There are three types of income: earned income, passive income and portfolio income.
Earned income consists of income you earn while you are working a full-time job or running a business. Note that “running a business” does not include a rental real estate business in most cases.
Passive income is income earned from rents, royalties, and stakes in limited partnerships.
Portfolio income is income from dividends, interest, and capital gains from stock sales. Portfolio income will not be discussed in detail in this article.
Earned income will always be subject to high taxes. Earned income should be used to quickly build wealth, but in order to minimize your tax position, your wealth should be moved into passive and portfolio income streams. Earned income is subject to your full marginal tax rate and FICA taxes. There are certainly ways to reduce tax exposure, like running earned income through an S-Corporation, investing in the business and creating currently deductible expenses, etc, but the net income will still be subject to high effective tax rates.
The problem with earned income is that in order to reduce tax exposure you must always spend more money.
Passive income, from rental real estate, is not subject to high effective tax rates. Income from rental real estate is sheltered by depreciation and amortization and results in a much lower effective tax rate.
For example, let’s say you own a rental property that nets $10,000 before depreciation and amortization. Let’s also assume that your depreciation and amortization totals $8,000. This leaves you with $2,000 in net taxable income. If you are in the 37% tax bracket, you will pay a tax equal to $740. But when we compare that $740 to the amount earned ($10,000), you see an effective tax rate of only 7.4%.
If you earned that same $10,000 in earned income, you would need to spend money in order to reduce the amount subject to tax. Otherwise, you’d pay $3,700 on the $10,000 in earned income, assuming you’re in the 37% tax bracket.
With rental real estate, you don’t have to pay for depreciation each year. It’s a phantom expense that you get to claim. That’s why passive income beats earned income from a tax perspective.