October 1, 2020

JF2221: Cashflow Quadrant | Actively Passive Investing Show With Theo Hicks & Travis Watts


Today Theo and Travis will be sharing the “CashFlow Quadrant” based off of the book from Robert Kiyosaki. “The cashflow quadrant will reveal why some people work less, earn more, pay less in taxes and feel more financially secure than others” – Robert Kiyosaki. Today Travis will break down how he understands and utilizes the lessons he learned from the book to hopefully help you in your own journey 

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow.


Theo Hicks: Hello, Best Ever listeners and welcome to the best real estate investing advice ever show. I’m Theo Hicks and we’re back with the Actively Passive Investing show with Travis Watts. Travis, how are you today?

Travis Watts: Theo, doing great man. Happy to be here.

Theo Hicks: Awesome. Thank you for joining me yet again. Today’s topic is going to be the Cash Flow Quadrant. I’d probably say that 25% of the people I interview, I’m going to ask them what their best ever book is, it’s some Kiyosaki book. And so I’m sure everyone listening is familiar with Robert Kiyosaki.

This concept, the cashflow quadrant, is based off of his book, Cashflow Quadrant. I’m pretty sure he, at the very least, introduces it in Rich Dad, Poor Dad. We’re going to go over what each of these quadrants mean, and the overall quadrant works, and how you can apply that to your actively passive investing business.

Travis wrote this very detailed blog post on it. He is the expert between two of us, so I’ll let him start, and then we’ll talk about his background and how he was introduced to this concept in the first place.

Travis Watts: Yeah, you bet, Theo. First of all, have you read this book, Theo?

Theo Hicks: No, I have not read the full book. I’ve read Rich Dad, Poor Dad, but not the Cashflow Quadrant.

Travis Watts: Sure. Alright. Well, for those familiar with my story, my mind started to open to this world of real estate and investing through one of Kiyosaki’s books. It was not this book, it was called Rich Dad Prophecy, written around the year 2000, give or take.

The Cashflow Quadrant that I have here up on the screen, that was the second book. So Rich Dad, Poor Dad came out, I think in 1997, this may have been ‘98/’99, and just before Prophecy, so it’s kind of the sequel if you will. That’s how Robert Kiyosaki describes it. It’s the sequel to Rich Dad Poor Dad.

What he’s talking about here, as you can see up on the screen, if you’re tuning in on YouTube, is you’ve got the ESBI. There are four quadrants, and what that symbolizes is, there are four ways to make money, essentially, in our society. You can be an employee, which is the ‘E’; you can be self-employed, small business owner, specialist, doctor, dentist, that kind of stuff. That’s an ‘S’. You can be a ‘B’, which is a big business owner; that’d be 500 or more employees. These are usually your corporations. And then an ‘I’ would be a professional investor. So not putting money into a 401k per se, but actually being a professional real estate investor, oil and gas, self-storage, whatever.  Those are the four ways.

And what was amazing about this is I started studying taxes at a certain point. I started to understand the tax implications, and that’s really what my blog post goes into. And with the disclaimer I’m not the CPA or tax advisor, or a tax professional, but I’m basically just taking the information out of the book and relaying it there in the blog post. As we talked about last time, Theo, about the speed reading, if you will, the point of this today is just to condense timeframes. Yes, you can go out there and you can buy this book, and you can go spend a month or two reading it, or you can just spend 10-15 minutes here and kind of get the gist of it, and the takeaways. That’s the value that I’m trying to create.

Let’s talk about the taxes here, and this is really what changed my whole trajectory, is how I earn income. This happened many years ago, but I’ve been on a pursuit in a whole different direction. I was at one point, again, those that listen to my podcasts and things, I was in the oilfield, so I was working a ton of hours as an employee. That was essentially the bulk of my income by a long shot.

Now, I was also self-employed to an extent, because I was fixing and flipping houses and doing that kind of stuff, running a vacation rental. So I certainly didn’t have 500 plus employees, but I was self-employed. You could also say in some regard, I was an investor, though at the time I wouldn’t have said I was a professional investor. I was dumping money into 401Ks and IRAs and things like that.

You can be in all these quadrants, you can be in one quadrant, whatever. But here’s kind of the tax side of it, I’ll run through really quick. An employee, if you really run the numbers, which I do in the blog, an employee is usually in on average, talking about the whole United States, paying roughly 40% of their earned income in taxes. Now, that’s a combination of your federal tax brackets, your state tax, if applicable, and then also the Social Security and Medicare. I’m not including other forms of taxes, like property tax, or sales tax in your state, stuff like that. So it could be higher, but roughly 40%. As a self-employed, believe it or not, actually the highest taxes paid come from self-employed individuals.

The reason is, when you’re an employee, you’re getting half of your social security and half of your Medicare paid by your employer, number one, and as you’re a self-employed individual, you’re paying 100% of all of those taxes, in addition to statistically speaking, self-employed individuals often earn more income, so you’re probably going to be in a higher tax bracket, in addition to both of those. Kiyosaki points out this could be roughly 60% of your total earned income and taxes, which is just crazy.

Theo Hicks: Yeah, I did not know that before reading this blog post.

Travis Watts: It gets crazier if you look at states like New York, or say California is the classic example. High-income earners in the ‘S’ quadrant could be paying 13.3% state income tax, almost 40% at the federal level, and then all of the social security and Medicare, it could be higher, so… Crazy to think about.

Now the ‘B’ quadrant; in 2017 – I don’t think this is in the book, because this was the JOBS and CARES act that got passed, they took C corporations and gave them a flat-rate tax. It’s 21%. That may be temporary, but even historically speaking, when Kiyosaki wrote this book back in 1999, he says, “’B’ quadrant is roughly 20% tax,” so significantly lower.

In a C Corp, for those that may not know, that’s usually your big corporations; your Apple and Google and Facebook, they usually structured as a C Corp. You see more the S corp structure as you get into the ‘S’ quadrant, and a lot of folks are operating just as a sole proprietor, also in the ‘S’ quadrant, just their individual names.

In the ‘I’ quadrant, this is what blew my mind. He claims that it’s possible to have a zero percent tax owed legally. Okay, and again, this is why a lot of the real estate gurus out there, and not to be political, but the Donald Trumps and whatnot, can legally pay zero percent in tax as real estate professionals. That was mind boggling to think that here I was, thinking I was going to be real smart one day money-wise and be in the ‘S’ quadrant, making [unintelligible  [00:10:54] and money or whatever, but I’d be paying so much in tax, it’d be insane. I could literally make half as much in the ‘I’ quadrant and come out ahead.

How that happens – we can take, since this is best ever community here Actively Passive Show, we’ll talk about real estate real quick.

The way that you pay zero percent in tax is because we have depreciation advantages to real estate. And not only just the straight line, 27.5 years in a lot of cases, but we have bonus depreciation that comes from doing these cost segregation studies. And, again, in 2017 the JOBS and CARES Act passed, and you can take these lifespans of certain items in your property, the ceiling fans and electrical and the trees, the landscaping, you can itemize this stuff out and you can do an accelerated depreciation, often all in year one.

It’s very possible when you invest in a piece of real estate, let’s say you’re earning some cash flow, you’ve got $10,000 in cash flow that you received – well, you might have losses on paper of $20,000 or $30,000, or something like that. That can be used to offset that, hence the zero percent tax and/or carried forward. In rare cases, if you’re a real estate professional, you can actually offset earned income as well with passive losses. I’m not going to get in the weeds with that, I’m not a CPA, I’m not a tax advisor. Please seek your own licensed professionals there. But I did want to point that out. That’s how that happens.

Additionally, let’s talk about stocks, because a lot of people invest in stocks. When you have long term capital gains, so you bought into an ETF or stock or something, and you’ve held it more than 12 months, and you go to sell it. That’s a long term capital gain. I think, don’t quote me on this, but I think for like a married couple right now, you could earn up to almost $80,000 doing investing that way and pay zero percent in tax, which is pretty incredible. A lot of different ways. There’s a good book called Tax-Free Wealth, it’s Tom Wheelwright’s book, check that out if you want to dig a little deeper, and of course, seek out your own CPA and advice there. But that is it in a nutshell.

What happened, back to my story real quick – I decided instead of going from ‘E’ to ‘S’, which was really my life plan at that time, I decided to go from ‘E’ to ‘I’. Today, I’m a professional investor, and the bulk of my income is coming from the ‘I’ quadrant. Now that being said, I do earn income a little bit in the ‘S’ quadrant, and in the ‘E’ quadrant, but the majority is from ‘I’.

So just learning the simple stuff, a book like this that’s 20 bucks can literally save you tens of thousands of dollars, not only sometimes in the first year, but for the rest of your working career. It’s really worthwhile to dig into certain topics like this, and then leverage the experts to help you out kind of on your own business plan. I know I’ve been rambling for a while, but that’s kind of the gist of it, and what the blog’s about, and the book.

Theo Hicks: Yeah, thanks for sharing that, Travis. You mentioned one thing I wanted to follow up on was the depreciation and the cost segregation, and there’s depreciation recapture, there’s a bonus depreciation… We actually wrote a blog post—again, we’re not tax experts. This is just general advice. But it’s called the Five-Tax Factors when passively investing in apartment syndications. It kind of goes into more detail on what Travis was talking about. We tossed in some examples with real numbers, so you can understand what the differences are between regular depreciation and accelerated or cost segregation, and when you’ll have to pay taxes on recaptured depreciation on the backend, and what Travis was talking about with the bonus depreciation for the tax cuts and JOBS Act.

Obviously, the tax aspects of the ‘I’ are the best, but at the same time, this is the actively passive show, so I wanted to briefly talk about the time investment associated with all of these. Surprisingly, reading through your blog post, not only is the ‘S’ quadrant the greatest tax cost, but it could potentially be the greatest time investment as well. Correct me if I’m wrong, but the greatest time investment is going to be between the ‘S’ and the ‘B’. But depending on what type of ‘B’, you are, as you mentioned in your blog post, it could be relatively passive, right? For example, I’ll talk to some people who obviously invest in real estate, but they’ll have some other businesses on the side, like consulting or something. And then they’ll hire a bunch of employees under them and they’ll hire a high-level CEO guy, and they’ve got people that are running the day to day aspects of the business; they’re not necessarily working that much, but when you’re kind of self-employed, you’re the person. When you’re employed, sure, you need to work hours, but when you’re self-employed, you’re the guy or your the girl, and you’re going to need to do everything. So not only is self-employed the greatest tax hit, but it’s also the greatest time investment. Whereas on the flip side, the ‘I’ has the greatest tax benefit, and also potentially, and again, it’s possible that you could be spending a lot of time here if you’re active, but as a passive investor, you could be spending the least amount of time by paying the least amount of taxes. I did want to mention that as well.

Travis Watts: Exactly. And that’s a famous quote, Warren Buffett talks about, if you don’t learn how to earn income in your sleep, then you’ll work till the day you die, which is a bit extreme. But to your point, so the ‘S’ and the ‘B’, big difference there is the ‘S’ is the operator, to your point; you’re a plumber, you’re an electrician, you’re a speaker. It’s you; you’re the business. But on the ‘B’ quadrant, you’re the owner of the business, to your point, so that you can walk away from the business, and it continues earning income for you.

So yes, absolutely. As you can see, if you’re not already familiar with this cashflow quadrant, you’ve got to get over to the right side of the quadrant, the ‘B’, and ‘I’. It’s tough to make a leap over to ‘B’ from ‘S’. I would say most people have probably the best chance at getting into the ‘I’ quadrant, because you literally can do that with $10. Just buy a share of a stock or something and you’re already there in the quadrant, and then just keep building on to it. It’s not to say you should only be an ‘I’ or you should only be a ‘B’. Like I said, I’m virtually in all quadrants except for ‘B’.

Extremely helpful to start thinking about tax implications, because again, it’s kind of a compounding effect. If you learn about taxes, say when you’re 20, and you start implementing this stuff, well, you’re going to be decades ahead of most people, and that savings can compound into more investing, and it’s going to have the biggest impact. If you’re listening to this today and you’re 85 years old, well, you can still make changes, it’s not too late, but it’s not going to have as big of an impact, obviously.

Theo Hicks: Yeah, it’s also important. We talked about how—I wouldn’t say it’s a drawback, but one of the prerequisites to being in the ‘I’ is you need to actually have money. And so sure, you can start with $10, but you’re not going to live off of $10. It’s not like you’re going to hear — every single person listening to this episode right now is going to quit their job and jump into the ‘I’ and make a million dollars. Obviously, that’s not the case.

As Travis mentioned, the goal is to be more on the right side, the ‘B’ and the ‘I’; and less on the ‘E’ and ‘S’, and maybe ultimately being completely on the ‘B’ and the ‘I’. But the first thing is becoming aware that this type of quadrant exists, and then as Travis mentioned, it’s a compounding effect.

Figure out how much money you can save each month or each year from your ‘E’ or ‘S’ job to put into ‘I’ and then do that for, depending how much money you have, a few years, or five years, 10 years, whatever, then you can start to pull back from the ‘E’ and the ‘S’. I think that’s a key here, is that you need to, in a sense, use the ‘E’ and the ‘S’ to get to the ‘I’. The ‘I’ is in regards to passive investing. Obviously, you don’t need to do this for active investing. This is not the active investing part of the show. But for passive investing, you need that capital to invest.

Travis Watts: That’s a good point. Something to point out too is this cashflow quadrant is just more or less a generalization. There are ways and strategies as a self-employed individual to save on taxes, with your home office deductions and your car expenses and your commutes and your mileage. There are definitely ways to offset. There are also choices to be made about like we talked about with state income tax; you could leave a state with 13% state tax to go to Florida, go to Wyoming, wherever, go to a no-tax state and save that, too.

It doesn’t mean that when you’re an ‘S’, you do pay 60% in tax. That’s not true. But it’s a generalization that a lot of folks do, for the reasons that we pointed out. Just know that.

And also, one more thing on the ‘S’ quadrant. You could learn to operate like a big business. You could do the same strategies; you could elect to be taxed as a C Corp if you want. There are things that you could do to pay that 21% tax, things like that. Again, not a CPA or a tax professional, but things that you can do there.

Now with the ‘I’, you mentioned passive investing. That’s true. I think a single-family buy and hold, specifically a buy and hold. Some would say that’s passive, others would say it’s not. But regardless, that’s what would qualify you for the ‘I’ quadrant, because it’s mostly hands-off.

Now, if you’re flipping houses, like I used to do, and you’re not an ‘I’. You may think that you’re investing, but that’s not true. You’re in the ‘S’. You’re actually self-employed. This is now a business that you’re putting a lot of time into, so you actually fall into the ‘S’. Because also you’re earning, by the way, short term capital gains, which go into the regular tax brackets of federal income, right? So you’re not going to fall into long term capital gains if you’re doing flips, for example, or wholesaling, or any active business in real estate. So, something else to think about.

Theo Hicks: People who are essentially holding on to their investments longer than a year, until you start experiencing capital gains tax – that would be considered an ‘I’? Or is it only people who do that and aren’t spending a lot of time doing it? Like, if I’m a buy and hold person who’s buying 20 deals a year, that’s going to be a large time investment. Would that considered an ‘I’, or would that be considered an ‘S’?

Travis Watts: Say it one more time? Sorry.

Theo Hicks: Is it just the tax benefits that determine which one you’re in or is it also the time investment?

Travis Watts: The way I look at it, you’d have to go into greater detail in the book to see exactly how he defines this. The way I look at it is a) a longer-term approach to investing because of the tax advantages that go with it. If you’re really striving to do the zero percent or up to, let’s say – I think it’s 15% after that, but it’s still capped when we’re talking long term gains. That’s the biggest thing, right? Anytime you’re actively doing a business, spending a lot of time on it, then you’re going to be an ‘S’ in that situation.

Theo Hicks: Got it.

Travis Watts: Now, the reason that Kiyosaki excludes 401Ks and IRAs is because that’s not a tax-advantaged strategy, that’s a tax deferral strategy. If you weren’t aware, anybody listening, a pre-tax 401k, a pre-tax IRA, when you finally do go to pull that money out, assuming you’re over the age of 59 and a half when the IRS says you can pull that money, you’re actually taxed as ordinary earned income, which is quite crazy to think about, because the investments you hold, if you were otherwise to hold those investments say in a brokerage account, not an IRA account, you would be paying zero to 15% tax in most cases on the gains. But instead, you may be paying up to 40% to 50% in taxes by kicking the can down the road and taking it later. We’re not even going to get into early withdrawals, which statistically most people will pull that money out early anyway, and pay a 10% penalty on top of that tax. It can get really ugly in those accounts, and that’s why he doesn’t consider that a professional investor, because it’s a very seamless thing; it comes out of your paycheck, it goes in there. You’re not usually being very active with a 401k.

Theo Hicks: Got it. I would say from the perspective of our listeners, it would be kind of broken into two categories. It’s the people who are an ‘E’ or an ‘S’, or they are in an ‘I’. If you’re an ‘E’ and an ‘S’, you’re working a full-time job at a corporation, or as you mentioned dentist, doctors, or own a company. Then you’ll want to kind of transition into the ‘I’. And then if you’re an ‘I’, and you’re a long term hold investor, from there you’re already experiencing the tax benefits. From there, the advantage would be reducing the time investment, and so that’d be transitioning from more of the active ‘I’ to the passive ‘I’.

Travis Watts: Yep. And so many folks, I guess, subliminally pick up on this concept without even knowing about this book, because coincidentally, there are a ton of S’s that are doctors, dentists, lawyers, attorneys that invest professionally in these apartments syndications, private placements, or just real estate in general. The reason that they’re really after that is for the tax advantages.

And again, not to go too deep into the tax stuff, but you can learn how to become a real estate professional. In some cases, or even as a married couple, maybe the spouse or stay at home husband or wife, whatever the situation may be, the non-worker could be managing the single-family portfolio, could be putting in more than 750 hours a year, it could be their primary focus. If you can qualify, working with your CPA as a real estate professional, it is possible to take these passive losses that we talk about from depreciation and bonus depreciation, cost segregation; take that stuff, and apply it against your self-employed income or your employee income.

So it gets deeper and deeper and deeper. We’re not the professionals here on the subject. But I just want to open everybody’s mind to this concept and idea if you weren’t familiar with the book already, or to reiterate, hey, maybe it’s time to reread that book. It’s been 10 years. Hopefully, that’s helpful just as a concept for people here on this episode.

Theo Hicks: It’s been very helpful to me too, because I’m pretty sure I’m getting the cashflow quadrant and then the assets and liability thing mixed up. I don’t think this was [unintelligible [00:24:59].14] but what I was thinking of was the liability versus assets.

Alright, Travis, it’s been a solid episode. Thanks for joining me and sharing your wisdom on the Cash Flow Quadrant on these Actively Passive Investing Show episode.

Best Ever listeners, as always, thank you for listening, Hope this was valuable. Have a best ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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