August 8, 2022

Taxes are one of the necessary payments that we have to pay as law-abiding citizens of any country. However, even for some of the best of us, it can get a little cumbersome. But did you know that the richest amongst us pay some of the lowest taxes? We know it's a little ironic, but they take advantage of certain investment strategies and vehicles. One of the strategies is passive income. 

We will break down all there is to know about passive income, compare it to active income, and explain what a wealthy person's tax return will look like.

Passive Income

Since passive income will serve as the basis for this entire article, we would start from it. So what is passive income? Passive income is income that one does not actually participate in—basically, it is unearned income. Passive income is usually derived from rental real estate. 

Examples of passive income are rental properties—this range from long-term rentals to short-term rentals. You can also get passive income from being a silent partner in a business like a hair salon. Now that you have gotten the hang of passive income, let's discuss briefly on active income.

Active Income

Active income (also known as earned income) is a salaried income from rendering service for an agreed-upon task. There are a lot of examples of active incomes, such as getting a salary, allowance, or commission for jobs completed within a specific time frame.

One thing that stands out for active income is that you need actual participation, such as worked hours. So, that check your employer gives you weekly or monthly is an example of active income. Also, if you are self-employed, your income falls under active income.

As we have understood active and passive income, it's time for us to look at the key difference in taxation and how the wealthy ones navigate it.

Active and Passive Income - Taxation

A key distinction for active income is how much it is taxed! Essentially, if you are an active income earner, you will get to pay tax on FICA (Medicare and Social Security), which is around 7.65% and 15.3% for self-employed. 

This is where passive income edges out active income, as there is no FICA tax of any kind. In addition, people who earn passive income can further reduce any tax that they get from their passive gain returns. This is where wealthy people take advantage of passive gains.

How do wealthy people use passive income to their advantage?

This is where it gets a little interesting. Wealthy people who own rentals offset their taxes with passive loss and deductions such as repairs, property management fees, property taxes, and depreciation. 

See how it happens. Imagine you have three long-term rentals that will make a total of $100,000 in a year. If you leave this be, you will be subject to taxes. So, what should you do? They find depreciation worth $100,000 and start asking themselves how much property they will need to buy in order to create the depreciation. And just like that, there is little to no more tax.

One thing worthy of note is how this way of offsetting your tax makes wealthy people invest more, which can increase their wealth. This leads us to another strategy that is used to reduce tax in passive income: 1031 exchange strategy. 

1031 exchange strategy

The 1031 exchange gives you the chance to avoid tax on capital gains if you sell the property you got the capital gain from and use that money to buy another one within a period. For this strategy to be valid, the new property has to be one of either equal or greater value. 

For example, if you bought a home worth $100,000 as of 2014 and by 2024, it is worth $6,000,000. Your capital gain will be 6,000,000-100,000, which is equal to $5.9 million. This amount is referred to as capital gain. Now, to do the 1031 exchange, you immediately reinvest the entire $5.9 million in another property which allows you to defer the taxable gain 

However, because sometimes the rules of 1031 can be stringent, you may not be able to reinvest your capital gain within the specified time. What you will do instead is buy any property with your capital gain and then put that said property into service so you can generate tax-losses from it. If the amount you bought the property for is still not enough to cover your capital gain, look for more property to invest in. The general idea is to balance your passive gain with passive losses.

How to convert active income to passive income?

As we have seen, having passive income comes with a lot of advantages, such as lower taxes and more expendable income. So, if you have active income and are looking for ways to transfer it to passive income, use these tips. 

1. Have a clear and defined plan: If you have decided that you want to start investing so you can get money passively; you need a clear path. What do you want to invest in? What type of real estate do you want to invest in? How much do you know about investing? What is your exit strategy from your current active income job? Asking yourself questions like these would give you an idea of what you want.

1. Start small: The goal is passive income is to have as close to 100% of your active income transferred to passive. But this doesn't happen immediately; know that it is a gradual process. Start from 5%, then 10%, and go higher. Allow yourself to learn from it and grow. 

2. Do enough research: Knowledge is power. Do as much research as possible about whatever investment you want. Listen to podcasts, read books, watch videos and ask questions in areas relating to your interest. 

Conclusion

Wealthy people understand the power of passive income and low taxation, and you should do too. So, start finding ways you can move to passive income so you can fully explore all your options.