Blog | Entrepreneurship

How to Turn Ordinary Income Into Passive Income

Why Passive Income is better than Ordinary Income

Many times over the years I’ve heard people talk about how it’s possible to turn your business into an investment where you don’t have to go to work. For years, I didn’t understand how this was possible, and I certainly didn’t think it would ever be possible for my CPA firm. After all, I can’t think of a more labor-intensive business than a CPA firm. With help from my amazing team, we were able to turn our firm into a passive investment. We now have a business that runs without us.

Turning a business into a passive investment where you don’t have to go to work takes some serious effort, but the rewards can be huge. It took Ann, my business partner, and me five years to figure out how to do it with our CPA firm. The good news is that even if you’re not to the point where your business runs without you working, it’s easy to turn the income from your business into passive income for tax purposes. Here is why you would want to do this and a few simple steps for getting it done.

Different Types of Income

Remember that the right side of the CASHFLOW® Quadrant includes both business owners and investors. But there’s one catch; you can’t be a typical investor if you’re going to enjoy the tax benefits of investing. You have to become an active investor. That means you have to be an investor who actively invests for passive income, not earned income. Very simply, passive income is income that comes from dividends, rents, and business. It’s taxed at a much lower rate than earned income, which comes from appreciation and capital gains, or from your paycheck. In order to become a super investor, you must find good, cash-flowing investments that produce passive income.

Portfolio income, or income from investments, is always better than ordinary income. The reason Warren Buffet pays only 17 percent on his income is that most of his income is investment income.

When you have passive income, you can offset your income with losses from your real estate investments, for example. Real estate gets such high depreciation deductions that you can have losses for your tax return even though you have positive cash flow from your real estate. The challenge is that real estate rental losses in the United States are considered to be passive losses and can only offset passive income.

How to turn ordinary income into passive income through your business

So we would like to convert the ordinary income from our business into passive income. Here is how we do it. It’s not how much we own that matters; it’s how much we control. This is the rule we’re going to use to convert at least part of your business income into passive income. All we have to do is to give part of your business to a member of your family who doesn’t work in the business. When we do this, their share of the income from the business is passive income. Then, we also give them a part of the real estate that has passive losses. Now, their share of the real estate losses will offset the passive income from their share of the business.

While this is simple in concept, don’t do this without your tax advisor’s help. There are lots of details that your tax advisor will need to be aware of so you can make this great tax strategy work for you.

To find out more tips on permanently lowering your taxes, read my book, Tax-Free Wealth.