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The umbrella term “passive real estate investing” includes just about anything other than directly owned real estate. Common examples include real estate syndications (group investments in large properties), private equity real estate funds, real estate secured debt funds, private notes, real estate crowdfunding investments, and private partnerships where you invest money as a silent partner.
As a “recovering landlord” who sold my last rental property and a digital nomad living abroad, I love passive real estate investing – I can invest hassle-free from anywhere in the world.
When most people talk about building generational wealth in real estate, they mean passing on a real estate portfolio to their children and grandchildren. In that conversation, most people ignore passive real estate investing.
Here's why many investors shy away from passive real estate investing for generational wealth, and why I love it.
Reasons against passive investing for building generational wealth
Aggressive real estate investors like the idea of having tenants gradually pay off the mortgage on a rental property over several decades, so that by the time the investor passes away, their children will inherit a debt-free property that has appreciated in value over the decades.
Isn't that an appealing vision? Proudly handing over control of a cash-flow generating portfolio to your kids, who could potentially live off of that cash flow for the rest of their lives.
Active investors dislike passive investing, especially the lack of control over syndication. The average real estate syndication has a goal of a five-year hold, with a margin of error of a few years. As a limited partner (passive investor), you have no control over when or even if the sponsor will sell the property.
When the syndicated property sells, the passive investor is paid and that's the end of the story. You get a cut of the profits, which you have to reinvest (or leave as cash). There's no set of jingling keys to ceremoniously hand over to your kids.
The greatest tax benefits also come in the first few years of owning a real estate syndicate. Investors initially receive large depreciation deductions, which decrease over time. When you own the property directly, depreciation is usually spread out more evenly over time.
So when real estate investors stretch their financial planning out over decades and even generations, it's easy to see why many stick to direct ownership rather than passive investing.
Why I prefer passive investing to build generational wealth
I've always questioned conventional wisdom. My wife calls me a contrarian, but I consider myself a contrarian, which is not the same thing at all.
Before you give up on passive real estate investing in your generational wealth planning, consider the following discussion of its advantages.
Most heirs just want the money
It's hard for parents who are passionate about real estate to understand, but in most cases, their kids don't want their parents' real estate. Even if they dutifully accompanied their parents on property tours when they were growing up, they don't share their parents' passion. All they want is the cash.
Unless you structure your estate carefully and intentionally, your assets will be subject to probate when you die. Probate involves your heirs and executors having to figure out what to do with your assets. Of course, you can allocate certain assets to certain heirs, but that doesn't mean they'll want to keep them.
Most heirs simply sell the inherited property, often to a cash buyer, for a low price.
Passive investment rotation provides control
I like the idea of rotating passive investments every 5 years. This gives me a chance to reassess the market and choose the best place to park my money for the next 5 years. Inevitably, when you retire, you will move your money out of high-yield real estate investments into safe, boring investments. There's nothing wrong with that.
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Investment turnover allows you to choose where to best utilize your funds for your own retirement and ultimately your heirs.
High profit potential without labor
SparkRental’s co-investment club aims to provide asymmetric returns – high returns on low-risk investments.
For equity investments, this usually means investments that are likely to return 15% to 20% or more per year. For low LTV debt investments with regular interest payments, you can accept 10% to 12%.
Yes, we know that a skilled active investor can earn high returns on rental properties. But earning consistently high returns as an active investor requires two things: skill and effort. Finding good deals and managing an income property takes time and effort, even if you hire a property management company. Then you have to manage the management company, not to mention accounting and tax reporting.
My wife and daughter don't have to do anything when they inherit my passive investments — they can sit back and enjoy the dividends, interest income, and occasional profit share when properties sell.
Infinite Returns: How Long-Term Investing Gets Better Over Time
Not all real estate syndicates sell the property after four or five years. In some cases, the sponsor refinances the property after a few years and returns the investor's capital.
At that point, you get your investment money back, but you retain ownership of the property. Not only do you continue to receive dividends from the original property, but you also earn profits from any new investments you make with that same money.
Investors call this scenario infinite returns because they can reinvest their capital over and over again, with no limit to the returns they can make.
When you die, your heirs will inherit all of your passively cash flow generating investments, as well as the original cash you invested.
Death resets cost basis and depreciation
When you sell real estate, whether you own it directly or passively, you are subject to capital gains tax and depreciation recapture.
However, if you die while still holding these assets, their acquisition cost will be reset to their value at the time of your death, which will make them exempt from both capital gains tax and depreciation.
Again, we know that this benefit also applies to directly owned real estate, but passive investors tend to benefit from accelerated depreciation, making depreciation recapture a bigger threat to them. Passive investors get a huge tax deduction in the first few years that neither they nor their heirs necessarily have to pay back.
Estate Planning Benefits of Roth SDIRAs
Of course, you can also purchase real estate directly with a Self-Directed IRA, but the low annual contribution limits make it difficult to do.
Our co-investment club allows us to collectively participate in syndications and other passive investments with each member investing $5,000, which is much easier to do in a self-directed IRA than investing in a syndication or fund on your own, or investing the usual $50,000 or $100,000 you would have with down payments, closing costs, cash reserves and initial repair costs.
Roth IRAs offer significant estate planning advantages: They allow you to skip probate and directly designate beneficiaries, your heirs also receive tax-free distributions, and you can keep the account open for 10 years after your death, plus Roth IRAs add flexible options for planning trusts for your children, but they can quickly get complicated, so be sure to consult with an estate planning attorney.
Heirs inherit hassle-free investments with a long track record
A while ago, our collective investment club invested in a 10% bond that could be cancelled at any time with six months notice, secured by a first lien, personal guarantee, and corporate guarantee with a LTV of less than 50%.
If I die in a few years, my wife can end the investment if she wants, but she can also leave it alone and continue to receive interest every month, with the peace of mind that the bond has been making regular monthly payments for many years.
Yes, your heirs will also inherit a long track record of rental properties. But rental properties are a lot of work to maintain and have little liquidity. Selling a rental property can cost tens of thousands of dollars and involve the hassle of hiring a real estate agent and waiting months for settlement.
Final thoughts
When I die, my wife and daughter will inherit a mix of cash, tangible assets, and real estate investments. They can keep the investments if they want and don't have to do anything. They don't have to go through the hassle of dealing with real estate agents or selling at huge discounts to cash buyers.
In the meantime, I expect my passive real estate investments to generate double-digit returns as expected. As syndications switch, I will decide where to reinvest based on current market conditions. For example, if the federal government actually passes a nationwide rent stabilization law, I may eliminate multifamily properties from my portfolio entirely and only invest in less regulated property types.
I intend to leave myself with seven or eight figures when I exit, and to do that, I don't want my daughter to have to become a landlord and take over the hassle of dealing with tenants, property managers, inspectors, contractors and real estate agents.
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BiggerPockets Note: These are opinions expressed by the author and do not necessarily represent the opinions of BiggerPockets.