Passive investing is an investment strategy that aims to maximize returns over the long run by keeping the amount of buying and selling to a minimum. The idea is to avoid the fees and the drag on performance that potentially occur from frequent trading. Passive investing is not aimed at making quick gains or at getting rich with one great bet, but rather on building slow, steady wealth over time.
Also known as a buy-and-hold strategy, passive investing involves buying a security with the intention of owning it for many years. Unlike active traders, passive investors are not attempting to profit from short-term price fluctuations, or otherwise time the market. The basic assumption that underpins a passive investment strategy is that the market generally posts positive returns given enough time.
Passive Investing Strategy
Traditionally, passive investors attempt to replicate market performance by constructing well-diversified portfolios of individual stocks, a process that can require extensive research.
With the introduction of index funds in the 1970s, achieving returns in line with the market became much easier. In the 1990s, exchange-traded funds, or ETFs, that track major indices, such as the SPDR S&P 500 ETF (SPY), simplified the process even further by allowing investors to trade index funds as though they were stocks.
Now that mutual funds and ETFs allow for index investing with relatively little initial research, the most difficult skill for passive investors to master is emotional control. Resisting the urge to sell when the market experiences a downturn requires patience and a strong stomach. When a rapid sell-off triggered circuit breakers that shut down trading in August of 2015, for example, iShares Core S&P 500 ETF (IVV) and many other ETFs tracking the S&P 500 suffered significant losses, as investors panicked at the lack of pricing information and liquidated their holdings.
Passive investors must have the presence of mind to weather these storms and trust that the market will correct itself with time.
Passive management is a style of management associated with mutual and exchange-traded funds (ETF) where a fund’s portfolio mirrors a market index. Passive management is the opposite of active management in which a fund’s manager(s) attempt to beat the market with various investing strategies and buying/selling decisions of a portfolio’s securities. Passive management is also referred to as passive strategy, passive investing or index investing.
Followers of passive management believe in the efficient market hypothesis. It states that at all times markets incorporate and reflect all information, rendering individual stock picking futile. As a result, the best investing strategy is to invest in index funds, which have historically outperformed the majority of actively managed funds.
Earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not materially involved. As with non-passive income, passive income is usually taxable; however it is often treated differently by the Internal Revenue Service (IRS). Portfolio income is considered passive income by some analysts, in which case dividends and interest would be considered passive.
There are three main categories of income: active income, passive income and portfolio income.
Passive income has been a relatively loosely used term in recent years. Colloquially, it’s been used to define money being earned regularly with little or no effort on the part of the person who’s receiving it. Proponents of earning passive income tend to be boosters of a work-from-home and be-your-own-boss professional lifestyle. The type of earnings people usually associate with this are gains on stocks, interest, retirement pay, lottery winnings, online work, and capital gains.
While these activities fit the popular definition of passive income, they don’t fit the technical definition as outlined by the IRS.
Passive income, when being used as a technical term, is defined as either net rental income and income from a business in which the taxpayer does not materially participate, and in some cases can include self charged interest.
* Self Charged Interest
When money is lent to a partnership or S-corporation acting as a pass-through entity (essentially a business that is designed to reduce the effects of double taxation) by that entity’s owner, the interest income on that loan to the portfolio income can qualify as passive income. As the IRS language reads, certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity deductions if the loan proceeds are used in a passive activity.
Rental properties are defined as passive income with a couple of exceptions. If you’re a real estate professional, any rental income you’re making counts as active income. If you’re self renting meaning that you own a space and are renting it out to a corporation or partnership where you conduct business, that doesn’t constitute as passive income unless that lease had been signed before 1988 in which case you’ve been grandfathered into having that income being defined as passive. According to the IRS, it does not matter whether or not the use is under a lease, a service contract, or some other arrangement.
Yet, income from leasing land doesn’t qualify as passive income. Despite this, a land owner can benefit from passive income loss rules if the property nets a loss during the tax year. As far as holding land for investment – any earnings would be considered active.
* No Material Participation
If an investor puts $500,000 into a candy store with the agreement that the owners would pay the investor a percentage of earnings, that would be considered passive income as long as the investor doesn’t participate in the operation of the business any meaningful way other than placing the investment. If the investor did help manage the company with the owners, the IRS argues, the investors income could be seen as active since the investor was working with the business.
Another way to think about this is in terms of venture capital. If a general partner in a VC firm invested into the same company that the private equity fund did the earnings they received from that investment would be considered active income, while the earnings the limited partners made would be considered passive income. This is because the general partner most likely is dedicating more than just money to the company, sitting on the board or advising members of the company, while those who invested into the private equity fund that then invested their money into the company would have no material participation.
The IRS has a test for material participation: if you’ve dedicated more than 500 hours to a business or activity in which you’re profiting from, that is material participation; if your participation in an activity was the substantially all the participation for that tax year, that is material participation; if you’ve participated up to 100 hours and that is at least as much as any other person involved in the activity, then that is defined as material participation.
* Benefits of Passive Income
When a taxpayer records a loss on a passive activity, only passive activity profits can receive have their deductions offset instead of the income as a whole. It would be considered prudent for a person to ensure all the passive activities were classified that way so they can make the most of the tax deduction. These deductions are allocated for the next tax year, and are applied in a reasonable manner that takes into account the next years earnings or losses.
* Grouping Activities
To save time and effort, a person can group two or more of their passive activities into a larger activity provided they form an appropriate economic unit. When a taxpayer does this, instead of having to provide material participation in multiple activities, they only have to provide it for the activity as a whole. In addition, if a person groups multiple activities into one group and has to dispose of one of those activities, they’ve only done away with part of a larger activity as opposed to all of a smaller one.
The organizing principle behind this grouping, appropriate economic units, is relatively simple. If the activities are located in the same geographic area, if the activities have similarities in the types of business, of if the activities are somehow interdependent, for example if they have the same customers, employees, use a single set of books for accounting.
For example, if someone who owned a pretzel store, and sneaker store located in a malls in both Monterey California, and Amarillo, Texas they would have four options of how to group their passive income. Those could be grouped into one activity since all businesses were in a mall; into two groups defined by either geography or type of business (candy and shoes, Monterey and Amarillo), or they could remain ungrouped.
Passive activity is activity in which the taxpayer did not materially participate in during the tax year. Internal Revenue Service (IRS) defines two types of passive activity: trade or business activities not materially participated in, and rental activities even if the taxpayer materially participated in them (unless the taxpayer is a real estate professional). Material participation is defined by the IRS as involvement in the activity of the business on a regular, continuous and substantial basis.
The passive activity rules apply to individuals, estates, trusts (except grantor trusts), closely held corporations, and personal service corporations.
Income from rental properties is a suitable example of a passive activity. Making a distinction between passive and active income is important because the taxpayer can claim a passive loss only against income generated from passive activities. A passive loss cannot be claimed against active income. Any excess passive activity loss can be carried forward to future years until used, or until it can be deducted in the year when the taxpayer disposes of the passive activity in a taxable transaction.
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