Passive Investor Tips is a weekly series hosted by full-time passive investor and Best Ever Show host, Travis Watts. In each bite-sized episode, Travis breaks down passive investor topics, simplifying the philosophy and mindset while providing tactical, valuable information on how to be a passive investor.
In this episode, Travis discusses the benefits of passive income versus traditional earned income, specifically the tax advantages that many use to preserve their wealth such as depreciation, extracting equity, and 1031 exchanges.
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Travis Watts: Welcome back, Best Ever listeners, to another episode of Passive Investor Tips. I'm your host, Travis Watts. I've got a really exciting episode for you today. What we're talking about are the three types of income that you can earn, and why the wealthy tend to seek passive income. Disclaimers, as always, not financial advice, not tax advice, not legal advice, so please, always do your own due diligence and seek licensed financial advice when it comes to your own investing.
Now, to kick this episode off, if you've read Robert Kiyosaki's book Rich Dad Poor Dad, you may remember that it begins with lesson number one, "The rich don't work for money." And I remember being confused by that statement years ago, but today it makes complete sense, and in this episode I want to dissect why that is.
So first of all, the three ways to earn income are as follows: earned income, portfolio income, and passive income. Earned income is when you work for money; you're either an employee, or maybe you're self employed, but either way you're earning the income and working for the money.
Portfolio income would be the example of let's say you buy a stock at $10 per share, it goes up in value to $15, so you decide to sell that stock, and now you have a $5 gain. It would be a capital gain, or what we refer to as portfolio income. Passive income can be earned through different vehicles, but for sake of this episode and simplicity, I will use real estate for the example. So if you own a rental property, this passive income is essentially your cash flow from the property.
Okay, now that we know this, let's examine why the wealthy seek passive income. And the answer is quite simply, taxes. One more disclaimer - I'm not a CPA, not a tax advisor; not giving anybody tax advice. What I'm doing is providing an educational-only example, so it's something that you can have a conversation with your tax advisor.
So starting out with earned income... Here's the problem with earned income. Earned income is taxed at the highest possible tax brackets. And for a visual representation, I'll share with you on the screen right now - the 2023 tax brackets here in America for earned income. And as you can see, if you're a very high income earner, as we're talking about in this episode, the wealthy or the rich, we could say, you could pay as much as 37% tax on your income at the federal level. And that doesn't include FICA tax, which is an additional tax to cover Social Security and Medicare. This also doesn't factor in state tax if you happen to live in a state that has a state tax.
And to make matters worse, if you happen to be a self employed individual and a high income earner, you have this 15.3% self-employment tax. Now, to be clear, when you're an employee with a company, this tax is still there in the equation, but it's split. 50% the employer pays, and 50% the employee pays. So the fact of the matter is if you're self employed, you're paying even more tax. So just throwing out an example of somebody in 2023 living in California, very high income earner - this could be a professional athlete, this could be an actor or an actress, this could be a CEO at a company... If you're making over a million dollars per year in California, depending on this hypothetical person's situation, you could basically be paying around 65% in taxes on the income you earn. And this is why Robert Kiyosaki says "The rich don't work for money."
Now let's talk about portfolio income and capital gains. And for another visual representation, I'll put it here up on the screen for you, 2023 brackets; as you can see, you're either going to pay 0% in tax, 15% in tax, or up to 20% in tax. So obviously, much more favorable. And this is perhaps why so many CEOs that are making multiple millions of dollars per year prefer to be paid in shares of stock, versus a salary. For example, the CEO of Apple, Tim Cook in 2022 had a total compensation of $99.4 million throughout that year, but only 3 million of that was in the form of a base salary.
Travis Watts: Alright, so now let's talk about passive income and why the wealthy pursue passive income. And this is a lesser known, often misunderstood type of income, and how taxes work. Let's take for example that we own a large piece of real estate; we'll say it produces a million dollars per year in income, because again, we're talking about us or somebody being a wealthy individual or rich individual... We'll say that the value of that property minus the land cost is $30 million. Whether or not this was paid in cash, whether or not this was leveraged with a mortgage is beside the point.
The beautiful thing about real estate and the reason why so many wealthy people invest in real estate is you have something first of all called depreciation. And the IRS deems that a property's life - again, not the land underneath, but the actual brick and mortar and the materials and the structure of a residential real estate property, they deem the lifespan to be 27.5 years now. We all know there's plenty of real estate out there that's 100 plus years old here in America... But for tax purposes, that's what they say the lifespan is; and they being the IRS.
So what you get to do - if your property is valued at $30 million, excluding the land that it sits on, you can simply run the math by dividing 30 million by 27.5 years. And if you run the math, what you come up with is a little over a million dollars per year. This is what's known known as depreciation. This is essentially a paper loss. You're not literally losing a million dollars per year; hopefully you are making money. In this example we're saying you're making a million dollars per year through cash flow or passive income. You get to use these losses, this depreciation to offset that passive income. So if this were a real scenario, this investor may be paying zero in tax.
Now, additionally, on top of this, if you can do a refinance down the road - there's some equity in the property, it's appreciated over time, and you don't want to sell it, so you put a new loan over the old loan, you can extract some of the equity, and that's a non-taxable event if you're doing a refinance, because nothing was actually sold; you're just essentially borrowing money out of the property. So yet another reason why the wealthy seek real estate.
And last but not least - and obviously, this is not an all-inclusive list, you can do a 1031 exchange. So if and when you do want to sell this property and buy something equivalent or bigger in the future, you can potentially defer the taxable gains and roll them into another property. And if you end up passing away, at least the way that the tax code stands today, years down the road, then somebody can inherit this property at the current market basis, and not have to pay all of the back taxes for all the years that they weren't paid.
So at the end of the day, why the wealthy seek passive income has a lot to do with real estate. It has a lot to do with taxes. It's yet another reason why the rich get richer, and that's why so many of these big mogul real estate investors can pay little to no tax, legally.
"He's paid nothing in federal taxes."
With politics and all jokes aside, I think you get the point. So thank you guys so much for tuning in. I hope this was a valuable episode for you. Feel free to like, share, subscribe, share these episodes with anyone you think could find value. Reach out anytime if I can be a resource or mentor to you. Travis Watts or, at Passive Investor Tips on social media. Thanks so much, everyone. Have a Best Ever week and we'll see you in the next episode.
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