How to Grow Passive Income & Pay Little-to-No Tax Forever

Have you ever wondered how the wealthy pay so little in taxes relative to their income?  In fact, you may wonder do rich people even pay taxes? Truthfully, there are many methods to lower your effective tax rate, which is why when you make an income with two commas, it behooves you to hire a savvy accountant.  Maybe you should take a page from their playbook and learn how to pay zero tax on your income as well. But one of the more popular methods utilizes the different tax treatment of capital gains, or the profit received from the sale of an investment or property, compared to ordinary income. The IRS taxes short-term capital gains at the equivalent of your marginal income tax rate.  For long-term capital gains, they tax at 0%, 15% or 20%, depending on your annual taxable income. As you can see from the chart below, if your income exceeds $523,600 and you can manage to hold an investment for longer than a year, it makes a lot of sense to do so.  When you sell after a year, there’s a 17% difference in tax rate you’ll pay on your long-term capital gain.

Short- and Long-Term Capital Gains Tax Rates for Single Taxpayers

After tax reform in 2018, the biggest spread comes in the in the $209,426 – $445,850 income range.  This differential is 20% and the largest gap between short-term and long-term gains. If you find yourself in this tax bracket, it makes the most sense to delay taking a capital gain until at least year has passed assuming the asset won’t dramatically decrease in value as a result. The same table for married, filing jointly taxpayers appears below.

Short- and Long-Term Capital Gains Tax Rates for Married, Filing Jointly Taxpayers

What is Passive Income?

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Passive income is money earned as a result of little effort and you can make money while you sleep, go on vacation, fall ill, or any other circumstance which would bar you from actively earning income. Further, passive income should require little effort to maintain, lest it be considered active income. When attempting to grow your passive income, many commonly refer to it as progressive passive income ideas when the earner expends little effort to grow the income. As discussed more below, some common examples of passive income include rental income, portfolio income, and any business activities in which the earner does not materially participate. However, not all of these passive income ideas result in favorable tax treatment.

Is Passive Income Taxable?

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In a word: yes.  As with active (earned) income, passive income usually qualifies as taxable. However, passive income can receive different treatment from the IRS, as discussed more below. Portfolio income is considered passive income by some analysts, so dividends and interest would therefore be considered passive. Passive income does not solely avoid taxation simply for being passive.  Special rules apply for passive income when it falls into qualified categories (discussed more below).

How to Pay Less Under Long-Term Capital Gains

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If you need more evidence of why long-term investing is the best type of investing after tax reform, look no further than the chart above. This means returns you recognize from long-term investing receives preferential tax treatment, thereby making it a superior type of investing compared to short-term capital gains (taxed as ordinary income under the 7 tax brackets currently used for calculating federal income tax). This quality makes long-term investing one of the best investments for young adults because this type of gain faces less tax and diversifies your assets. This long-term investing can also manifest other tax benefits in the case of qualified dividend investing. Purchase a qualified dividend-paying stock through a free stock trading platform like Webull and hold on while the payments hit your brokerage account. And if you see the upper end of the 0% tax range shown above, you’ll see just how to pay zero tax on your investing income: make it long-term (and passive in the case of qualified dividends)!

What is a Passive Activity?

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Naturally, passive income comes from passive activities.  Non-passive activities (otherwise called active) are businesses in which the taxpayer works on a regular, continuous and substantial basis. Passive income does not include salary, portfolio, or most forms of investment income. In general, the IRS considers an activity passive if it involves rentals or any business in which the taxpayer does not materially participate. The IRS uses material participation as a test to meet the passive income standard.  Some of the ways to meet the material participation categorization (and thus not have this activity qualify as passive) include:

• Being the sole participant in the business during the year
• Working at least 500 hours in the endeavor during the year
• Working at least 100 hours and as much as any other individual at the business during the year
• Working at least 100 hours in the activity and a total of more than 500 hours at all passive activities for the taxpayer
• Having materially participated in at least 5 of the past 10 tax years
• For personal services businesses, having materially participated in three previous tax years at any time

A final facts and circumstances test allows the IRS to consider whether you engaged in regular, continuous, and material participation in the activity during the year.  However, you still need to work at least 100 hours in any circumstance.

Other Top Investment Opportunities to Consider

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Check out some of these other investment options for a complete listing of every FinTech-enabled investment opportunity popping up. They might represent some of the best assets to buy for your portfolio.

Which Types of Passive Income Qualify for LT Capital Gains?

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I should point out the importance of making sure your passive income qualifies for long-term capital gains treatment. As mentioned above, if you sell an asset held for longer than a year and realize a capital gain, the IRS treats this as a long-term capital gain. Likewise, corporations can pay dividends, some of which are considered “qualified” and meet the long-term capital gains treatment. For reference, a dividend is generally considered qualified if it is paid on stock you held more than 60 days during the 121-day period that began 60 days before the ex-dividend date. This is the first date new investors are not entitled to receive the stock’s next dividend. For any dividends not meeting those requirements, they are considered ordinary dividends and are taxed at ordinary income rates. Some other examples which do not satisfy the qualified dividend treatment are:

• Master limited partnerships (MLPs)
• Real estate investment trusts (REITs)
• Dividends paid on employee stock options
• Dividends paid by tax-exempt companies
• Dividends paid on savings or money market accounts

Passive Income Received from Crowdsourced Real Estate Platforms

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In recent years, FinTech companies like Fundrise have become popular alternative investment options to traditional real estate investing. These services enable crowdsourced ownership of real estate to produce passive income akin to that described above. In fact, experienced and inexperienced real estate investors alike can participate in this new and unique opportunity to tap into a traditional path to building wealth for lower capital commitment. However, what type of tax treatment does crowdsourced real estate receive? In broad strokes, two types of investors exist: accredited and non-accredited.  Strictly speaking, an accredited investor has more investment options than non-accredited investors, all things being equal. As a specific call out: some investment platforms only allow access to accredited investors (or those people who meet one or both of the following criteria):

• Earned income in excess of $200,000 (or $300,000 with a spouse) for each of the last two years with reasonable expectations for that amount this year, OR
• Has over $1,000,000 in net worth (with or without a spouse), excluding the equity in a primary residence

For accredited investors, they will often invest in equity projects through some crowdsourced real estate investment services like EquityMultiple. In simpler terms, this means the accredited investor actually becomes an owner or partner in a company, often in an LLC (Limited Liability Company) or LP (Limited Partnership). Profits and losses from LLCs pass through to investors and will be reported on Form 1065 (K-1s). These company structures are therefore referred to as pass-through entities. Because of this pass through nature, the LLC does not pay any taxes, rather accredited investors pay taxes on their personal returns. Another common form of real estate crowdfunding investment occurs through debt financing. For this investment type, non-accredited investors can participate and do not own equity in a company. Instead, these investors treat the income received as interest income. Most debt structures allow investors to buy shares in a fund, sometimes called eREITs. Fundrise allows this option to non-accredited investors. In this scenario, these investments act similarly to investing in a stock or bond in terms of tax treatment.  Following this initial investment, the LLC will then invest in specific real estate projects. Looking specifically at a hypothetical example from Fundrise, the treatment of dividend types may differ due to a number of factors. The company’s eREITs allow non-accredited investors to participate and as an investor in any REIT (real estate investment trust), they should receive a Form 1099-DIV tax form. This form includes pertinent information on dividends paid to the investor in a given tax year. Depending on the results of operations for the firm, REIT dividends can classify as ordinary dividends, qualified dividends, or a return of capital, all of which receive different tax rates. In fact, when invested in FundRise’s eREIT product, in a given year, an investor’s dividends may comprise a combination of each of these types of dividends.  Generally speaking, REITs do not regularly issue qualified dividends. For dividends to qualify for the long-term capital gains rate, the income generally would already have faced taxation, which is not how the REIT structure tends to operate. Actually, a primary advantage of the REIT structure is to avoid taxation at the fund level and instead pass these payments through to the individual investor. Therefore, the amount an investor pays in capital gains tax will also vary based on their tax bracket and annual income. What REITs do provide, however, is a return of capital, also called a non-dividend distribution. A return of capital distribution reduces the shareholder’s cost basis and faces taxation as a capital gain when the investor redeems their investment. Because long-term capital gains face lower rates, non-dividend distributions may serve as a beneficial distribution from a tax savings prospective. In any event, we think Fundrise offers a great opportunity for non-accredited investors to begin investing in real estate. Consider signing up through the button below, creating your account and learning more. Related: 11 Best Fundrise Alternatives [Accredited & Non-Accredited Apps]

How to Pay Zero Tax – Use these Different Tax Preferences

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From the tables above, you can see from the federal level how to pay zero taxes by generating qualified passive income (e.g., qualified dividends). Specifically for qualified passive income (long-term capital gains) tax rates in 2021, if you make $40,400 for single taxpayers and $80,800 for married, filing jointly taxpayers in 2021, you fall into the 0% tax rate. Of course, these income levels are tax-free (not including the consequences of state taxes) if you don’t also make ordinary income above those levels plus your respective standard deduction to push you into the 15% long-term capital gains bracket. In other words, if you make $12,550 (2021 standard deduction for single taxpayers) of ordinary income as a single taxpayer and $40,400 of qualified passive income ($52,950 total), you wouldn’t have any federal income tax liability. Likewise, for married, filing jointly taxpayers, they can have $25,100 (2021 standard deduction for married, filing jointly taxpayers) of ordinary income and $80,800 of qualified passive income ($105,900 total) to pay zero tax (federal income tax). If you could find a way to generate that level of income in retirement (early or otherwise), you’d tell Uncle Sam to go away because it’s all yours to keep. You could find qualified dividend-paying investments which yield 2% and live federal income tax-free off of capital investments worth roughly $1,286,000 if you’re single or $2,573,000 if you’re married.  For simplicity, let’s say $1,250,000 and $2,500,000. Of course, you could also pay zero federal income tax on some higher-earning qualified dividend investments on less capital investment. For example, a 5% qualified dividend investment would earn you the max free of federal income tax liability on $800,000 or $1,600,000 worth of capital investments for individuals and couples filing jointly, respectively. This could also come from selling assets held for longer than a year and realizing long-term capital gains. If you want more federal income tax-free income, you could buy municipal bonds from your state and pay no income taxes. However, the lower risk profile of these investments often allow for lower interest payments compared to their corporate bond counterparts. Therefore, these tax-advantaged debt instruments typically reside in higher-income taxpayers as a means for receiving a tax shield on their investment income. If you did earn ordinary income above the standard deduction and hold real estate, you’ve got more options available to you. This real estate investment might produce losses you could use to offset your ordinary income earned above the standard deduction if you qualify for the Mom and Pop exception above. But the real advantage of lower long-term capital gains tax rates is if you end up generating more qualified passive income or long-term capital gains, the first $40,400 or $80,800 in gains are tax-free depending on your filing status and income level. If you earn between $80,801 and $501,600 as a married, filing jointly taxpayer, you only pay 15% on passive income. Because of this, to the extent you can manage, you should consider investing in qualified passive income generating assets. Further, you should find a way to earn as much qualified passive income as you can until you find your optimal level of financial independence.

Looking for Investing Options to Build Passive Income?

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Now that you understand the tax advantages of qualified passive income, how do you act on the information? Well, if you feel conviction in pursuing a strategy of paying Uncle Sam less on your tax-advantaged passive income, the next step is identifying the assets which will produce the best return on your investment. In addition to Fundrise, the best retail brokerage I’ve found for individual stock trading is Webull. This leading stock trading app for beginners offers commission free trading, has real-time market data, and allows you access to thousands of securities which provide qualified passive income like that discussed above. And for the time being, Webull offers a chance at free stocks for opening an account and making a nominal deposit as an extra incentive to get started. Consider using this great Robinhood alternative’s stock screeners to find high-quality dividend-paying investments best-suited to your needs.