Passive Aggressive Behavior
by Richard
Back in the mists of time….we experienced a convulsive revision to the tax code. The Tax Reform Act (TRA) of 1986. This was the trigger that ignited the booming stock market for the next fourteen years.
Not so surprising, when you consider that the top tax rate permanently dropped from 50% to 28%. Until it was raised a few years later.
This tax reform business is always best understood as a work in progress. More of a journey than a final destination.
This act was also aimed at curbing abusive tax shelters, and in that vein it divvied up income into three distinct categories…a distinction still followed 22 years later.
- Earned income was wages and proprietorship income.
- Portfolio income denoted profits from securities, including dividends and interest.
- Passive income included income from patents, royalties and license agreements…and income derived from rental properties.
Passive income was defined as money received on a regular basis, “without continuing effort”.
Yeah. Right.
To nail the distinction down, Passive Activity Income was defined to include all income generated from real estate investments — regardless of how active the investor was in managing the property.
The act was designed to severely limit passive income deductions. But in addition to the damage done to the investment real estate markets, lets examine the damage caused by the Orwellian language.
We’ve had time for two real estate booms since passage of the act: The steady recovery from the 1990-91 recession, and the wild real estate bubble resulting from the Fed’s overly aggressive ultra low federal funds rate following the 2001 recession.
But Really - How Passive?
I wonder, in each case, how many casual, armchair investors took the phrase “passive income” literally. The evidence is that way too many did exactly that.
During the decades of the eighties and nineties, average middle class families were transmuted into investors, often kicking and screaming, with the widespread adoption of 401K plans and IRAs. Over time, they learned to manage their own investments online, and gained confidence in their do-it-yourself abilities.
But this has not served them well with real estate. I’m not talking about owner-occupied homes. I’m talking about all the non-owner occupied investments, where the goal was to “flip” properties, using ultra leveraged minuscule down payments.
What no one bothered to tell them is that investing in income producing real estate is a business, despite the soothing terminology from the tax code. It involves marketing, repairs and maintenance, accounting, legal and a score of other skills.
Sounds a whole lot more active than passive to me.
Many learned this lesson the hard way. There are two ways you can truly get to know another human being. One is to marry them. And the other is to rent to them.
Every dysfunction in that family’s fabric will be on display. Their lack of sanitation. Their poor budgeting and cash management. Their out of control kids and pets. Their sloth, resentment and anger. It’s all on parade, 24 x 7.
Professional management companies have learned to deal with these issues. Most individual investors learn too little, and too late.
If you have the time and skills to do minor repairs, to closely supervise random and unpredictable behavior, and have deep enough pockets to ride out the lean periods, this may be a profitable sideline venture.
Much like investing in a franchise, or any other start up business.
But this is not anything like your mutual fund portfolio, that can be remotely managed by keystroke, at your leisure.
This is hands on, gritty, and intense. And costly.
Millions of investor owned condos sit empty, and un-flipped, draining both your cash and patience. The lucky ones can cover maybe half of their negative cash flow with patchwork rentals.
It’s the most aggressive passive income you will ever earn.
