What is an Active Investor?
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Active Real Estate Investing
An active investor is personally involved in each real estate deal they invest in. In most cases, an active investor purchases a property—residential or commercial—and leverages their personal assets to do so.
Active investors are involved in every aspect of the investment, from finding the right property to obtaining financing and either reselling it or managing the tenants if the property is rented. As a result, the active investor generally reaps greater returns for their efforts.
There are many ways to invest in real estate, each involving a different level of commitment, capital, and risk. Active investors take a hands-on approach to their real estate investments, and in most cases, they assume a higher level of risk than their passive-investor counterparts.
Below are four of the most common active real estate investing strategies.
Real estate wholesaling is a short-term strategy. One common wholesaling strategy is where the wholesaler signs a contract with the seller for the right to buy a property—typically a distressed property—at a specific price. The wholesaler then finds an end-buyer willing to pay a higher price than the contract price and assigns the contract to the end-buyer. The wholesaler’s profit is the difference between the contract price and the price paid by the end-buyer.
Wholesaling is not as risky as other types of active real estate investing strategies because the wholesaler doesn’t have to put up their own capital. However, it is labor-intensive, because it involves finding suitable properties, maintaining an active buyers list, and marketing deals.
Rehabbing / Flipping
This is the most hands-on real estate investing strategy because it involves buying, renovating, and selling a property. Rehabbing is also a short-term strategy; most investors don’t like to keep their capital tied up in a project for more than a few months.
Flipping is a high-stakes strategy and one of the riskiest ways to invest in real estate. The investor puts up a significant amount of personal capital to acquire property, rehab it, and market it for sale. It requires in-depth knowledge of the real estate market and the ability to move quickly on suitable properties.
Long Term Rental Property
This active investing strategy is more long-term than wholesaling and flipping. Most investors buy and hold their rental properties for a period of years and reap the rewards of a steady income and generous tax breaks.
Owning a rental property can be as hands-on or hands-off as the investor prefers. Some contract out all of the management to a third-party management company, while other investors prefer to manage their properties themselves and pocket the savings. Developing and managing a portfolio of rental properties can easily become a full-time job.
Short Term Rentals
Short-term rental investors either buy a separate vacation property and lease it by the week or month, or they rent out a room or portion of their home to guests on a nightly basis using a service such as Airbnb. This type of short-term rental can be a lucrative side gig for investors who are not quite ready to quit their day job.
Active Investor vs Passive Investor
Active investing requires extensive real estate and financial knowledge, but passive investing offers those with limited knowledge to benefit from movements in the real estate market.
In general, passive real estate investors contribute capital only. Investors can choose publicly traded real estate securities, such as mutual funds and public REITs, or they can opt for private equity funds, private REITs, and Opportunity Funds, which offer significant capital gains tax incentives.
There are also online real estate investing platforms, a relatively new development that allows investors to get into real estate with minimal financial commitment.
Most passive real estate investments offer steady if unspectacular returns. While all real estate investments are inherently risky, passive ones tend to carry less risk than their active counterparts.
Pros and Cons of Active Investing
Active investing is a time-consuming and highly involved activity. Whether active investors are trading on the stock market or building a real estate portfolio, they typically devote some time each day to their investment strategy and are always on the lookout for opportunities.
This style of investing can have many advantages:
- More control. Active investors have more control over their level of risk. They choose which investments or properties fit their strategy and risk tolerance instead of being at the mercy of a fund manager or partner.
- More opportunities. Active investors can exploit short-term opportunities and movements in the market. Many passive real estate investments commit capital in the long term.
- Potential for larger returns. There is a potential for much larger returns in active investing. Not only is there no fund manager or middleman to skim a chunk of the profits, active investors often take on much of the day-to-day management of their investments, significantly cutting costs.
On the other hand, active investing presents several disadvantages:
- Time commitment. Active investing requires a much larger time commitment. Regardless of the chosen strategy, active real estate investors spend time cultivating professional partnerships with lawyers, accountants, real estate professionals, contractors, and financiers, searching for properties, and putting together deals. If they own rental property, they assume all its associated management responsibilities.
- Investment lock-in. It is challenging to diversify as an active investor. Most specialize in a particular niche or property type or invest within their geographic area. On the other hand, passive investments allow opportunities to invest in different property classes and locations.
- Unpredictable income. Deal flow—and therefore income—can be unpredictable. By contrast, passive investors aren’t tied to one particular property or deal, so their income tends to be more stable.
- More risk. Although active investors exercise more control over the level of risk, they still typically assume much more risk than a passive investor, including personal assets through loan guarantees. Meanwhile, passive investors only risk the actual amount they invest.
Tax Considerations for Active Investors
Many active real estate investments earn income. Rental income, both short- and long-term, is generally taxed as ordinary income, but investors can deduct taxes, insurance, maintenance, repairs, and other expenses to offset income. Depreciation further offsets tax liability, although investors may have depreciation recapture when the property is sold.
Capital gains taxes also apply to any appreciation realized on the sale of a real estate investment. If the property is held less than a year, the short-term capital gains tax rate applies.
Long-term capital gains tax rates are generally lower and apply to properties held at least a year or more. An active investor can defer capital gains taxes by rolling gains into a 1031 exchange. They can reduce and even eliminate, taxes by rolling capital gains into a Qualified Opportunity Fund investment.
Tax Differences between Active Investments and Passive Investments
Here’s how their assets and liabilities break down:
|Active Investments||Passive Investments|
|Subject to ordinary income tax||Yes||Yes|
|Can deduct operational expenses||Yes||Generally no (taken at the investment level)|
|Can deduct depreciation||Yes||Generally no (taken at the investment level)|
|Subject to short-term capital gains tax||Yes||Yes|
|Subject to long-term capital gains tax||Yes, but can be deferred or with 1031 exchange or reduced and deferred with Opportunity Fund rollover||Yes, but can be reduced and deferred with Opportunity Fund rollover|
|Eligible for 20% deduction on qualified income||No||Yes with certain REITs and mutual fund|