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