Unless you keep all of your investments in IRAs or other qualified accounts, you will need to pay taxes on the gains you realize each year. With a trust deed investment, you must pay taxes on the interest that you are paid by the borrower. Many trust deed investors wonder if their investment income will be treated as a capital gain or as ordinary income tax. Before we answer that question, let’s discuss what constitutes a taxable gain in the investment world and explore the difference between ordinary income and capital gains.
Realized and Unrealized Gains
An investment can increase in value without triggering any tax consequences if the gain is not realized. For example, if you have invested in a property, and the property value increases but you do not sell it to extract the increased equity, then you have an unrealized gain.
But when you realize a gain by selling an investment for the increased value or received interest or dividends on the investment then you are triggering a taxable event.
Understanding Ordinary Income and Capital Gains
There are two ways that gains can be treated for tax purposes—as capital gains or as ordinary income. The sale of real estate or stock are examples of gains that could be treated as capital gains. Dividends from a sole proprietorship, gambling winnings, and rents are items considered ordinary income. The interest you are paid on a trust deed loan is also considered ordinary income.
In order to understand the difference, you must first understand the concept behind the words, capital gain. A gain made from the sale of a capital asset is a capital gain. Capital assets are comprised of things that are tangible—stocks because they have stock certificates and represent ownership of a company, real estate and automobiles are great examples.
The interest you receive each month from your borrower is considered a realized gain and is taxed as ordinary income tax. If the note is prepaid, then the prepayment and penalties are taxed as ordinary income, as is a note assignment. In a note sale, when the note is sold at a discount, it is treated as a capital loss.
What about Unrelated Business Income Tax (UBIT)?
If you have invested IRA funds into a trust deed investment, you may be concerned about UBIT, which is a tax that comes into play when you have a tax exempt entity creating an income from a business activity instead of permissible, passive investments. But since your IRA custodian serves as the lender, the income from the trust deed is not subject to UBIT. If you were to put your IRA up as collateral against a real estate loan, then the income derived might be considered UBIT.
As with all tax matters, it is best to discuss your questions with a CPA or tax attorney before filing your annual tax return. They can help you wade through the mire of tax code and determine how you should expect to be taxed for your investments and ensure that you are reporting all gains and income appropriately.