Working With Advisors is Important Before Making Passive Investments

Key Takeaways:
  • Passive income can reduce reliance on full-time work while creating flexible income streams that support early retirement and long-term wealth goals.
  • The right mix of passive investments can unlock meaningful tax advantages, but requires careful planning around IRS rules and participation limits.
  • Involving wealth and tax advisors before investing helps you avoid costly missteps and align each decision with your broader financial strategy.

 

The term “passive income” refers to money that is earned with little or no direct involvement in a venture, other than having invested in it. Sources of passive income can include such earnings as rental income, investment dividends and interest income, as well as income from a minority ownership interest in a business. 

For individual investors, business owners and families with complex investments, passive income can be a powerful tool for minimizing taxes and providing a stream of income during the pre-retirement and retirement years. Moreover, passive income can play a key role in a broader strategy when tax planning, risk analysis, cash flow needs and long-term goals are aligned.  

Active vs. Passive Income

Fundamentally, the difference between passive income and active income is determined by how much involvement the investor has in the investment property. For example, if you have an ownership interest in a local business, do you sit on the board, participate in day-to-day decision making and perform management functions? Or are you a minority investor who keeps abreast of the company’s operations and financial performance, but is not directly involved in decision making? 

If you are the former, you’re an active investor. If you are the latter, you’re likely a passive investor. But it’s not always that simple, and the IRS has a specific participation test that helps distinguish active and passive income, since there are different tax treatments for each and considerable tax benefits for passive income. 

Many individuals have passive investments without expressly seeking them, since the investments held in a non-qualified brokerage account, including stocks and bonds, are largely passive. But moving beyond stocks and bonds to broaden the role that passive investing plays in your wealth plan can help you achieve the financial goals you have set for yourself and your family. 

Passive Investment and Wealth Planning

Many investors are being more intentional about their future planning these days, starting earlier than their parents did and setting goals to fully retire by age 62 or even 55.  

With these goals in mind, from a wealth planning perspective, passive income can reduce reliance on full-time work and provide a sound stream of income during life transitions. An individual who plans to retire early can use passive investments to bridge the income gap between, say, age 55, and the years when major assets such as a home or business are transferred to a younger generation, and when retirement plan distributions and Social Security benefits kick in. 

Moreover, certain passive income sources, such as real estate and stock dividends, tend to rise with inflation, making passive investing a hedge against inflation. As the value of those investments rises, so will the returns. 

Tax Considerations of Passive Income

From a tax perspective, passive income often provides significant advantages. It provides many benefits, including lower tax rates, deductions and options to defer taxes. Moreover, passive investment gains can be offset by passive investment losses to minimize taxes. Specifically, tax advantages include: 

  • Many sources of passive income are taxed at long-term capital gains tax rates, which are considerably lower than ordinary income tax rates. Depending on your income, capital gains tax rates can be 0%, 15% or 20%. 
  • Even if an individual once worked in a company — even in an executive position — but now has a passive minority interest as a retiree, they can benefit from the company’s success without the burden of self-employment tax. 
  • Losses from passive investments can offset gains from other passive investments dollar for dollar. One exception is publicly traded partnerships, which can only use losses to offset gains. 
  • With few exceptions, the IRS considers real estate to be a passive investment, and the ability to deduct depreciation is a significant tax advantage for real estate investors.  
  • Real estate investors also may deduct certain expenses related to generating passive income, including mortgage interest, property taxes, maintenance costs and management fees for rental properties.  
  • Through a 1031 exchange, a real estate investor can defer capital gains taxes by reinvesting the proceeds into another property of equal or greater value. This strategy allows investors to grow their real estate portfolios without immediate tax liabilities. (However, 1031 exchanges are complicated and must follow strict rules and timelines.) 
  • Even though an investor’s position in a company is passive, they may still qualify for at Sec. 199A deduction — also known as Qualified Business Income or QBI deduction, which provides a 20% reduction in their business income subject to tax. 
  • On the negative side, gains from passive investments above a certain threshold are subject to the Net Investment Income Tax (NIIT) of 3.8%. 
  • Additionally, investors may find themselves holding suspended losses, which occur with an unused tax deduction from passive activities, including income from rental properties and certain business investments, are greater than the passive income that is earned. Suspended losses are carried forward to offset passive income gains in future years. 

Types of Passive Income

There are many sources of passive income, and these are the most common: 

  • Private Investment in a Non-Publicly Traded Business — Retired business owners often retain a minority share of their companies and step away from management responsibilities while also receiving dividends. Other investors may buy a minority interest in a startup company that they consider promising. 
  • Dividend-Paying Stocks — Profits distributed from stocks and mutual funds, which can be re-invested to create a continuous income stream. 
  • Bond Interest — Options include government, municipal and corporate bonds. Advantages are predictable income and higher stability, though generally lower returns. 
  • Real Estate Rentals — Options include long-term rentals, short-term rentals, residential and commercial. 
  • REITs — Real Estate Investment Trusts offer real estate exposure without property management. Options include equity REITs, mortgage REITs and hybrid REITs. 
  • Royalties and Digital Assets — These include can include income from creative works such as art and books you have produced that are still selling long after the initial rollout. 

Work With Wealth and Tax Advisors

As with all investments, individuals should work with their wealth advisors, tax advisors and possibly attorneys to determine the right mix of passive investments for their portfolios.  

Some of the factors to be considered are risk tolerance and time commitment, as some investments — even though they are passive — require more attention than others. Some options, such as real estate rentals, require significant upfront investment, so capital requirements must be discussed. 

Additionally, an upfront discussion should include your overall time commitment and how your time will be managed. Certain passive investments do require some attention and management — particularly in the real estate arena — and overshooting the IRS’s guidelines about the number of hours one may be involved with a business as a passive investor could result in negative tax consequences.  

Above all, working with the right mix of advisors before making a passive investment is an important step. Making the investment and then informing your tax advisor at the end of the year may result in foregoing certain tax benefits. Working with the advisors before making a move into a passive investment is critical. 

Managing your wealth and tax strategy shouldn’t feel fragmented. Adams Brown’s Pinnacle Program integrates tax, wealth and estate planning into one coordinated approach—helping you reduce tax exposure, protect your assets and grow wealth with clarity. No more juggling multiple advisors and no more conflicting advice. 

Pinnacle is designed for individuals with $1M+ in investable assets who want a fully integrated approach to wealth, tax, estate and long-term financial planning. A CPA and wealth consultant collaborate with you in real time throughout the year. This comprehensive service model ensures every aspect of your tax strategy, estate planning and financial planning is aligned, leaving no detail overlooked. 

Questions?

Weigh the value of potential passive investments in relation to your existing portfolio. Would a passive investment serve a specific purpose or fill a gap in your portfolio? Would it strengthen a long-term investment strategy that you have already established? 

If you are considering passive investments, now is the time to evaluate how they fit into your broader tax and wealth strategy. An Adams Brown advisor can help you identify opportunities, avoid unintended tax consequences and align investments with your long-term goals. 

If you would like to discuss how passive income investments may strengthen your portfolio or discuss the Pinnacle Program, contact an Adams Brown advisor.