One of the many things we didn’t understand when we were getting started in passive real estate investing was the difference between investing on the debt side or the equity side of the deal.
Whether you’ve already invested in a multifamily deal OR are just thinking about getting started, you’ll need to understand the difference AND pick the one that fits YOUR needs and strategy.
Here are some of the differences between debt-side and equity-side investing: (Disclaimer – I’m not a CPA and everyone’s tax situation is different. These are general principles and common scenarios, but multifamily deals can be set up in many different ways and the tax implications can vary from investor to investor.)
- Equity-side investing means you are a partial owner of the deal. As such, you’ll get a portion of the cash flow, a portion of the gain on sale, and a portion of the tax benefit (depreciation).
- Debt-side investing means you are essentially a private bank to the deal. You’re “investment” is like a loan to the deal and your cash flow is essentially an “interest” payment.
- Because equity-side investors get to participate in the gain on sale and depreciation, their annual cash flow will typically be lower than that of debt-side investors.
- Debt-side investors get a higher and more dependable annual cash flow, but they don’t typically get any upside on the deal and they don’t get any part of the depreciation to decrease their tax liability.
- Equity investors get a K1 at the end of the year that delineates both their deprecation amount and their annual gains (cash flow + gain on sale).
- Debt side investors typically get a 1099-INT at the end of the year that delineates how much “interest” they were paid.
- Equity investors can shield much of their passive income from taxes by utilizing depreciation from the deal. If they DO have to pay tax on any of their passive income, it will be at a capital gains rate (which is typically much lower than their earned-income tax rate).
- Debt-side investors will have to pay earned-income tax rates on the cash flow (interest) they are paid and typically can’t shield any of the income from the taxes.
- Debt-side investors are typically second in the “capital stack” (behind the bank) whereas equity-side investors are usually third in line (assuming there are both debt and equity positions in the deal). This means that under normal circumstances, the debt-side investors can count on regular cash flow at a predetermined amount. Equity-side investors are more likely to see pauses or dips in their cash flow during economic downturns or unexpected pandemics!
There’s really not a right or wrong answer as to which side you invest on. It depends on your strategy and whether or not you need dependable cash flow at the moment.
Most of our deals have only offered equity positions, but a few have offered both options. We’ve had several investors choose the debt side in order to replace some of their income and slow down the number of hours they have to work at their W2 job. Most others choose the equity side so that they can more quickly grow their net worth (by participating in the gain on sale AND by reducing their tax payment with depreciation).
Both positions have their advantages. We just want to make sure that everyone understands what they’re getting into with they choose a side! While higher cash flow is great with debt-side investing, you’ll have to pay taxes on the income and you won’t get any benefit from the gain on sale.