APU Business Original

Smart Personal Finance 101: Active and Passive Investments (Part I)

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By Dr. Gary L. Deel
Faculty Director, Wallace E. Boston School of Business

and Dr. Karin Ford-Torres
Faculty Member, Wallace E. Boston School of Business

This is the fourteenth article in an ongoing series on sound tips for financial security and prosperity. Nothing in these articles is intended as formal legal or financial advice. Readers should consult with an attorney or licensed financial advisor before making any financial decisions.

In the previous parts of the Smart Finance 101 series, we talked about equity, interest, credit cards, home ownership, and most recently, retirement strategies. One thing we made clear in the retirement articles is that you should be saving aggressively for your golden years through diversified investment options. In this installment, we’re going to look at options for investment that go beyond the scope of retirement.

Growing Your Net Worth with Active Investments

Tax laws limit how much individuals and couples can invest in retirement accounts depending on age, income and other factors. But an important question that some may be in a strong enough financial position to have to ask is: Once you’ve maxed out on retirement contributions, what else can you invest in to grow your net worth?

On this subject, there are really two main strategies: active and passive investments.

An example of an active investment would be using money to start a new business, either alone or with partners. This type of investment is considered “active” because although you are investing your money with a hope of return, you will also have to actively put in some work managing or operating your business.

Another common example of active investment would be rental property ownership. We talked about rentals in previous articles and why you should almost never rent a home if you can afford not to.

But renting properties to others can be a great way to earn growth on your money. In fact, depending on the market and other variables, rental ownership can generate some of the highest returns achievable in the investment world — regularly earning 14%-18% and sometimes even more.

But there is a reason for this rate of return, and it’s because, again, rental ownership is an active investment. Why? Because you, the property owner, typically need to be actively involved in the rental business — vetting tenants; negotiating leases; handling maintenance, repairs, and damage; and dealing with complaints.

You could, of course, hire a management company to handle all of that mess for you. But such companies charge a fee for their services — typically 10% of rental income per month or so. This fee can substantially diminish your profit margin on the rental. So landlords have to decide for themselves whether hiring a management company to do the legwork is worth the expense.

But one other reason why rental properties are particularly attractive as investments is that not only does the landlord profit from rental income, but he or she also benefits from appreciation on the property itself. In other words, real estate is an appreciating asset at most times and in most markets, meaning it tends to be worth more over time. So property owners can not only earn their returns from tenants who occupy the property, but they also get to cash in on the property at the time of sale, as most of the time real estate can be sold at a profit.

But note that any profit on real estate sales depends on the economic environment. If the housing market crashes, a home could lose value year-over-year. But generally, if you hang onto the property long enough, it will recover and continue to appreciate.

The Home Sale Exclusion

Of course, income tax is owed on the rental revenue, and a capital gains tax is usually owed on the profit from the sale of real estate. However, there is currently a critical capital gains tax exclusion available to investors. If you take advantage of it strategically, you could avoid almost all of the capital gains tax liability. It’s called the home sale exclusion.

Under the home sale exclusion, you can exclude up to $250,000 in profits from capital gains tax liability if you occupied the property in question as your primary residence for at least two out of the last five years of ownership prior to the sale.

Why is this home sale exclusion helpful? Because if you make strategic real estate acquisition moves, you can take advantage of this exemption over and over to pay no capital gains on home sales.

Suppose you buy a home today and use it as your primary residence for two years. Once you’ve hit two years, you buy another new home for yourself. You then rent out your old home to cover the costs of ownership and make a small profit through rental income. After just under three years of renting the old home, you sell it.

Since you lived in the old home for two of the last five years that you owned it, you can exclude up to $250,000 in profit. Since it’s rare to make more than $250,000 in profit on a single-family home in just five years of market appreciation, this rule usually has the effect of covering all of your profits.

Now suppose you lived in the new home (the second one you bought) for two years and then do the exact same thing. After the first two years, you buy another one to live in and rent out the previous one for just short of three years before selling it.

You are eligible to take advantage of the home sale exclusion once every two years, so that means you could continue to do this rolling-over strategy with your homes every two years and never pay a dime in capital gains on the profits.

Dr. Deel took advantage of this exclusion with several of his rental properties and saved tens of thousands of dollars in capital gains tax liability. Many real estate investors take full advantage of this exclusion as a means to maximize their return on investment.

Aside from active investments, though, there are also passive investments. In the second part, we’ll talk about different passive options and where your money might be best allocated.

About the Authors

Dr. Gary Deel is a Faculty Director with the Wallace E. Boston School of Business at American Public University. He holds a J.D. in Law and a Ph.D. in Hospitality/Business Management. Gary teaches human resources and employment law classes for American Public University, the University of Central Florida, Colorado State University and others.

Dr. Karin Ford-Torres is an Associate Professor with the Wallace E. Boston School of Business at American Public University. She holds a Ph.D. in Business Administration with a concentration in Advanced Accounting and Financial Management. Karin teaches accounting and finance courses for American Public University, Purdue University Global and Colorado State University-Global. She has 24 years of prior banking experience with Bank of America.

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