How to Transition to Full-Time Passive Investing (And Pay Little to No Tax)

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I now earn my income (mostly) as a full-time passive real estate investor. Because of this, I am often asked…

How am I able to pay little to no tax on the income I bring in from my investments?

I said, “now” because it did not use to be this way. I used to earn most of my income actively as an employee and solopreneur. However, I learned over time that if I wanted out of the “rat race” on my own time schedule, I needed to scale a portfolio that would leverage the power of full-time passive investing. 

And to do this efficiently, you must understand two fundamental principles: how you earn income and how you are taxed on it. 

Why Full-Time Passive Investing Matters (Even if you LOVE your Job)

When you look at how you make your money, those who trade time for dollars as an employee or as a self-employed earner pay the highest individual taxes. Contrarily, the IRS (Internal Revenue Service) gives the greatest tax breaks to businesses and investors in those businesses. A great resource to illustrate this concept is Robert Kiyosaki’s book The Cashflow Quadrant.

For an accredited investor, your tax bill is most likely your largest expense. To compound the problem further, for every dollar you pay in taxes, you lose a dollar that you could invest to help you grow your wealth faster. 

However, as a passive investor (full- or part-time) you are not actively earning income (i.e., not trading time for dollars… bonus!), and the taxation of the income changes since you get to take advantage of business deductions, entities, and income shifting to lower your tax burden. All of this helps keep the income and quite possibly the equity growth sheltered from taxation. 

How to Transition from Full-Time Work to Full-Time Passive Investor

Although earning income as a full-time passive investor is conceptually simple to grasp, most aspiring full-time passive investors get stymied by how to make this transition a smooth one. Unfortunately, they add in the unnecessary complexity of trying to add controlled real estate ownership into their already super busy lives (remember, passive investing is supposed to create massive time leverage for you!).

So, if you do not want to own any controlled real estate that you manage full-time, or if you have a higher and best use of your time in your current profession, think about following the three steps below to take a gentler glide path into full-time passive investing.

Step One: Invest in solid passive investments as often as possible (outside of a retirement account), so you can benefit from business deductions (with accelerated and bonus depreciation being the largest deduction and tax shelter) and the tax breaks afforded to entities (i.e.. LLCs, S-Corps, LLPs, etc.). A great resource to understand this concept in greater detail is Tom Wheelwright’s book Tax-Free Wealth. According to Wheelwright, the last thing an investor should do is contribute to a retirement account if they want to take advantage of the tax code to accelerate their wealth build and reduce their overall tax burden. However, if your funds are already in a retirement account, do not panic! Work with a real estate tax strategist to lay out a plan to maximize your investment write-offs.

Step Two: Make sure that your passive investments possess a minimum of these four tenets (of the seven tenets) of conservative investing:

1. Capital preservation (i.e., the investment is backed by a hard asset such as real estate).

2. Cashflow.

3. Equity growth (i.e., natural and forced equity).

4. Tax Benefits.

a. Accelerated and bonus depreciation to shield cash flow and equity from taxation.

b. Access to 1031 exchanges to defer depreciation recapture and capital gains.

By ensuring that your assets have at minimum four of the seven core principles of conservative investing, you are significantly de-risking your portfolio to move with market forces.

Step Three: As your passive income becomes more reliable, consider stepping down your active income streams. This is also the step where many investors get stuck, as they have not thought about what comes next as they transition into full-time passive investing. By transitioning gradually, you can address the mindset work needed in preparation for a possible workforce exit. This could be reducing your hours to part-time or taking on an entirely different role that allows you more time and flexibility. Before making any large moves, talk to your real estate tax strategist to map out your annual tax impact as you make this shift. 

As you tick down active hours, if you want to accelerate your transition, you may consider working with your real estate tax strategist on how you can check the real estate professional box and utilize your suspended losses to accelerate your tax savings.

Wrapping Up

As you shift your income from earned income (trading time for dollars) to true passive investment income, you now have built a portfolio that is generating stable periodic cash flow but also continuing to build equity for you without your direct involvement. All with little to no tax! But more importantly, you now have your most valuable resource back—your time—to spend as you desire!