On this episode of The Engineering Passive Income Show, Joseph discusses the four best investments for passive income that are mature and dependable, Index funds, Dividend stock, Peer to peer lending and Commercial real estate. Joseph explains what each one of the four are and how you can invest in them alongside the pros and cons of each. Don’t forget to subscribe and leave a five star review if you found this episode helpful.
0:00 – Intro
0:36 – Joseph states that this episode will discuss the four best investments for passive income
0:48 – Joseph speaks about index funds and why they’re ideal core portfolio holdings
1:34 – Joseph states that there is an index fund for almost every type of financial market in existence
3:18 – Joseph talks about how index funds have lower management costs associated with them due to their passive income style
4:22 – Joseph explains how high dividend stocks are one of the simplest and lowest costs ways for investors to create passive income
6:21 – Joseph describes peer to peer lending
7:32 – Joseph informs us about the number one investment option for passive income; commercial real estate
9:15 – Joseph explains the down side to REITS
9:26 – Joseph describes how syndications work and the pros and cons of these types of investments
12:27 – Joseph speaks about how you can invest in real estate with a self-directed IRA which is a non-tax able entity
13:07 – Joseph titled the top four types of passive income investments are index funds, dividend stock, peer to peer lending and commercial real estate
13:32 – If you liked what you heard don’t forget to subscribe and leave a five start review
Welcome to the engineering passive income show, where engineers and other professionals come to learn how to generate passive income, grow their wealth and get their time back. Your host is Joseph Bramante, an accomplished civil engineer, oil and gas professional, multifamily investor, an industry speaker. Learn about investment alternatives, the same types of investments that he used to achieve Financial freedom himself broken down like only an engineer can. Now here’s your host, Joseph Bramante.
Welcome back engineers. On this episode, we’re going to discuss the four best investments for passive income. There are many options out there, but these four are the most mature and dependable for you to invest in.
Starting things off, we have index funds. Which are basically like mutual funds that are linked to a particular market index. They’re considered ideal core portfolio holdings for retirement like 401ks and IRAs. They have been promoted by the legendary investor, Mr. Warren Buffet himself as a Haven for savings for later years in life. Now the objective of an index fund is to closely match the performance of the particular index they’re tracking. So like there’s one called the Russell 2000, which is made up of a bunch of small cap companies. And then there’s also the Willshire 5,000 total market index, which is the largest US equity index out there, plus many, many more. There’s an index fund for nearly every type of financial market in existence. And these funds are then passively managed as opposed to actively managed, which is when a fund manager tries to beat the market. It’s called the EMH or the efficient market hypothesis states that at all times, markets incorporate and reflect all information known, making it impossible for a fund manager to beat the market through stock selection alone for any period of time. As our success is only a matter of chance.
Now, a friend of mine who runs a very successful wealth management company once told me this story about fund managers and just kind of helped me understand how some can rise in the right to notoriety and others do not. And the analogy he gave was basically imagine you’ve got 300 people flipping a coin and you know, a percentage of those would get heads. So like 50% would get heads and 50% would get tails. Well, if all the guys who get heads again, get to keep flipping that will continue on and on for several rounds. And you would have some people, a smaller and smaller sub of those fund managers who continue to hit heads. And then eventually over time, all of them would’ve eventually struck out.
The difference is that the guys who got heads for say 10 times in a row would think that they’re just geniuses, instead of just realizing that, Hey, they just got really lucky cause the odds of them hitting heads that many times is very, very low. Well there you go. That’s basically fund managers. That’s kind of how he described them. How I always think of them.
Now as a result of this passive management style they have lower management costs associated with index funds and the passive management fees are about actually 20% of those on active managed funds. And you have lower annual turnover rates of your stocks, which means you’re going to have more long term capital gains for short term capital gains, which makes index funds more tax efficient. Though you do pay tax on the dividends they kick off. So in a way you’re double taxed, cause you get the capital gains. Plus there’s the ordinary income tax you’re paying on those dividends. And lastly, just want to point out at the returns would mimic whatever index they’re tracking, but the stock market has historically returned about 6% to 8%. So that fund would generally track it around 6% to 8%. Although this obviously depends on the history of that fund. And of course, as we all know, past performance does not predict future results.
Coming at number three, third place are high dividend stocks or just dividend stocks. This is one of the simplest and lowest cost ways for investors to create passive income. As public companies on a stock exchange generate profits, a portion are allocated back to their shareholders in the form of dividends. The dividend amount per share can vary a lot from one company to the next and can also change from year to year. One year they may offer a like a 5% share and the next year maybe a 2% share. Though, they’re also very liquid. So you’re able to reallocate your stocks in any given year as they’re adjust their dividends. And also if you’re unsure about which dividend paying stock to choose, you should choose or sorry, you should look for ones that have at least a 25 year track record of increasing their dividend regularly. And these are termed a dividend aristocrat stock.
So once you get your, you know, you get your dividend, you can either keep the proceeds or reinvest them to grow your equity position of that company, however, whichever option you choose, whether you reinvest it or you keep it, those dividends are going to get taxed by IRS because it considers all those dividends income and you get taxed based on your ordinary income rate.
So if you look at companies, I think there’s this one company called Econ enterprises, which has the highest dividend yield as of June 2021 at about 14.18%, which seems pretty amazing. It is really good actually. But if you apply just a 24% tax bracket, which many people are at you get an effective after tax return about 10.78 each year, not including any share value growth or decline. So very strong returns on some of these dividends. But obviously each will come with its own performance metrics.
Next runner up is peer-to-peer lending. This has been around for just over a decade now and it’s basically just lending money directly either to another person or to their business through online platforms like prosper and lending club. They’ve got a few others. Your returns can range from 7% to 12% and once the loan is made, that’s it there’s very little work for you to do as the investor.
The investors can fund loans with investments as little as $25. So basically just kind of equivalent, little bit more than what you would pay on a stock market and it’s available to both accredited and non-accredited investors as defined by the SCC.
As a reminder, accredited investors have a net worth of over a million, not including their house or annual income of 200K for single person or 300K for those filing jointly plus for their criteria. But each platform will also have its own set of investment criteria as well for you to participate. From a taxation perspective, All of the interests you earn on your loan investment is fully taxable as ordinary income, which brings me to the number one investment option for passive income.
The top pass to investment for you to invest in is real estate, big surprise, right? There are many different types of real estate. So from a market maturity and access perspective, we’re going to focus on commercial real estate. Single family has another option out there, but it tends to be much more active versus passive form of investing. And it’s a lot more volatile. You know, if you’re looking for a residual income, passive form of income single family would have the greatest volatility, meaning that if the resident moves out, you’re going to be sitting a hundred percent vacant in that unit for a couple of months until, or a couple weeks, at least best case until it’s full again.
Commercial real estate though consists of office buildings and retail centers, industrial facilities, storage units, warehousing, and apartments just to name a few, the most accessible option to all investors is what’s called a REIT or a real estate investment trust, which are publicly listed on the stock exchange. Anybody can go out right now, just buy a stock in REIT. So REITS, this is a little fun fact, REITS pay out 90% of their income as dividends. That means they keep a 10% manager fee which allows them, cause that’s a relatively lower managed fee compared to other forms of real estate investment, but allows them to pay so much more for their assets. And they tend to also buy much larger assets because they have so much capital they got to deploy. So they can’t go out and buy small properties cause they just, it just wouldn’t work. They’d have to buy it a million small properties versus just a couple of very large ones.
The downside to REITS though is that their dividends are taxed at ordinary income, which may be an issue for those of you in the higher tax bracket. Another option though is what’s called a syndication which is when a private company will pull a bunch of investors capital together to purchase a single as set or even a portfolio of assets in a fund. When publicly marketed these investments are only open to accredited investors through what’s called a 506C offering. Though with a bit of research, Investors can find sponsors who syndicate what are called 506B offerings. That’s B as in boy, which are open to non-accredited and accredited investors alike.
Unlike the options above both of these offerings tend to have much higher minimum investment amounts, which can range from $25,000 to $250,000 minimum investments, depending on the term of the deal. Now, each deal is unique and may have special terms depending on the amount you invest, potentially rewarding investors for investing more, but regardless the returns do tend to range from 6% to 8% annually with a significant capital event every five years or so, that returns all the original investment plus an additional 40% to 60% of profit again, depending on the deal. Plus since investors are actually members who are partners in the particular entity that owns or holds the real estate, they get all the tax benefits that come with it. So all the benefits that come with just buying the property yourself, like you would your house, you get buy an also being a part of this syndication.
So all that passive income or dividends are offset by those passive losses, which typically results in them not paying any tax on those dividends for several years. And then once the investment does eventually end, they can roll their original investment into the next and defer a hundred percent of the capital gains into the future and continue to do so in definitely via a 1031 exchange. There’s a running joke about real estate investing and that you’ve got to continually invest in deals. You know, every time you start to get like that third or fourth year into an investment, your amount of depreciation, your passive losses starts to decrease or really your passive income is starting to outpace those passive losses. And so like just like a junkie, you know, you’ve got to look for your next fix, you know, get your next real estate investment deal. So you can continually to have larger and larger passive losses and geez, it’d be just the absolute worst if you ever actually had to pay tax on your passive income. So it’s just, you know, just kind of running joke within real estate investors, as you’re constantly buying, cause you just don’t ever want to be in a position where you’re getting those passive losses not strong enough to write off and have to pay tax on all those passive incomes.
So to really spice things up, you can actually invest in real estate with a self-directed IRA, which is a taxable entity, meaning none of the investments dividends or sale proceeds are taxed. So regardless if they do a 1031 or if they invest as an IRA, none of the income, passive income gets taxed. The only downside to that is that it can take a while to accumulate the wealth within an IRA because you’ve got limit on how much capital you can contribute to the IRA each year. Either way, you’ve got two really great options for deferring or avoiding tax on your passive income.
So in summary, the top four types of passive income investments and are index funds, dividend stocks, peer to peer lending and my personal favorite commercial real estate of the four real estate has the greatest tax advantages and the highest total returns, talk about a win-win.
Well, that’s it for this episode engineers, I hope you learned something. And if you liked what you heard, please go ahead, and hit that subscribe button and give it a five star review, I’ll see on the next episode of engineering passive income. Bye for now.
This was another episode of Engineering Passive Income with Joseph Bramante, download resources and join our private investor group at www.engineeringpassiveincome.com. Then be sure to leave us a review on apple podcast. Thank you for listening. And we’ll see you on the next episode.