Passive income is a curious beast. Essentially it involves money that you don’t “directly” earn. If you show up at your office or at the factory, put in the hours, and do your job, then you get paid a certain amount of money for your time.
Even in lame court TV shows, you see people successfully suing to get reimbursed for earned income when they prove they put in the hours. This is “ordinary” income. And the government taxes this type of income on the basis that you are more likely to show up on a daily basis, put in your hours, and get your pay check. There is relatively little risk to you not getting paid and hence little risk of Uncle Sam not getting to collect their cut.
But real estate rental income is different. You get paid because you own the property. There may be fees, but in general you don’t have to lift a finger to collect your rental income. It doesn’t mean it’s easy. But it doesn’t require you to put in a certain number of hours to earn the income.
The trade off is that you take on the risk of not collecting. The tenant may not pay. You can go to court to collect past rent. But the property could also be vacant. And if your tenant is behind and you evict him or her, you will be losing money until you find a new tenant.
This is passive income. The government looks at it as riskier income and not as likely to bear fruit. So they cut you a break and charge lower rates. And there are different options in tax deductions. There are even barriers between sharing tax deductions between ordinary income and passive income.
This means that investing in real estate can produce a lot of income with better tax rates, but it has risks. It is one reason to seek top quality properties, because that is how you attract top quality tenants. That hedges the risk that comes if you lease junky units.
What’s another reason to get into real estate? Because when you accumulate enough, you can stop your busy day job and stop “putting in the hours.” Retiring and living off passive income is a boon.
Real estate also comes with added benefits. It allows you to use prudent leverage, which is one of the greatest wealth building tools available to the middle class.
P.S. By no means am I a CPA or tax expert. Please contact your tax advisor and start firing questions about passive vs. ordinary income. If they stare blankly, it might be a clue that aren’t right for you. In fact, ask them if they know how to handle a K-1 form as well as an 83(b). If they don’t have a clue what those might be, or don’t ask you questions to glean if your qualified, its another sign they might not serve your needs.