Ep. 21 | Hunting (PIGs) Passive Income Generators
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Speaker 2:Welcome back to the podcast, everyone. Before we jump into episode 21 and the great topic that we have for you today, let's take a brief moment and thank our sponsor.
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Speaker 2:You're used to having two of us, maybe three of us, including a guest on these, but today, we actually brought everybody out of the cave, at least a couple of us from the teaching tax flow team. Myself, John Topolsky, we have Nate Hamill with us. Hey, Nate. How are you doing, buddy?
Speaker 4:Great. How are you, buddy?
Speaker 2:Good. Good. I'm doing fantastic now that we got you all here. And I would say we put him off to the side, but then we'd figure we'd bring him back into it. So, Chris Pacira, how are you, sir?
Speaker 5:It's great to be back, boys. How are you? Pretty good. We're we're glad you you joined us on
Speaker 2:this one to keep us keep us in line. We we'll call you the chaperone, the the wiser chaperone, but our topic for today is awesome. So what do we wanna call this thing? What what Chris, what do we call passive income generators? What do we call these things?
Speaker 5:Well, it's kinda like when you wake up in the morning and maybe someone in your household is cooking breakfast and you smell some bacon and you're like, man, that smells good. So we're gonna call a passive income generator in the tax world. It's called a pig. And in honor of, National Pig Day, which I believe you said it was March 1? Yeah.
Speaker 5:Just a couple days ago.
Speaker 2:So as as we roll into this so let's let's actually start this. And and Nate, as always, I mean, you you have a lot of insight with this as well. Chris, You're the you're basically me and Nate rolled in tenfold. You you know everything about the tax world, so we'll kinda let you let you guide us down this path. But I would be misplaced if I didn't give us a rollout right of, Chris, why don't you tell us about these pigs and just bring home the bacon, would you?
Speaker 5:We will bring home the bacon. And, we've got to mention episode 21. So our podcast could officially sit up to the bar and order a beer. Oh, I know. Now, if you have bacon, John, you know, and I know you're a condesor of Bloody Marys, that you that the bacon goes well on that Bloody Mary.
Speaker 5:So here's a situation that we run into quite a bit out there. We have a lot of folks that invest in rental properties. In our teaching tax flow world, one of the three laws is understanding the difference between tax flow and cash flow. So we have many, many people in the teaching tax flow community that have a positive cash flow with from their rental property. But from a tax perspective, because of the depreciation deduction, you have a loss.
Speaker 5:So you're reporting a loss from that property on your tax return, and due to several factors, which include income, the amount of time you put in activity, etcetera, etcetera, those losses are considered passive. So rental losses by default are considered passive, and for many people, maybe the majority of people that invest in real estate, those passive losses cannot offset your w two wages or your business income or what we call active income. So those passive losses get stuck for lack of a better term on your tax return. Doesn't mean they're gone, but they carry forward. And to get technical for just a smidge, they carry forward on a form eighty five eighty two.
Speaker 5:So if you are sitting around, now if you're driving, pull over, and if you feel so, inspired to open up your form eighty five eighty two, go do so. But the the problem we have or the challenge is that those passive losses are carrying forward, and the strategy of what we call hunting pigs is to is to allow people to take advantage of those losses and to change the way they invest potentially, not completely, but as a as a strategy to get passive income because that passive income will not be taxable if you have a passive loss.
Speaker 4:So, Chris, just to clarify, because I think this one will hit home for a lot of people listening. What you're saying is if I buy the house next door to me and I have to put a lot of work into it and, yeah, I get rental income, but, ultimately, I take a loss on it. And my day job is a w two employee. Those losses in the rental house next door will not offset my w two income. Correct?
Speaker 5:In most cases, that's correct. There are some income thresholds, and there's some special rules that we have covered in some other podcast. But in general, you have a that rental property is a passive activity for you. In most a lot of times, those passive losses are carried forward. So you're correct.
Speaker 5:So the thing is we love tax free income. Right. So typically, people that have passive activity losses are in the 24% marginal tax rate plus. So if they were to generate income that's not taxable, it's a it's a of even a larger benefit. And that that means a PIG, passive income generator.
Speaker 5:Because, unfortunately, just like capital loss carry forwards, you can't take your passive activity losses with you if once you deceased. They're just lost deductions.
Speaker 2:So not to switch gears too hard on this too, but taking into account everything that really falls under, you know, passive income generators. So what might be we can call it, you know, misconceptions or myths or maybe just incorrect way of approaching these? I mean, are are there a few things that you've seen, you know, over your hundred and seventy five years of doing this, that that may have been, you know, not misappropriated. But talk us through maybe a couple couple examples I think would be fantastic. If we have any real world examples, you know, we can obviously, you know, redact names in these and addresses and everything else, but just give us some examples where these may or may not have actually helped out somebody's tax situation if you have any.
Speaker 5:I know you. Well, let's let's go with an example of a taxpayer. Let's say, married taxpayer, w two wages of $300,000. They invest in an apartment complex. That apartment complex has a cost segregation study run.
Speaker 5:That's another podcast episode that you in, but a cost segregation study performed on it. And let's say this person invested a hundred thousand dollars into this this syndication or this apartment complex. The apartment complex is most likely an LLC and will issue the taxpayer with something called a k one, just a tax form, showing a tax loss. That tax loss might be $70,000. Now the the taxpayer didn't lose $70,000, but that $70,000 loss is a deduction for the taxpayer.
Speaker 5:It's considered a passive activity for the taxpayer. So even though it's a deduction of $70,000, that doesn't mean that taxpayer can take advantage of that deduction this year. So in this fact matter, the and the taxpayer might want to jump into different passive activity, generators to produce some income. So there are there are a few main passive pigs, for lack of better term, passive income generators. Rental real estate is is one of them.
Speaker 5:So not all rental real estate's gonna have a ton of depreciation deduction. For instance, there there's some there's some triple net leases out there. There's some opportunities to basically get a return on your investment that is considered a rental or passive income for tax purposes. Another one, royalties. People invest in music royalties music royalties, and that's also considered
Speaker 2:a pig. So if anybody wants to buy the rights to me singing Kumbaya, I'd be happy to happy to offer those up. But, until then, I wanna maintain those. Talk to us a little bit about that one for an example because I think that's a new opportunity. Nate, Nate, I'm sure you've come across these in in your past experience.
Speaker 2:And, Chris, obviously, you know, you living in in the Nashville area, I'm sure you, you know, have plenty of opportunities with that. But talk us through that a little bit because that's a that's an interesting concept, right, of not only just the passive income side or the we'll call it a a pick up. Right? A pick opportunity. Now we're just naming stuff, here, Piggy Piggy.
Speaker 2:But, tell us a little part tell us about these music royalties either. Yeah.
Speaker 4:Yeah. Chris, pull this part apart for me.
Speaker 5:Yeah. Yeah. We love our technology. So with the so here's what happens. Musician there are a lot of there are a lot of different types of I would've stick to music because there's film.
Speaker 5:There are a lot of different royalties when it comes to a song. There's production. There's writing. There's performing. And what happens is, let's say you're a songwriter and you write a song that produces income.
Speaker 5:Well, if you're the songwriter, that income is considered active income. And if you're self employed, which most folks are, that's subject to your marginal tax rate and self employment tax. So your tax on that income is a lot of money. Mhmm. Well, if you were to sell that royalty because what what the royalty is is that's just a stream of income.
Speaker 5:It's like an annuity based on the amount of times that song is played over several different platforms. So in that case, you might have a songwriter that let's say they're getting married. Let's say they have a life event. They they want they have a hit song that they want to have an influx of cash for, and they don't like paying 40% on that income. They can sell the rights to that royalty, and the cool thing is they change that income.
Speaker 5:The money they receive from their royalty is a long term most likely a long term capital gain taxed at half to a third of the rate they were paying Right. Royalty. Yeah. Now put the hat on of the investor. Back up with a royalty just like a rental property because it has income.
Speaker 5:But now you don't have to pay for the, repairs and maintenance and property taxes, and you get to amortize the cost of that royalty. So if you paid a hundred and $50,000, this would be an expensive song or production for for that. You would get to deduct $10,000 a month a year for the next fifteen years on but let that a hundred and $50,000 royalty would probably be bringing in almost a hundred thousand dollars of income. No. Maybe not that much, but let's say $40,000 of income a year.
Speaker 5:You know, they're all priced differently. There's a whole market for these. But if you have someone that instead of that has a chunk of money that wants to diversify their portfolio, they might wanna invest in royalties because even if they even if they target an 8% return on buying a a music royalty, well, that's tax free if they have that $70,000 loss with that same taxpayer. So that's the example of a music royalty. There are other options like a business that you invest in that you're not what's called materially participating.
Speaker 5:So for instance, you, Nate, and I start a car wash. Now, let's say a hair salon. I don't have hair. We gotta have one ball joke in here. Right?
Speaker 5:So clearly, you're the passive one. Exactly. Yeah. Yeah. You and Nate are working in the salon.
Speaker 5:I'm not. I just put up some money. I get 10% of the profit, but I'm not materially participating, so that's passive to me. So if I can get a 10% return by investing in your business and I
Speaker 2:have these passive activity losses, then it's tax free. And that's a great example too to really draw the line between active and passive. I think that's a great example. Right?
Speaker 5:Yeah. So if you if you invest in a trade or business that you're not what's called materially participating, that's another show topic. And I would say, definitely, go to the defeating taxes Facebook page, defeatingtaxes.com, shameless plug, because we have a ton of resources and we can tell you what constitutes material participation. A lot of times someone look. When we talk about the short term rental loophole, you want to be materially participating.
Speaker 2:Right.
Speaker 5:But in this tax strategy, you don't want to be materially participating. Right.
Speaker 4:And and it's a great opportunity, Chris, because the the the very nature of passive income is you don't have to work at it. You may have to invest into it. But if all goes well, you recoup your investment and then some while working your day job, while sitting at home, while in retirement, while on the beach, whatever it is, that's why we purchase these. That's why we invest in these is because it is exactly that income that is passive.
Speaker 5:Exactly. And that's that's the nine so if you can obtain that income tax free, that's even better. And you can really get into, so so anything that's a rental property or something where you invest and you're gonna get a k one that has a box two income or loss is going to be in, passive income. And there are a lot of strategies. We're not gonna talk about advanced tax strategies for multi member LLCs.
Speaker 5:But let's say that that, John, you're a real estate professional and I'm not, and we buy a beach house together. You might want those depreciation deductions, and I might not need them, and they might not help me. So you could do special allocations within and out a limited liability company to benefit one person because you can you're gonna have specially allocated expenses and and income versus the other. And that's where tax planning strategy that's why it's so important to live by our three laws of teaching tax flow, and tax flow and cash flow are two different things, and understanding that tax agencies are our involuntary business partners. So we need to we need to create our own operating agreement and or the IRS is going to pick your tax.
Speaker 5:And and the laws are written to negatively or to punish kind of, and for, like, a better term, someone that's a passive investor. Now I would argue that having passive activity losses isn't the worst thing in the world in some ways because tax rates are gonna go up, but we typically want to take advantage of our deductions that we have as quickly as possible.
Speaker 2:And so, basically, the the one the one rule that's always gonna be in place, right, is the, the IRS is always gonna want more of the the piggy bank. There's another another one of my pig drops. But but a question for you too, Chris. So I I don't know if, honestly, if we touched on this at all or or started to and then maybe deviate a little bit, but bringing it down a little bit to a a little more of a more of an example or something that could happen. Right?
Speaker 2:So say, for example, you are a passive investor in a business. Say your partner is active. Say something happens, a life change for that individual over the course of, say, two weeks they're in the hospital. You have to step in and theoretically become active. Does that cause any issues as far as for down the road or does there really need to be that truly defined line in the sand between active and passive?
Speaker 5:Well, unfortunately, the tax code is pretty complicated, and there what we're talking about is not really active versus passive. What we're talking about is material participation. So there are seven distinct tests for material participation that if you have a business partner and you have to step in for a two week period, most likely, you're not going to have material participation in that short of a time frame. Mhmm. What the the takeaways for the podcast would be, if you have invested in in different investments in real estate or and you have passive activity losses and you want to utilize those, this is where you would wanna hunt for pigs.
Speaker 5:Because you in order to utilize those, you need to have passive income. And that's where this, you know, that's where that's where hunting pigs gets gets, gets attractive because you've got there's there's a lot of people that don't that don't that understand that, yes, you there are a lot of tax advantages for owning real estate. Some of them are just delayed a little bit.
Speaker 4:And so, Chris, the the the point I'm taking away is if I own one rental home and I've got losses and I'm still interested in real estate, it might be worth looking for a house that already has a lease in place, a tenant, take the income right away, offset it with my existing rental home losses. Right? Absolutely. Absolutely. And and that's where in some ways, the the a
Speaker 5:lot of things play a role. For instance, I'll give you an example. Let's say you're in a situation where you have, a dis you have a mortgage on your primary residence and you have a mortgage on your rental property. Let's say they're the exact same amount and you wanna pay one off. We're not advising you do this.
Speaker 5:And let's say they're the same rate and everything. In general, you're gonna want to have the deduction on the rental property. Mhmm. But if you if the mortgage interest from the rental property is just creating a passive activity lot a greater passive activity loss, you might wanna pay off the rental property loan and take advantage of it, the itemized deduction. And that's where we're we have a passion for creating awareness, and every, you know, every situation is unique.
Speaker 5:And but a lot of times, people don't don't even know typically, someone knows if they have a passive activity loss because they're typically surprised by it. They they it and it can be it could be frustrating. So let's take a negative and no positive. And let's say, okay. Well, let's look at some options for you to generate income that's tax free,
Speaker 4:and that's pretty attractive. Yeah. And and, Chris, what I love about having the opportunity to keep hanging out with you and to work with you as we build this and grow this, the well and, John, you can agree or disagree. The the the limited amount of hair, but the amount of knowledge that comes out of your head is is outstanding. And so when I look and say, man, if there's anybody that has questions that wants to pick Chris's brain, we offered it last time, John Lawford again this time.
Speaker 4:My email is nhamil@teachingtaxlaw.com. If you have a question for Chris, email me. I'll get it in front of him. Maybe we'll maybe we'll do a podcast that's just us answering questions from people. Send those
Speaker 2:to me, and we'll get them answered for you. Excellent.
Speaker 5:Excellent. Exactly. We are listening. We wrap up. We are committed.
Speaker 5:Final thoughts,
Speaker 2:but I do wanna mention one more thing too, Nate, just on the tail end of that one. So a lot of a lot of the questions we get around hunting pigs, and we're not talking, you know, like our our our Texan friends and that are probably thinking we're we're shooting boar from a helicopter here. It's a little bit more strategic than that. A lot of these questions we do get asked on social and at events. And it I I know there's a lot of people come to us.
Speaker 2:Right? And they're, oh, passive income generators. I know exactly what that is. But there is some depth and there's some strategy in this. So before we wrap up, I I did just wanna mention that, and then, actually, I'll toss it back to you guys too for any final thoughts as mentioned.
Speaker 2:But shoot us those messages on social. Shoot them over to Nate. Again, this is stuff that we could talk for hours. I say, do we? No.
Speaker 2:Chris could talk for hours on this. We just kind of moderate and keep him out of trouble. But Yep. There's a lot of, not a gray area, but there's a lot of strategery. There we go.
Speaker 2:We'll come up with another word in here that can be taken from this. So let's, let's wrap this one up. But, again, before do you guys have anything else we wanna we wanna jump in and add to this?
Speaker 4:I wanna pick Chris's brain a little bit. Chris, off the top of your your head, in your brain, and maybe this is how you bring us home, what are the top three passive income generators in your opinion?
Speaker 5:In no particular order, I would say investing in some type of oil or gas. Those are we always talk about, you know, involuntary business partner and there are certain industries that are tax favored. Oil and gas is one of them. So can tax oil and gas is number one one of the three. Rental real estate is still another one, assuming that you can specially allocate or you don't have a mortgage on something or it's fully depreciated.
Speaker 5:Yeah. And then another one would be investing in a trader business that you that you're not materially participating in, such a and that can kinda tie in. I'll give you let me give you an example. Let's say you have a taxpayer that has a has a child that's in in their in the in their college years, and the taxpayer buy some personal property, and eight I e three vehicles and puts it up on Turo. Mhmm.
Speaker 5:And it generates a lot of income for that person. But they're not at they're not really materially participating. The that activity is being run by that person's child. That could be a pick, a pick for that taxpayer. So, those are my top, and, obviously, you know, depending on the taxpayer situation, we're not saying we say don't let the tax tail wag the dog all the time.
Speaker 5:We'll bring a dog into this one, into this this equation. But, yeah, those are the top three. And and, again, don't be afraid to to reach out to Nate. He has a wealth of knowledge himself, and, we are listening and we are constantly growing this community and learning, what what is what everyone's looking for. Awesome.
Speaker 5:Awesome. Well well, thank you, gentlemen, for for joining us on this one, and I guess we should close
Speaker 2:it out with one more pig joke just for the fun of it. It's it's been a fun time collab boar aiding with you. So hopefully hopefully, you guys enjoyed it. Enjoyed it as much as I did. It's cool.
Speaker 2:And this is definitely something we'll be we'll be touching on kind of over and over again as part of that strategy. Right?
Speaker 5:Yep. Thank you, guys. It was a pleasure, and have
Speaker 2:a great rest of the day. Oh, I'm hungry. So we will see everybody next week. Keep on plugging away. I know we're we're getting close to wrapping up q one here of 2023, believe it or not already.
Speaker 2:And we are good to go with this podcast, and we will see y'all next week.
