Active vs. Passive Income from Tax Perspective

Active vs. Passive Income from Tax Perspective

Imagine the following scenario:

You’re a high-powered CEO burning both ends of the candle to the tune of 60-70 hours a week.

You’ve reached the pinnacle of your achievements.

You were Valedictorian of your high school, graduated Magna Cum Laude at your university, and paid your dues on Wall Street while completing your Executive MBA at Columbia.

You graduated near the top of your class at and went right to work for an up-and-coming corporation in your home state.

You climbed the corporate ladder and made it to the top.

You and your family have it made – a big house, nice cars, country club membership, private school education, a couple of vacations a year.

That’s you.

Then there’s your neighbor:

He lives in the same neighborhood, drives nicer cars, belongs to the same country club, your kids go to the same schools, but his family seems to be on vacation at least six times a year. He doesn’t seem to go to an office and seems to spend a lot of time golfing, mountain biking, and working on his garden.

What does this guy do?

The curiosity is killing you. So you decide to make small talk one Saturday morning while you’re both outside talking to your landscapers.

You talk about your families, your backgrounds, yadi yadi yada. It turns out, he never went to grad school and has not punched a clock in ten years. He says he does a lot of passive investing – private equity, start-ups, private commercial real estate.

You and your neighbors seem to be about the same age, but he seems to have a lot of energy. “That’s because he’s not busting his butt like I am,” you think to yourself.

You take particular pride in the fact that you’re toiling for your money and resent your neighbor for the “easy life.”

BUT HERE’S THE KICKER. IF YOU KNEW WHAT YOUR PASSIVE INVESTING NEIGHBOR WAS PAYING IN TAXES, YOU WOULD BE EVEN MORE UPSET!

The tax code is stacked against workers and wage earners – from the building engineers to the CEO. It may not seem fair, especially when you consider your passive investing neighbor is paying taxes at a lower tax rate than a married couple making $80,251 a year in wages.

So, while you’re working hard for your money, your neighbor’s money is working hard for him 24-7. His money doesn’t sleep, and it doesn’t go home when the lights go out in the office.

On top of that, the IRS is rewarding him with a lower tax rate.

Why is that?

That’s because while your active income (i.e., earned income) is taxed at ordinary rates, his passive income is taxed at capital gains rates.

While the top capital gains rate is 20%, the top tax bracket for earners is 37%.

Here is the latest tax table for the 2019 tax year:

You can either get mad at the tax code for rewarding passive investors or you can take advantage of a system that rewards entrepreneurship and risk.

Here is a breakdown of the tax benefits of passive investing:

Lower Tax Rate
Passive investments that are set up as partnerships (whether as LPs or LLCs) are designed to maximize tax benefits.

Profits distributed to the members are taxed at the individual levels at the capital gains rate. Profit distributions on partnership interests held a year or less are taxed at the short-term capital gains rate, which is the same as the ordinary rate. Interests held longer than a year are taxed at the long-term capital gains rate, which tops out at 20%.

Since most passive investments don’t distribute until after a full year of operations, the one year hurdle for qualifying for the long-term capital gains rate is a minor inconvenience.

So let’s compare the CEO who earns $500,000 a year in wages and the passive investor who makes $500,000 a year in passive income:

THE PASSIVE INVESTOR SAVES $75,000 A YEAR IN TAXES OVER THE ACTIVE INCOME EARNER ON INCOME OF $500,000.

No FICA
The tax savings don’t stop there. In addition to the lower tax rate, the passive investor is also not subject to FICA (Social Security and Medicare) taxes.

That’s a savings of 7.65% on that income.

Sale or Redemption of Partnership Interest
When the passive investor sells his partnership interest or is cashed out, his gains are taxed at the long-term capital gains rate.

Additional Deductions
Passive investments in commercial real estate offer additional tax benefits in the form of distributable pass-through depreciation deductions that can be used to offset ordinary income, including the following:

  • Regular Depreciation. Regular depreciation deductions allow investors a business deduction for the cost of items that have a “shelf life” like a building. The typical depreciable period is 27.5 years.
  • For example, if the cost basis of a multi-family property (the building only and not including the land or improvements) is valued at $1,000,000, the annual depreciation deduction allowed over 27.5 years would be approximately $36,400. In a passive investment, this depreciation would be distributed pro-rata to all the partners.
  • Bonus Depreciation.  In addition to regular depreciation, the bonus depreciation allows for a deduction of 100% (increased from 50% to 100% with the Tax Reform) of items with a shelf life of 20 years or less. This bonus depreciation is geared towards commercial building improvements.

The Retirement Account Kicker
Because Self-Directed IRAs allow for investments in alternative assets like private equity, venture capital, and private commercial real estate investments, tax strategies involving incorporating passive investments along with the right IRA structure can reduce tax liabilities even further.

Consider the benefits of investing with a Self-Directed Roth IRA. With a Self-Directed Roth IRA, if you are under the age of 50, you can contribute up to $6,000 per year into an IRA and an additional $1,000 if you are 50 or older.

Because you contribute to a Self-Directed Roth IRA with post-tax dollars, your investments will grow tax-free.

Investing in Passive Investments with Self-Directed Roth IRA funds can reduce your overall tax liability significantly.

Most of us weren’t born with silver spoons in our mouths, and all likely started as professionals or in the corporate world trading time for money.

Unfortunately, there is only so much time in the day, so earned income is limited – even for high-level executives and athletes.

On the bright side, although taxed at higher tax rates, earned income is necessary for most of us to make the transition to a more tax-friendly passive income.

The transition will require saving the earned income to allocate to passive income investments.

This is where the tax savings will allow you to amass wealth much quicker than sticking your excess earned income into a savings account, CD, or money market account that are all taxed at ordinary income rates.

DON’T RESENT PASSIVE INCOME INVESTORS, ADOPT THEIR TAX STRATEGIES THROUGH PASSIVE INVESTMENTS ON THE PATH TO WEALTH.

John

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John Turley

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