Private Lending -vs- Equity Investments
I’ll define Equity Investments here as investing in a partnership. This might include going 50/50 on a fix & flip or investing passively in my Self Storage Development in Lawrenceville, GA. Private lending is when you lend money in the form of fixed debt-usually using a Note & Mortgage. I personally allocate about 70% to Equity Investments and 30% into Debt Investments as a Private Lender.
These two investments come with very different Risks, Rewards, & Tax Implications. I’m not giving tax or investment advice here-just sharing from my own experience. Please note-the structure of Debt & Equity investments can be very nuanced and anyone considering any investments should seek proper legal council before doing so.
Private Lending / Debt Risk:
- Secured by the Property: If the Borrower cannot complete the project and pay you back, you could become the owner of the property you’re lending on. If the loan is well below the actual value of the property, this might be a good thing.
- Borrower Risk: Does the operator with whom you’re investing have more cash available to cover your interest & guarantee your principal-even if they lose money on the deal you’re lending on?
- Construction Risk: The more construction being completed on a project, the greater the risk of cost overruns & delays. Back to the Borrower risk-do they have enough cash reserves to cover unforeseen issues like this? I personally never go back to my lender for cost overruns. It is always paid out of pocket.
- Market Risk: If the market for the property you’re lending on declines, will the Borrower have enough cash to return your principal? And Interest?
Private Lending / Debt Reward:
- Defined Reward: I pay my lenders 2 points & 10% interest, no matter what. We lost $150,000 on a single deal and our lender made about $80,000. His reward was defined & his selection of Borrower (Diamond Equity) was ideal because we had plenty of cash to cover that shortfall.
- Principle Protection: When I borrow money from my Private Lenders, I am agreeing to pay their entire principle & interest back, no matter what. I’m contractually obligated to do so-which is the defined principle protection, in writing, which are expected on Debt Investments
Private Lending / Debt Tax Structure:
- Short Term Capital Gains: Debt is normally taxed as short term capital gains, or ordinary income
Equity Investment Risk:
- Principle Risk: In Equity Investments, or Limited Partnerships, your principle is NOT guaranteed to be returned. No matter how much cash the operator may have outside of the deal you’re investing in, they are not agreeing, or obligated to pay back the full amount you invest. If the deal fails, you may lose some, or all of your investment.
Equity Investment Reward:
- Contingent Upon the Outcome of the Deal: If the deal succeeds, Equity Investors participate in that upside. If the deal breaks even, Equity Investors receive their money back, with no interest. If the deal fails, Equity Investors lose some, or all of their money. That last outcome isn’t really an Equity Investment Reward, I guess…
Equity Investment Tax Structure:
- Long Term Capital Gains: Right now, the US Tax rate for Long Term Capital Gains is 20% for those in the highest tax bracket. Short Term Capital gains are 37%.
- Depreciation: Many Equity Investments come with tax losses, such as depreciation, which help minimize tax bills. You can listen to this podcast for more detail on this tax benefit.
The Right Time & Place for Each type
Equity Investments that I currently own were made for these reasons: first, the tax efficiency of the gain. I’m making good money now and have heavy taxes to pay. Making Equity Investments that will distribute profits later as Long Term Capital Gains help me maximize the money I’m left with after taxes. Second-the expected greater return. I’m aiming for 20%+ returns in all of my partnerships.
As mentioned, I’m about 70% in Equity Investments right now. This is a lot of risk. Since I’m not yet near retirement age, this risk is acceptable to me right now in search of greater reward-and a more efficient tax structure.
As time goes on, I’m intentionally moving more toward Debt Investments. Defined risk & defined reward are more desirable long term-as you are better insulated from market swings. Of course this assumes you’re lending to a well capitalized, high quality Deal Maker. If you’d like to view my projects which are available to lend, please sign up at www.FundRehabDeals.com