How to implement "passive-pairing" to drastically cut or wipe out your investment tax bill.
((Disclaimer: I'm not an accountant, financial advisor or attorney. Always consult your own financial and/or legal advisors before making any tax, financial or legal decisions. Code of ethics: We do not receive any money from any sponsor or platform for anything including guides, tutorials, postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves above what we negotiate for the benefit of private club members.)
Part 1 of this article looked at traditional retirement-vehicle tax-sheltering methods (self-directed IRA, solo 401k)... examining how they are good and how they fall short. Part 2 looked at how experienced investors like John Frederick use non-retirement money to pay zero taxes while still maintaining maximum financial flexibility ("defer, defer and die" via serial 1031 exchanges). Part 3 looked at how to dramatically cut or eliminate your tax bills on a wider variety of investments using "passive-pairing". Here in Part 4, we'll explore how to actually do that, by identifying investments that work with this technique. And then we'll talk about how to apply that to your portfolio in the most efficient way to max out your tax savings.
I Know It's "Passive". But is it "IRS Passive"?
As we mentioned in Part 3, this technique only works on investments that generate passive income. So how do you identify these?
The first thing is to understand what the IRS means by "passive" income. It has almost nothing to do with what you and I mean by "passive" in ordinary life.
Most people would say a "passive" investment is any investment where somebody else makes all the decisions and we have no control and are just along for the ride. This describes pretty much every single syndication/crowdfunding deal, as well as investments in stocks, bonds, CDs that generate interest, etc. All of these are "passive" in the everyday sense.
That's not what the IRS is talking about. For example, CD interest, stocks and bonds are not passive in their minds, and neither are certain syndication/crowdfunding deals. To make things more complicated, it's possible for two funds to look the same on the surface and for one to be ruled as passive by their accountants and the other is nonpassive. Getting a handle on this is crucial to harnessing the tax savings of passive-pairing.
So what exactly does the IRS mean?
The first hoop an investment has to jump through, to be deemed passive, is that it needs to be (per Investopedia) "rental property, limited partnership or other enterprise in which a person is not actively involved". When they say enterprise, they mean a business. So that's means CD interest, stocks and bonds are all ruled out.
Since we're talking about real estate and alternative investments, they are all going to easily qualify here. So then let's look at the next hoop.
1099-DIV or K1?
Generally, your investment is going to give you one of two tax forms at the end of the year. You'll either get a 1099-DIV tax form (like many real estate REITs). Or you'll get a K-1 (like many non-REIT real estate deals and alternative finance deals). This is key to figuring out if an investment is truly passive or not.
If it's a 1099-DIV, then unfortunately you're out of luck. 1099-DIV income is non-passive income. Generally, all REITs fall into this category (such as Blackstone Real Estate Investment Trust (BREIT), Broadstone Net Lease and Broadmark). These investments can have other advantages (including tax shielding before they get to your tax form, which I'll discuss below). But for passive-pairing, they're tax dogs. And you'll need to plan to deal with them, which we'll talk about in a minute.
On the other hand, if the investment produces a K-1, then it passes this test and we can move on to the last hoop.
Which Little Box?
Just producing a K-1 isn't enough, though, because not all K-1 income is passive. So you need to ask the fund how their accountant characterizes the income they produce ("passive or non-passive")?. It's also helpful to get a redacted K-1 from the previous year so you can show your own accountant to confirm.
In the IRS's most recent version of the K-1 form, income shown in boxes 1-3 is great news. These are generally considered passive for limited partners like us. (Box 1 is "Ordinary Income/Loss from Trade or Business Activities", box 2 is "Net Income/Loss from Rental Real Estate Activities", box 3 is "Net Income/Loss from Other Rental Activities"). The other boxes are usually not so good and many are guaranteed to be nonpassive. (See TaxSlayer for more information.)
I said earlier to always ask the fund, and wanted to say again how important this is. As an example, for many years, the accountants for a certain hard money loan fund ruled it to be passive. However the accountants for a very similar hard money loan fund ruled it to be non-passive. And by the way, the accountant for one was the auditor for the other, so it's difficult to claim that one of the accountants was wrong. So the rules are complex, and looks can be deceiving. And this is why I recommend to always ask.
Putting It All Together
So now you know how to identify passive income. And you can identify the super-shielders and also other passive investments that can be paired with them to lower or eliminate your tax bill.
So here's how you maximize your passive-pairing tax savings. Take a look at the two different types of income and then allocate appropriately:
If you've gotten this far and were able to put all of your non-passive income into your traditional retirement vehicles, then you're looking really good. You may ultimately end up with a $0 tax bill for your investments (after doing the "passive-pairing" in the next step). But even if you didn't, you will still have maximized your tax savings by doing the above.
Next, you take a look at your passive income.
If you've gotten this far and were able to pair all of them with super-shielders (after previously shielding all your non-passive income) then congratulations! You now have a $0 investment tax bill!
And again, even if you didn't, applying these techniques to any of your holdings will reduce your taxes and maximize your tax savings.