The Problem (and solution)With Private Lending
Private Lending. If you’ve followed me for more than a few months you know this is my favorite way to generate passive income. I get to invest in real estate without any of the downsides. I am not a landlord. I don’t have to fix anything. Rent moratoriums cannot effect me. I’m not tied down to an area because I own property there. Literally all I do is collect my interest check everything month and if they fail to pay, foreclose. It’s a lot less work and it is what I have used to scale my wealth and build my own personal financial freedom.
As I stated, it comes with none of the downsides of owning real estate. But does it have all of the upsides? And what are its downsides itself?
I’m going to describe those to you here.
What are the upsides of owning good income producing real estate? Well for one there is cash flow. There is appreciation. There are tax benefits such as deductions and depreciation. There are tax deferred exchanges. Does private lending naturally offer all of the same benefits? The short answer, is no.
But let’s take a look at each one.
Cash flow. Private lending does offer cash flow and in my opinion it does it better than real estate can. Why? Because I can get an 8–12% yield on my private lending deals and it is 100% passive. With most real estate, I may see similar yields and maybe even higher than 8–12%, but it is usually not passive meaning a larger amount of my time will be traded for the real estate cash flow. Which defeats the point for me.
Appreciation. This is when the price of a property I own increases over time. This is something I actually cannot achieve with Private Lending in and of itself. You see, when I loan someone $100,000, they are going to pay me interest of 8–12% on that $100,000 over our agreed upon length of time. But the $100,000 of principal does not appreciate or go up in value. At the end of the loan they will return my $100,000 back to me and not more than that. This can be a downside, however I have a solution that I believe is better than real estate appreciation.
It is called a Collateralized Asset. So let’s rewind to the part about me loaning $100,000 to someone. Prior to me doing that I am going to put roughly $130,000 in either life insurance, gold, or residential real estate/land. I now own one of these three assets. I will then take a collateral line of credit against the life insurance, gold, or property for $100,000 and then continue on with my loan. What did I just do here? Well my $100,000 is yielding me 8–12% as we discussed. However the $130,000 is growing at 3–5% annually and tax free in life insurance, 8–10% annually and tax free in gold, or 3–5% annually and tax free in a property. I’ve just created the same exact appreciation mechanism that real estate offers, but again with less hassle.
Deductions & Depreciation. Without getting into the weeds too much, with real estate I can write off the depreciation of a property as well as deduct certain management, operating, and interest expenses. With private lending, in and of itself I cannot. But here’s why.
With Private Lending there is no management. So there is no deduction, but there is also no cost.
With Private Lending there are no operating costs. So again, there is no deduction, but there is also no cost.
With Private Lending, there is no interest expense. Again, no deduction because no cost.
There may be small little fees like a $150 annual escrow fee or a small account fee with the bank, etc. but these are fairly minor.
So how do I get tax benefits with Private Lending? First, if we go back to my earlier point about Collateralized Assets we can borrow against these assets to then do private lending. There is interest when we borrow (usually 1–3% cost to borrow) and this interest can be deducted against our private lending income as an expense.
Outside of that, there are a myriad of ways to setup different entities and structures around our Private Lending deals to reduce taxes. They are “add ons” and while they may not come innately within the Private Lending deal like they may with real estate, they effectively achieve many of the same outcomes. I’m a great example of this. I own no real estate and only do Private Lending deals and I still pay little to no taxes.
Tax Deferred Exchanges. In real estate, this is when I buy a property, it goes up in price, and instead of selling it and paying taxes on my gains I choose to “trade” it for another similar property and defer the taxes on the property being exchanged. I cannot do this with private lending. But mostly because there is no need to.
As we discussed earlier, when I do a Private Lending deal, the principal amount I am lending does not appreciate. Meaning when it is returned to me at the end of a deal, it is considered a return of my principal which is a non-taxable event.
Now, if we take a look at the Collateral Asset strategy, these are also not taxable. A loan against an appreciating asset is not a taxable event and so there is no need to defer any taxes here either.
So while a 1031 exchange in real estate may be a great deal, it is merely an answer to a problem that is caused uniquely to owning real estate in this scenario and does not exist as a problem (therefore not needing a solution) in the private lending world.
As you can see, there are some similarities with Private Lending and Real Estate, but also some major differences. They are definitely not the same animal and so any comparison made will really accentuate the differences more than show similarity.
I like Private Lending better because it is simpler, cleaner, more passive, and either directly or indirectly (through some of the points mentioned above) can offer me all of the same benefits as real estate (where needed) with none of the headache of owning real estate.
Now, I would be dismayed if I didn’t cover the 1 major and unique risk to private lending.
Default Risk. What if I loan money out on a deal and they don’t pay me as agreed? In real estate this would be the equivalent of a tenant not paying rent. Well in real estate there is a long legal proceeding called eviction and you’ll go through that process to remove the tenant and possibly collect damages from the tenant.
In Private Lending we don’ evict, we foreclose. Meaning when we setup a deal we are looking at 3 things.
- Collateral. What is the value of the asset that I am lending for? I want to 50–70% loan to value ratio so that if my borrower defaults, I still stand to double my money.
- Cash flow. What are the earnings of the fund/borrower/property I am lending to and can they reasonably cover my interest payments with that cash flow.
- Credit-worthiness. What is the track record of my borrower? I don’t loan to anyone who does not have a 5 year or greater track record of profitable investing, paying on time, and return the lender’s money on time.
But in addition to these I want the see the borrower is registered with the SEC, legally compliant, and also I am going to write into my loan agreement the conditions of foreclosure so that they are undisputable and also write into my loan agreement that in a foreclosure event, the borrower will be covering all of my legal expenses. And then I’m going to make them sign it and I’m going to fully enforce it if need be.
Look, risk exists in any investment. It exists even in your savings account at the bank. It’s not about having no risk. It’s about being educated on those risks and setting up strategies to handle them if they ever become realized risks.
The biggest way to protect yourself against Default Risk? Be very intentional with who you are lending your money to and what you loan it out for. I don’t lend to just anyone and neither do my clients. I have a handful of registered, legally compliant, and personally vetted Private Lending Funds that I personally invest with and also connect my clients with because that gets rid of 80% of the risk just due to the fact that we already know the borrower checks off all of the boxes.
In summary, invest the way you see fit, but if you’re not financially free yet it should ONLY be for Passive Income so that you can achieve PI > S+E+T (Passive income greater than savings, expenses, and taxes). And in my personal experience there is no better way to do that than through Private Lending.
If you’d like to learn more about how I loan money out as the bank, grab a free copy of my book How To Create Wealth (click here).
To Purpose, Wealth, and Freedom.
Jerry Fetta is the CEO and Founder of Wealth DynamX. He is a nationally recognized financial expert featured in Forbes, Yahoo Finance, Fox, Chicago Weekly News, New York Finance, interviewed on over 45 podcasts with world renowned experts, earning endorsements and affiliations throughout his career with names like Grant Cardone, Dave Ramsey, and Pamela Yellen.
Jerry’s mission in life is to help create millions of financially educated and solvent families achieving greater financial freedom and sharing the truth about money with those around them.
Learn more at www.WealthDynamX.com