While it is important not to let the tax tail wag the investment dog, an investor's three greatest enemies are inflation, investment fees, and taxes. Of these three, taxes have the potential to decrease your meaningful return the most. Consider a perfectly tax-inefficient investment with a return of 10% and how much goes to each of those three enemies for a high earner:
- Inflation: 2%-3%
- Advisory/management fees: 0%-1%
- Taxes: 4% (32%-37% federal + 0%-10% state + 3.8% ACA = 35%-50% total)
Add it all up, and as much as 80% of your return could be wiped out! Thus, reducing your tax bill substantially can dramatically increase your after-inflation, after-fee, after-tax return. This is why techniques like:
- Buying and holding to reduce capital gains taxes
- Offsetting passive income with depreciation
- Taking advantage of qualified dividends
- Tax-loss harvesting
- Using retirement and other tax-protected accounts
- Flushing out appreciated shares with charitable giving
can make such a big difference.
3 Types of Income
The IRS has divided income into three types, and if you want to understand how the taxation of your investments will occur, it's critical you understand the difference.
#1 Earned Income
The first type is earned income. On earned income, the taxpayer pays taxes at ordinary income tax rates AND pays payroll taxes, typically Social Security taxes on some income and Medicare taxes on all of it. If you've ever complained that billionaires pay taxes at a lower rate than you do, you may be right if all of your income is earned income and none of theirs is.
#2 Portfolio Income
Portfolio income is classic investment income, including interest, dividends, and capital gains. You may pay ordinary income tax rates on this income, but if you are a long-term investor, you may instead pay taxes at the lower qualified dividend and long-term capital gains rates. Capital losses can be used to offset capital gains as well. Royalties, while taxed at ordinary income taxes, are also considered portfolio income. The main taxation difference between ordinary income and portfolio income is that no payroll taxes are due on portfolio income. The ACA taxes (technically 0.9% “Additional Medicare Tax” and 2.9% “Net Investment Income Tax”) paid by high earners (3.8% total), however, do apply to portfolio income.
#3 Passive Income
The third type of income is much more difficult to understand. This is not income you earn, but it's not portfolio income either. The classic example is real estate income. Basically, it is the total of the rents (revenue for the real estate business) minus the total expenses for the property, including depreciation. Other sources of passive income include oil and gas investments, cattle investments, and investments in businesses in which you do not “directly and materially participate.” As you can imagine, that phrase has been carefully defined by the IRS, and we'll discuss it more below.
Taxes on passive income are paid at ordinary income tax rates. Payroll taxes are not applied, but the ACA taxes are. That doesn't sound all that different from interest, non-qualified dividends, or short-term capital gains—all of which are portfolio income. However, the main difference between portfolio income and passive income is seen when it comes to losses. In the portfolio income category, capital losses can offset capital gains, but passive losses are treated differently from capital losses. Passive losses do not offset capital gains (at least until the passive investment is sold), and they don't typically offset active losses. But they do offset passive income, and that is the subject of today's post.
More information here:
10 Ways to Avoid (or at Least Delay) Capital Gains Taxes
20 Ways to Lower Your Taxable Income for High Earners
What Is a PAL?
PAL stands for Passive Activity Loss. That sounds like a bad thing, right? Who wants to lose money? However, in reality, these losses are often just “paper losses,” an accounting convention. Ideally, your investment still has an overall positive total return even if the PALs allow you to report a loss to the IRS.
How can you make money and report a loss to the IRS? Well, you made the money in ways that the IRS does not count as taxable income, such as unrealized gains or debt reduction, while losing money in ways that the IRS does count as taxable income, such as the difference between your revenue and expenses. The chief way this is done is by counting a “paper expense,” such as depreciation (real estate or equipment) or depletion (oil and gas). Sure, your cash flow was positive before depreciation was applied but not afterward. With bonus depreciation, accelerated depreciation, cost segregation studies, and ample amounts of leverage, depreciation in the year you purchase an investment can add up to even more than your investment. So, you can tell the IRS you bought an investment for $100,000, yet lost more than $100,000 on it! All while actually earning a positive total return.
What Happened in 1986?
In 1986, tax laws were changed so passive losses could only be used to offset passive income. Prior to that time, you could use passive losses to offset your earned income. This was significant for high earners, since the top federal marginal tax rate (tax bracket) in 1985 was 50%. However, Congress felt like it had to act to stop abusive tax shelters. Way too many investors were letting the tax tail wag the investment dog, and they would buy stupid investments just to lose money and lower their tax bill.
The Tax Reform Act of 1986 killed these abusive tax shelters (and hurt lots of doctors who had bought them primarily for the tax benefit). Starting in 1986, you could no longer use passive losses to offset earned income. You had to carry them forward (indefinitely) until you had passive income for them to offset. There were lots of other tax law changes, too, but many of those were later reversed. However, this whole discussion about the difference between earned, portfolio, and passive income started in 1986 with that law. Not coincidentally, 1986 is also when we started seeing discussion of the PIG/PAL technique.
What Is a PIG?
We've already defined PAL. A PIG is a Passive Income Generator, or an investment that generates most of its return as passive income. A good example is a fully depreciated and paid-for rental property. There is no deduction for mortgage interest or depreciation, so the revenue for the property is likely dramatically higher than its expenses, producing a large amount of passive income—all fully taxable at ordinary income tax rates plus 3.8% for high earners.
What Is the PIG/PAL Technique?
The PIG/PAL technique is simply combining a PIG with a PAL in your “passive income portfolio.” The PIG allows you to use up the capital losses you're producing or have been carrying forward due to the PAL. While using up the capital losses isn't necessarily a good thing, the PIG produces income that you can spend, and when combined with a PAL, that income can be spent on your lifestyle tax-free. While not exactly the same as a Roth IRA withdrawal, it sure feels the same when it comes to your tax bill.
Material Participation Tests
It can be challenging to determine if income from a business is earned income or passive income. It really comes down to whether you materially participate in the business. As you can imagine, the IRS has defined material participation. Here are the ways you may materially participate in a business.
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours.
- You materially participated in the activity for any five (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Real estate has some special rules. As a general rule, real estate rental income is specifically defined as passive income. However, lower earners (<$100,000-$150,000) can use up to $25,000 in losses to offset earned income if they “actively participate” (easy to do) in the business. Note that “material participation” (which few real estate investors do) is a much higher standard than “active participation” (which most real estate investors do by owning 10%+ of the property and approving tenants).
Two additional “loopholes” exist where anyone, including high earners, can use an unlimited amount of real estate losses against earned income.
The first is Real Estate Professional Status (REPS). Basically, you must work in real estate for at least 750 hours per year, and you cannot work more in anything other than real estate. Real estate professionals are exempt from the material participation rules.
The second is the Short Term Rental Loophole. Basically, if the average stay in your properties is seven days or less, the IRS considers you in the hotel business, not the rental home business. So, the default classification for your business is not passive. Instead of having to work 750 hours in real estate, you may only have to work 100 hours in the hotel business, and you can use passive losses to offset the income from the activity.
More information here:
Do You Need a ‘Tax Strategist?’
Examples of PIGs
Perhaps you have some PALS, and you want more spendable income. Why not find yourself some PIGs so that the income will be tax-free? What do PIGs actually look like? Here are some examples.
Rental Real Estate: Wait. I thought most PALS were rental real estate. How can they also be PIGs? Typically, a property starts out as a PAL and gradually becomes a PIG. A PIG has used up most or all of the available depreciation, and it likely also has a relatively small mortgage payment (if any) when compared to its revenue.
Limited Partnerships: Income from a business where you are a limited partner, whether real estate or not, is typically passive income. If the business makes a lot of it, it's a PIG. You generally do not meet the active involvement definition as a limited partner.
Equipment Leasing: Just like renting a building is passive, so is renting equipment. Equipment can also be depreciated, so an equipment-leasing business can transition from PAL to PIG as the business ages.
Non-Materially Participating Business: Any business where you do not participate regularly, continuously, and substantially is passive. If it generates a lot of income, it's a PIG.
Self-Rental: If you rent your own building to your own separate operating business for more than 14 days per year (the Augusta Rule exception), that income is passive, and it could qualify as a PIG.
Gains from Sale of a Passive Activity: Selling a property releases suspended passive losses that have been carried forward, which can even be used against other types of income. But if there is an overall gain even after applying those losses, this is a PIG.
What Is Not a PIG?
One of the best sources of income in real estate investing is a private real estate debt fund. Essentially, 100% of the return is paid out as income every year. However, you must consider WHERE that income comes from and HOW that income is classified. The income is interest from the developer borrowing your money. Interest is not passive income; it's portfolio income. Not a PIG. Some of these funds adopt a REIT structure to take advantage of the 199A deduction (which excludes 20% of its income from taxation at all). However, REIT income is also considered portfolio income, so you can't just buy equity real estate investments as PALs and combine them with debt real estate investments as PIGs. Too bad, because that would be a really easy way to improve the tax-efficiency of our real estate portfolio.
What Is Not a PAL?
Another thing to keep in mind is that an investment that only ever loses money is not a good investment, no matter the tax benefit. The PIG/PAL technique is all about releasing suspended losses to offset otherwise taxable income. You want paper losses, not real losses. Eventually, any property or other business you buy as an investment has to generate an overall positive return. Don't let the tax tail wag the investment dog. Yes, losing money lowers your tax bill, but it doesn't leave you wealthier overall, even after paying taxes.
More information here:
The Passive Income Spectrum and the Greatest Hits of Passive Income
The Most Common Way to PIG/PAL Your Way to Wealth
How does this actually work in real life? In reality, wealthy real estate investors use the PIG/PAL technique by continually buying more properties (whether directly or via syndications/private funds) throughout their lives and getting the depreciation out of them as fast as they can. The new properties in the portfolio are the PALs, and the older ones are the PIGs. Maintaining a reasonably high amount of leverage also minimizes the amount of taxable income generated (because the rental income is being used to pay mortgages).
If a portfolio has too many PIGs in it for the number of PALs, the investor would borrow against the older properties and use the proceeds of those loans to buy more PALs. Once you quit buying new properties and/or pay them all off, you end up with plenty of PIGs and no PALS. That gives you a lot of income, but it's all going to be taxable at ordinary income tax rates.
Tax Preparation Headaches: K-1s and Schedule Es
One of the worst parts of chasing PIGs, PALs, and other passive income investments is the complicated taxation. Portfolio income is downright simple by comparison. Your brokerage sends you a single 1099, and everything you need is right there and easily plugged into tax software by the layperson.
The taxation of passive investments is far more complicated. You will need a Schedule E for each property you invest in directly, and more passive investments, like syndications and private funds, will each generate a K-1. A diversified portfolio might mean dealing with 20 or more K-1s at tax time. K-1s are often late, making it challenging to ever file your taxes by April 15. Filing an extension isn't too big of a deal, but many of these sorts of investments also require you to file taxes in multiple states, at least once they transition from PALs to PIGs. Even diehard DIY tax preparers find themselves relying on professional tax preparers once that happens. And if the amount of passive income is not very high relative to the additional tax preparation costs, it all seems kind of silly.
As a general rule, investing less than $100,000 into an investment that will be sending you a K-1 or that generates its own Schedule E probably isn't worth it, especially if it will require additional state tax returns. After all, $300 of passive income that results in a $600 higher tax preparation bill is foolish.
The Bottom Line
The PIG/PAL technique, done properly, can dramatically increase your wealth by allowing you to invest and spend money that would otherwise go to the IRS. However, it's complicated and doing it properly is not as easy as it looks.
What do you think? What do your PIGs and PALs look like? Have you found chasing passive income worth the hassle?