A discussion of capital gains and passive income may sound as exciting as drying paint, but this is one of the most important areas of real estate investing to understand. It’s so important I’m devoting these next two blog posts to it. I’ll do what I can to make it clear, and even interesting!

A quick start-at-the-beginning to be sure no one is left behind – skip this section if you already know these definitions:

• Capital gains are the profits on the sale of an investment such as real estate, including property flips. The profit is the price at which you sell your investment property, less the price you paid for it and the cost of improvements that added to the property value,along with selling expenses. For properties owned less than a year (which is the case with most flips) you are taxed at whatever your personal income tax rate is.
• Passive income, for our purposes, is the income on rental properties. This is a complicated tax subject, so a couple of quick notes are that expenses reduce taxable passive income, as does depreciation on the property and the interest paid on the financing. Passive incomeis generally taxed more favorably than capital gains or earned income (salaries & wages) depending on a number of calculation factors. Thanks to depreciation, in many cases you have little or NO tax to pay on rental properties.

Many new property investors are attracted to the fast pace and the adrenaline jazz of the flip – it even has a cool term to use in “flipping”. The big push to purchase, work and sell the project should end in a big payoff. Hot stuff! On the other hand, “rental” is not a word that inspiresmost people. Collecting rents, dealing with tenants and fixingfritzed-out air conditioners doesn’t exactly sound like fun, especially compared with seeing a flipper’s fat bank balance just after a successful sale.

But like a quarterback that passed  40 yards for a Super Bowl touchdown two years ago, all that really matters is what you are making happen in the game today. Flipping a project house isjust one scoop into the profit money pit, with nothing more coming in until you do another project.

Rentals are the gift that keeps on giving, a steady income stream that lasts as long as you care to keep and manage the property. Unlike your flip house, a well-managed rental property in the right market could last your lifetime. If all goes well, unlike your salary, you could even leave this continuing cash flow to your heirs. And passive rental income has more favorable tax treatment than capital gains from flipping.

The most successful real estate investors usually choose a mixed strategy of big hits from flipping, and steady income from rentals, to sustain their own quality of life and build a strong real estate portfolio. Although I encourage new investors to focus on a small scope at first, do keep an open mind, listen to the voices of experience and learn from the real pros who do well over a long period of time. In my next blog post I will discuss a dual approach for flipping and renting.