How Is Passive Income Taxed? 7 Things You Should Know About Taxes & Investing

how is passive income taxed

How Is Passive Income Taxed?

If you’re an avid reader of the Debt Free Dr site, then you know how much I stress the importance of creating multiple streams of passive income.

Related article: Passive vs Nonpassive Income: Which is best?

If you want to work until you physically can’t work anymore, then you don’t need to worry about creating passive income. Instead, do what most of us do (including myself up until a few years ago) and only have active or earned income coming in.

This will virtually guarantee that you won’t reach financial freedom early in your career.

If financial independence is important to you, then pay attention to what I’m going to tell you today.

Passive income is so important that it’s something that I even stress to my teenagers. They get that trading time for money is a JOB.

They also know that the MORE money they make, the MORE people they can help.

If you want to retire early, work on your own terms and help people along the way then passive income is going to be an important aspect of your financial goals.

Passive Income

Investopedia defines passive income as:

Earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not actively involved.

In a nutshell, passive income is what you stand to make from an activity in which you’re not actively involved in.

When I first started learning about passive income, it seemed that rental property was one of the more popular sources as it pays in cash flow.

Now, if you’re an active real estate investor, unless you have someone to help with management, repairs and marketing the vacancies, then you’re going to have to put in some work.

This income would be considered active and not passive.

While most investors will look into real estate investing for cash flow and passive income, it’s important to note that the benefits they have extend far beyond that of the capital they bring in.

Yes, the extra income is great but don’t forget about the tax benefits they bring to the table.

The tax benefits associated with a property spinning off passive income can very well be the most attractive part of the asset.

Let me ask you a question.

Wouldn’t it be nice to get paid while NOT being actively involved?

As someone that’s practices solo, this sounds quite appealing.

What’s really nice is that each time I passively invest in a real estate syndication, another deposit hits my account each month.

Mailbox money is great!

Here’s a quote that I’ve once heard about passive income:

“Passive income isn’t you working for money; instead it’s your money working for you.”

This in turn frees up our time so we can do all of the things that we want to do when not working.

Which leads me to something else I’ve heard about time and money:

Rich people buy time, while everyone else sells it.”

What About Taxes?

As a doctor or other high-income earner, you probably get a LARGE tax bill each year from Uncle Sam.

I get that we have to pay our fair share but too many of us don’t put together a strategy to lower their overall tax bill. And that’s too bad.

In a previous article, we highlighted 5 ways that you can lower your tax bill by:

Before you focus on creating passive income, make sure that you’re doing some or all of the above to lower your taxes from your active income.

How Is Passive Income Taxed?

Before we discuss taxes, let me say that I’m NOT an accountant nor do I play one on TV.

I’d advise you to speak with your CPA for any individual questions you may have or you can consult with my personal accountant, Rodney Boswell, at Waskom and Brown.

Now that we’ve gotten that out of the way, here are:

7 Things You Should Know About Taxes and Passive Real Estate Investing:

#1 – The tax code favors real estate investors.

As someone that’s studied what it takes to become a millionaire, I’ve come to realize that MORE have achieved their status through investing in real estate than through any other path.

And believe it or not, the tax code plays a big role in that.

The government realizes how important it is to have a roof over your head and how important real estate investing is.

Because of this, the tax code is written in such a way that it rewards real estate investors for:

  • investing in real estate
  • maintaining those units
  • making upgrades over time

#2 – Passive investors get all the tax benefits an active investor gets.

For me, this was a MAJOR reason I elected to become a passive real estate investor. So even though you’re not performing landlord duties (fixing toilets or leaky roofs), you continue to get full tax benefits, whether you’re an active or passive investor.

Why? Because as a passive investor in a real estate syndication, you invest in an entity (typically an LLC ) that owns the property.

And that entity is disregarded in the eyes of the IRS (sometimes called “pass-through entities”).

It’s just what it sounds like… tax benefits pass or flow through that entity to you (the investor).

Sometimes people get confused whenever they invest in a REIT, or real estate investment trust, when it comes to tax benefits. Occasionally they assume that they should get the same tax benefits as a passive or active investor, but that’s not the case.

With a REIT, you’re investing in a company, not directly in the underlying real estate, and hence you don’t get the same tax benefits.

Some of the common tax benefits you can obtain from investing in real estate include:

  • writing off expenses related to the property such as
    • repairs
    • utilities
    • payroll
    • interest
  • being able to write off the value of the property over time – AKA depreciation

Speaking of depreciation, let’s take a closer look at this powerful tool.

#3 – Depreciation is powerful.

I’ve heard it once said that depreciation is one of the most powerful wealth building tools in real estate.

It lets you write off the value of an asset over time. How? It’s based on the wear and tear and the useful life of an asset.

What is depreciation?

One of the best ways to describe depreciation is to use something that most of us own, a computer. Let’s say you recently purchased a new top of the line computer.

As you know, overtime, it’s starts to show its age. Usually it slows down due to overloading the processor with tasks and memory. Sometimes the keyboard starts to stick and the monitor goes out.

Eventually it gets to the point that it’s not functioning like it used to and what happens if you try to sell it? That’s right. It’s not worth much if anything at all.

This is the essence of depreciation.

Regarding real estate, the IRS is acknowledging that, if the property is used day in and day out, and if you do nothing to improve it, over time it’ll succumb to natural wear and tear.

Then at some point in the future, the property will become uninhabitable (just like when that computer eventually dies).

As you can imagine, every asset has a different lifespan. You wouldn’t expect a computer to last more than a few years. On the flip side, you would expect a house to still be standing several years, or even decades, later.

For residential real estate, the IRS allows you to write off the value of the property over 27.5 years.

As a side note, the only things that is eligible for depreciation benefits is the property itself. It doesn’t include the land.

The IRS realizes that the land will still be there in 27.5 years and will still be worth the same if not more.

Here’s an example

Last year Dr. A purchased property for $1,000,000.

  • Building was worth $825,000
  • Land was worth $175,000

With the most basic form of depreciation, known as straight-line depreciation, Dr. A can write off an equal amount of that $825,000 every year for 27.5 years.

If he takes what the building is worth, $825,000 and divides it by 27.5 years ($825,000/27.5 = $30,000)

That means that, each year, he can write off $30,000 due to depreciation.

Here’s what makes this such a big deal. Let’s say that the first year Dr. A purchased the property, he was able to make $5,000 in cash-on-cash returns (i.e., cash flow).

Instead of paying taxes on that $5,000, he gets to keep it, tax-free.

Not too bad.

That $30,000 in depreciation means that, on paper, he actually lost money, while in reality, he made $5,000.

#4 – Cost segregation is depreciation on steroids.

In the previous example, we talked about something called straight-line depreciation, which allows you write off an equal amount of the value of the asset every year for 27.5 years.

But, for most of the real estate syndications I invest in, the hold time is around five years.

Now, if we were to deduct an equal amount every year for 27.5 years, I’d only get five years of those benefits.

The remaining 22.5 years of depreciation benefits would be lost.

Enter cost segregation.

A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations.

It acknowledges the fact that not every asset in the property is created equal and is typically performed by qualified engineers and/or CPAs.

The primary goal is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 or 15 years) than the building.

Items include things like outlets, wiring, windows, carpeting, and fixtures.

This can drastically increase the depreciation benefits in those early years.

Here’s an example:

Here’s the power of just what a cost segregation study can do to lower taxes for real estate investors via The Real Estate CPA:

Scenario A

Jane Doe, who is in the 24% tax bracket, buys a 24 unit apartment building for $1,000,000, places it into service in 2018, and does not utilize a cost segregation study.

Her CPA determines the following:

The building is then depreciated over 27.5 years, allowing her to take $29,090.91 as an annual depreciation expense.

Her income and expenses were as follows:

Jane will have to pay taxes on the $90,909.09 received from the property. However, the depreciation expense reduced her tax liability by $6,981.82, and since depreciation is a noncash expense, Jane will still have the $29,090.91 in cash.

But wait, it gets better.

Scenario B

Now, let’s say Jane decided to have a cost segregation study performed on her property.

The study finds that the value of the property is broken down as follows:

Thanks to the Tax Cuts and Jobs Act, Jane can take 100% bonus depreciation on the 5-year property and land improvements in the first year.

The building is still depreciated over 27.5 years, allowing for an annual depreciation deduction of $13,090.

This gives her a total depreciation deduction in year one of $453,090.

Let’s take a look at how this affects her income this time around:

As you can see, Jane will show a net loss of $333,090 in year one. That means she will not have to pay any federal or state taxes on the $120,000 of net income. That’s $28,800 ($120,000 x 24%) in tax savings!

Plus, the remaining $333,090 loss will be carried forward and offset income in future years.

Do I have your attention now?

The additional cash flow can be distributed directly to Jane, or her investors. Alternatively, it can be retained for improvements and renovations that can increase the value of the property, or be used as a down payment to purchase additional properties.

#5 – Capital gains and depreciation recapture are things you should plan for.

If you’re still asking yourself how is passive income taxed, then we need to discuss how the IRS takes its cut.

They get their cut through capital gains taxes when a real estate asset is sold, and sometimes, through depreciation recapture, depending on the sale price.

During the initial call I have with new members of the Passive Investors Circle, most want to know how is passive income taxed.

In a real estate syndication that holds a property for 5 years, you wouldn’t have to worry about capital gains taxes and depreciation recapture until the asset is sold in year 5.

The specific amount of capital gains and depreciation recapture depends on:

  • the length of the hold time
  • your individual tax bracket

Here are the brackets and percentages based on the new 2020 tax law:

  • $0 to $80,000: 0% capital gains tax
  • $80,001 to $496,600: 15% capital gains tax
  • More than $496,601: 20% capital gains tax

For more details and the most up-to-date laws please speak with your CPA.

#6 – The 1031 exchange – a powerful wealth building tool.

Real estate mogul Grant Cardone gives us the 1031 exchange timeline plus a specific example from one of his callers in the video below:

 

As mentioned above, when a real estate asset is sold, capital gains taxes (and often, depreciation recapture) are owed. However, there is one way around this. And that’s through a 1031 exchange.

A 1031 exchange allows you to sell one investment property, and, within a set amount of time, swap that asset for another like-kind investment property.

Doing so means that, instead of having the profits paid out directly to you, they can be rolled into another investment. By doing this, you don’t owe any capital gains when the first property is sold.

Not all real estate syndications offer a 1031 exchange as an option. Often, the majority of the investors in a syndication have to agree to a 1031 exchange to make it a possibility.

Unfortunately, you cannot do a 1031 exchange on just your shares in the real estate syndication.

The sponsors must decide to do a 1031 exchange on the whole project. It’s all or nothing.

If a 1031 exchange is something you’d be interested in, be sure to ask the sponsor about it directly.

#7 – Some people invest in real estate solely for the tax benefits.

Have you ever heard the phrase, “The rich get richer and the poor get poorer“?

It’s because the wealthy knows what it takes to not only get rich but also stay that way. It’s for this reason that most invest in real estate because they get that the tax benefits are huge. They don’t have to ask how is passive income taxed, they know.

They realize that they can take advantage of the significant write-offs, and then apply those to the other taxes they owe, thereby decreasing their overall tax bill.

This is how real estate tycoons can make millions of dollars but owe next to nothing in taxes. And another reason they don’t like to show other people their tax returns because….they’re NOT paying any taxes!

Here’s what’s great about this whole thing.

You don’t have to be wealthy to take advantage of the tax benefits of investing in real estate.

The tax code makes the benefits of investing in real estate available to every real estate investor.

Summary – How is passive income taxed?

As we discussed earlier, you don’t have to worry about taxes when investing in real estate, especially as a passive investor in a real estate syndication.

In most cases, you’ll be able to make money via cash-on-cash returns, yet you won’t owe taxes on those returns due to benefits like depreciation.

As a passive investor, all you have to do is sit back, collect mailbox money, and turn in your K-1 form to your accountant each year.

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