Note investing vs turnkey rental properties - Tax perspectives

[Daniel Torres]

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

[Patrick Desjardins]

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.