These High Net Worth Investors know that real estate is the magic investment formula because you make money in four ways:
- Cash Flow — Actual distributions of income at regular intervals. (This is a core strategy that sets Wealthward Capital apart.)
- Appreciation — Land appreciates and so this adds to the overall value of the property
- Equity Paydown — Rental income, both from residential and commercial property, can pay down your mortgage. Soon, your interest payments become less and you're paying off more of the principal. Although you don't see this value in cash, it is raising your overall equity and net worth.
- Depreciation ― Certain paper depreciation losses can be used to offset passive gains on real estate. This is another core element of Wealthward's successful real estate investment strategy.
An important thing to know about Real Estate investing is that you keep more than you make.
I started Wealthward Capital many years ago to help hard-working tech employees get their ordinary income to start working for them. I am a tech employee myself. I've helped two tech companies go public. It was after the first company went public that I started asking myself questions about tax benefits, and what the best way was for my money to make money for me.
A lot of real estate investing opportunities are open only to accredited investors. But here's the awesome thing: Many tech employees are already accredited investors and don't even know it! Being an accredited investor is not only based on the total value of your assets, but can also be calculated according to the earned income from your employment. If you'd like to discover if you're an accredited investor, you can have a look at our in-depth article on it here: Accredited Investors & Investing.
In this article, we're going to talk about passive real estate investing, rental income, property taxes, commercial real estate, renting, and anything else you might need to know to obtain a better taxable net income by investing in the right type of investment property.
Quick heads up: This is not tax advice and neither Wealthward Capital nor any of its reps are financial advisors. But we do make our money work for our investors!
What is the tax rate on passive rental income?
The taxes paid on earned income are quite different to those paid on gains made from passive income. Generally speaking, passive rental income is taxed according to your tax bracket. But a depreciation expense can considerably lower this bill.
There are specific benefits to passive income obtained from real property compared to other types of passive income, such as royalty payments or dividends.
Income from a rental property can almost always be considered passive even if the real estate investor has materially participated in the activity. Additionally, operating expenses and an annual depreciation expense can considerably lower the final taxable income amount, opening the door to more tax benefits.
The mortgage loan interest can also be deducted.
Once the above items have been deducted, the individual investor will pay tax on that rental income according to his or her marginal tax rate. The rate of these taxes will be determined at both federal and state level.
Real-world example of passive rental income:
A passive investor purchases a property for $200,000 and the property earns $20,000 per annum as a rental activity. After the expenses on the underlying property are paid (such as maintenance and mortgage interest rates), the income earned from rent is down to $10,000.
In real estate, an investor can deduct an annual depreciation expense equal to the value of the property minus the value of the lot, divided by 27.5 years.
So, if the value of the lot that the $200,000 property sits on is $20,000, then the investor can deduct $180,000 ($200,000 - $20,000) / 27.5 years, or $6,545.45.
This then leaves the investor with only $3,454.55 ($10,000 - $6,545.45) net income on which the investor must pay taxes.
The investor will then pay tax according to their personal marginal rate — the same rate that ordinary income is taxed at — even though the effective rate is far less than that.
And, of course, the income generated was done without much participation from the investor, which is the true benefit of income that is passively generated: Having your money work for you.
What is the difference between passive income and investment income?
The IRS classifies income into three categories: Passive, Active, and Portfolio Income. Passive income is earned without material participation and generally includes rental income. Portfolio income is earned through an investment portfolio of stocks, bonds, etc.
Wealthward Capital has structured its real estate investment portfolio for tech employees to earn passive income.
Passive income from Real Estate is different to income from dividends or bonds. Even though you don't necessarily participate "materially" in receiving dividend and bond income, the fact is that the IRS taxes these two types of income differently. The main benefit of passive real estate income is that you can keep more of what you make due to passive losses and paper losses that can be used to offset your passive profit. This can't be done with another type of investment income.
By keeping more of what you make, you technically "make" more.
It is our philosophy that your hard-earned money should work for you, and that it should be sending you hard cash every month because of its returns.
The whole point of passive real estate investing is to general supplemental income to what you're already earning.
We have several products in place that help us achieve these passive earnings, including real estate syndication. New investors coming into the syndication enter as a limited partner which effectively means that they are automatically not materially involved in the investment. So any returns they make from Wealthward Capital investments in real estate are automatically passive.
The three types of income are taxed differently. The primary benefit of passive earnings is that it is earned while you are doing other things. The other benefit is that you can claim passive losses against the income, reducing the overall tax rate, according to the IRS's rules.
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What are the tax advantages of passive income?
Passive income is not subject to Social Security taxes or Medicare taxes. You can also deduct passive losses from your passive income, reducing the overall tax burden.
As far as investments in real estate go, you are also able to deduct maintenance and upkeep costs, operating expenses, depreciation costs, and any other valid cost.
Finally, one of the biggest tax advantages is that passive losses can be carried over to the next fiscal year.
Let me state that again, you can carry over your losses into future years. This isn't possible with income from your trades or sales (active income) or investments (portfolio income).
This little factoid was a game-changer when I first heard it and is one of the reasons I dived so fully into real estate investment. It's huge! By building up passive losses that can be carried over to future years, you continue to be protected against taxes!
Example of passive losses being carried over
For example, let's say that your passive income generated $50,000 in revenue, whether from a rental property or other types of passive earnings. In the same year, you had -$75,000 in passive paper losses, including depreciation and other passive losses.
For this year, you would record a net income of -$25,000 (negative $25,000). Additionally, you would be able to carry that -$25,000 in passive losses to the following year.
So, if you receive passive income of $50,000 the following year, and have only -$20,000 in passive expenses for that year. You will also be able to add the -$25,000 of the previous year, bringing your passive net income to only $5,000 for the second year.
Why is passive income taxed less?
Passive rental income is not necessarily taxed less, but it can be offset by passive depreciation and amortization passive losses. Unlike earned income, you do not need to spend actual money to reduce taxable net income.
As described earlier, passive income paper losses can also be carried over to the following years thereby further reducing the total tax liability.
The real estate industry benefits from several tax laws that incentivize investment in this growing sector. Wealthward Capital has built a portfolio that focuses primarily on real estate because real estate makes the most sense from a tax perspective. Our portfolio contains many asset classes — everything from multifamily to mobile real estate and some automated teller machines (ATMs) — that are all cash-flowing, meaning that they have been structured in such a way that they regularly put cash in your pockets.
You don't need to be a real estate professional or know anything about rental property to invest in one of Wealthward Capital's properties, but you do need to be an accredited investor. Fortunately, many tech employees are already accredited investors and don't even know it.
How is passive income taxed by the IRS?
The IRS typically taxes passive income using marginal tax rates. Real estate investors know that the tax code allows for many deductible expenses, such as depreciation expenses, that can reduce taxes on passive income.
All of Wealthward Capital's real estate investments result in passive income to our real estate investors because they are structured as limited partnerships. A limited partner is someone who does not materially participate in a business. When an investor materially participates, then the income he or she earns is considered active income.
The exception to this is income from a rental property. Even if someone materially participates in obtaining this, it is still considered passive income except in certain very specific circumstances.
Because certain deductions can be made on passive income, the total net amount that is taxed is reduced. The Internal Revenue Service will then only tax you on the next passive earnings.
How much passive income can you write off?
There are no limits to how much passive income you can write off through passive losses. But you cannot use active income losses to write off passive income or vice versa (passive losses to write off active income).
So long as you are not materially involved in the business, any loss it accrues is considered a passive loss for you. And there are also paper losses that can be deducted, such as depreciation and amortization.
An example of not being actively involved in a real estate investment is when you invest in property through a property management company.
Wealthward Capital regularly provides all passive investors with statements of their earnings, showing passive losses and earnings, and all necessary information required for tax purposes. Investors can then take this information to their certified public accountant to finalize all their taxes at the end of the tax year.
These are provided in a K-1 form, which is the form the IRS needs from people who invest in a partnership.
Active investing is a form of investment that is quite different from passive investing because people also need to invest "sweat" into any active investment. In a passive investment, an investor pays money and then someone else takes care of it.
How do investors pay no taxes?
There are numerous tax advantages that passive investors can leverage to reduce their passive taxes. Real estate investors are in an extremely advantageous position when it comes to paying no tax on passive income because they can claim many deductions.
Wealthward Capital is not a financial or tax advisor but we do know of many cases where a real estate investment can lead to zero tax on the passive income earned. The key thing to know about tax deductions and tax liabilities in real estate is that the IRS offers numerous incentives and tax advantages to people and companies that invest in real estate.
The reason for such incentives is because real estate and property development are great for the economy. Real estate development opens the door to jobs, raises an area's tax basis, and generally improves an area.
There are also different levels of capital gains taxes to know about. Long-term capital gains are gains obtained from properties that have been held for more than 12 months. And short-term capital gains are for properties that were held less than 12 months. Short-term capital gains are taxed as ordinary income and long-term capital gains are taxed as graduated thresholds of 0%, 15%, or 20%.
Wealthward Capital takes all these elements into account when optimizing our investments so they keep more income for our investors than they spend.
By hiring a tax professional who works with real estate investors and knows the ins and outs of rental income and passive investment, it is entirely possible that a taxpayer could end up paying zero taxes on their passively earned income.
Is rental property considered active or passive?
All rental income is typically considered passive income regardless of how much you participate in the activity. There are some cases where this is not true but these generally do not apply to the typical investor.
The question is moot when it comes to Wealthward Capital investments because all of our investments are structured in such a way that any new investors brought on are never materially involved in the activity. This means that all cash flow income that Wealthward Capital issues is 100% passive.
When can rental income be considered active?
The only time the IRS might consider rental income as active on a tax return is:
- If a real estate professional has ownership of the property. To be considered a real estate professional, the individual must spend at least 750 hours working on their real estate profession, and at least 50% of their work must be in the field of real estate.
- If the income from the rental property is generated through a personal residence, the income might be considered active if the owner uses it as a personal home for more than 14 days, or for 10% of the days that the personal house or apartment was rented to someone else.
- If the property has been rented to a business, such as a Limited Liability Company, in which the owner has an interest
- Short-term rental income (STRs) might be considered active income if the average period of the person's stay is less than 8 days.
Do REITs generate passive income?
REITs (Real Estate Investment Trusts) do provide passive income to investors. They have a special tax-exempt status and must pass at least 90% of their net income to shareholders. When you invest in a REIT, you are investing in shares in a company, not in real estate.
REITs have a very specific legal definition. Wealthward Capital instead offers something similar called a Private Equity Real Estate Fund where investors can pool their money into a professionally managed fund for maximizing the returns and minimizing the risk. One of the key benefits of this type of fund is that it makes it easier to finance large commercial properties that are usually out of reach of the private investor.
We manage this fund with the same care and diligence as we handle all our other properties.
Real estate is crucial to you becoming financially independent. Investing in real estate means you can keep more of what you make. For example, let's say you currently earn $200,000 but lose $50,000 in taxes every year. To maintain your lifestyle — quality of life, leisure, recreation, etc. — on a passive income basis, you would only need to make $150,000 in passive income because your tax bill can be offset by intelligent accounting.
In short, you need less real estate income than W-2 income to become financially independent because of real estate income's tax benefits!
Start earning passive real estate income with Wealthward Capital
To start earning passive real estate income with Wealthward Capital you need to be an accredited investor. A lot of people are already accredited investors and don't know it!
We specialize in building portfolios for hard-working tech employees who want to make their money work smarter.
Get in touch with us today to learn more about how we can help you.