investing in notes and rentals for years, I think you made a lot of great points about weighing the tax advantages/disadvantages. But I also should say that after all these years, I still haven’t figured out which one is actually “better”. And that’s probably because it varies so dramatically with each deal, plus with notes it’s a little different since you don’t know your true ROI until you exit – which could be years after purchasing (not to mention, you don’t know if you’ll end up owning the property after all is said and done either). Overall though, I think there are some note investments that are certainly better than rentals I own, and there are definitely certain rentals i have that are better than many notes available.

    I think one thing to add is the value of aggravation level that comes with each investment. Speaking from experience, personally managing 100+ re-performing notes has without a doubt much much easier than managing even under 50 properties.

    You’re right with the lack of deductions owning notes as an investor, but I think that changes once you have a note “business”. Then, you do get a lot of write offs. Plus with 1st liens, you tend to end up with a lot of properties anyway so then you’re right back to owning hard Real Estate again with all it’s tax advantages.

    But what it comes down to is, are the tax breaks worth the aggravation? For me, as a Realtor (with unlimited passive losses), I’ve managed to reach an acceptable amount of hard property that enables me to have the necessary deductions while working in a much more passive and relaxed space as a note investor.

    Best,
    Dave

    P.S.
    Look forward to hearing you speak at the SF Bay Summit in October!

    • Amanda Han

      Thank you so much for your comment Dave! You are exactly right in that for many investors note investing is actually a business and would allow for similar types of tax deduction and benefits as would a rental property investor. Look forward to seeing you in San Francisco as well.

  4. Aaron Norris

    What is the taxable rate inside the IRA for the UDFI? Is it your personal rate or is it different inside an IRA? AND…who decides land vs structure calc for depreciation purposes. I’ve been hearing rumors of late I can make up whatever I want. I have a feeling the tax collector might have a different take on that. 😉

    • Dmitriy Fomichenko

      Aaron, UDFI is Unrelated Debt Financed Income so if the IRA has such income it will be taxed at the UBIT (Unrelated Business Income Tax) rate. There is a sliding scale on how the income is taxed but it tops at 39.6% after you reach $12,400 of income.

    • Amanda Han

      The current udfi tax rate for the IRA is 39.6% at the highest level. It is essentially the trust tax rates each year and not the individual tax rate. For basis calculation of land versus building for depreciation purposes the most commonly used allocation would be based on either property taxes or the IRS will also sometimes except appraisals. Thank you for your question Aaron !

  5. Kendehl Rojanasthien

    Great article! I’m curious about this statement: “If you qualify as a real estate professional, then current year losses are not limited, and you can generally take the full amount of losses to offset all types of income.” What qualifies as a real estate professional? Is there a resource I can look at that specifically defines that?

    • John Murray

      @ KENDEHL ROJANASTHIEN The IRS has a definition of what is a real estate professional is. The easiest way to explain what is not a real estate professional. “The taxpayer may elect to aggregate all of his or her interests in rental real estate for purposes of determining material participation.” To put simply combine all rental activity into one activity and you are an investor. Other than that you are a non-passive real estate professional and pay more taxes. Kinda of no brainer.

    • Amanda Han

      Thank you for your question candle. From a high-level perspective real estate professional can be defined by the IRS as someone who is actively involved in their rental real estate activities in which they are spending at least 750 hours per year and also spending more time in real estate then they do at their other jobs or income activities combined.

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