Accurate passive income forecasting is important for tax minimization, better time utilization, stronger mental health, and increased overall happiness. Some passive income investments are harder to forecast than others.
In 2020, I made a big mistake by inaccurately estimating my passive income.
At the beginning of 2020, I estimated I would earn roughly $70,000 from my various real estate crowdfunding investments. The combined estimate for all my passive income sources would be roughly $265,000.
My Error In Passive Income Forecasting
Instead, by November, I had already received $226,600 in real estate crowdfunding distributions, alone. Although it's nice to make more money than expected, you don't want to make so much more that your taxes get blown up.
It is unclear yet how much of the $226,600 in real estate crowdfunding distributions is capital gains versus original principal. It certainly can't all be taxable capital gains.
However, there's wording in my investment dashboard that says “Earnings excluding principal.” If this is true, then my unanticipated extra tax liability for the year is going to be at least $50,000.
Realizing Capital Gains When Ordinary Income Is High
Paying an extra $50,000 in capital gains taxes on top of already paying a hefty amount in property, federal income, state income, and FICA taxes is a real kick in the shins. Yes, paying lots of taxes is a good way to help society. However, bad financial planning is not the Financial Samurai way.
If I had planned better, I could have cut the $50,000 tax liability probably in half. This would have been possible by paying myself a lower salary, investing in more growth stocks instead of income-producing assets, and increasing business capital expenditure.
Thankfully, the year wasn’t over yet when I wrote this post! Further, I'm pretty sure a good chunk of the $226,600 isn't profits. I'll just have to wait until I get my K-1 to see.
As a financial freedom seeker, it's important to know the difference between short-term and long-term capital gains tax rates. Long-term capital gains are taxed more favorable.
Let's talk more about the importance of accurate passive income forecasting for financial freedom.
The Importance Of Accurate Passive Income Forecasting
Passive income should be your #1 source of income in early retirement. Think of your passive income as your core life force. All other income sources are supplementary, including forcing your spouse to keep working long after you hang up your boots.
If you have enough passive income from your investments to cover your desired living expenses, you are financially independent. There is no other appropriate definition, no matter how many impatient souls try to redefine financial independence.
As you advance in your financial independence journey, you will calibrate the ideal income you need to live your best life. You will then take the appropriate steps necessary to get there.
The Ideal Passive Income
Before I had children, I thought the ideal household income for my wife and I was $200,000. $100,000 for me, $100,000 for her sound right. Equality is so simple. $200,000 wasn't as much as what we were making combined at our full-time jobs. But the lack of income was more than made up by our abundance of freedom.
Once we had our son, we bumped up our ideal household income to $250,000. $100,000 for me, $100,000 for her, and $50,000 to cover all our son's living costs. The figures seemed reasonable after running the numbers.
Then once we had our daughter, we bumped up our ideal household income to $300,000. $100,000 for me, $100,000 for her, $50,000 for him, $50,000 for her. Again, equality for everyone.
It's important that your passive income is truly passive, or semi-passive at most. Otherwise, you might end up spending more time and energy than expected, which takes away time doing other things.
Learn the difference between active, semi-passive, and passive income to avoid confusion.
How I Made Such A Big Passive Income Miscalculation
Although my passive income goals seemed logical to me, there was a lot of uproar after I published a post about living a middle-class lifestyle on $300,000 a year. The budget and income weren't specifically ours in the post. But it was similar to our ideal early retirement lifestyle.
There was anger at the idea that a middle-class family deserved to own a house, have two kids, afford college, and save for retirement in a big city. It was interesting how some of the critics couldn't reconcile cost of living differences across the country. Therefore, I mentally throttled back my passive income goals to avoid further backlash.
I felt bad and maybe even embarrassed for wanting to earn $300,000+ in passive income to take care of my family. When I had a $250,000 passive income goal, I didn't get a lot of backlash. Therefore, I decided to mentally revert back to the $250,000 figure instead.
By focusing on $250,000 as a more reasonable passive income goal, I failed to properly forecast the likely future returns of my investments. At the end of 2016, I had made $260,000 worth of real estate crowdfunding investments.
I then invested another $550,000 in real estate crowdfunding in 2017. The funds came from selling my rental property in San Francisco to simplify life. Managing a rental with five guys when I had a newborn was too much.
On average, the investment terms of my 17 real estate crowdfunding investments ranged from 3 – 5 years. Therefore, it would make sense that starting in 2020, a significant portion of my capital and profits would start getting distributed.
Even just estimating a 20% return on an $810,000 investment would equal $162,000 in profits. Instead, I estimated just a 8.75% return.
Pandemic Fears Might Reduce Capital Distributions
Further, because of the pandemic, I had my doubts that any capital would be returned. A more probable investment scenario would be a 24-36-month delay in distributions until 2022 -2023.
However, as I learned in my November 2020 review, Q22020 wasn't as disastrous for my real estate crowdfunding portfolio as anticipated. With only two hospitality investments out of the remaining 13, I was properly diversified. My portfolio could weather the worst of the storm.
Now, things are recovering. The strong performance of large IPOs such as DoorDash and Airbnb is proving there is a lot of pent-up demand.
Remember, hospitality is still largely shut down, but Airbnb's shares increased by about 100% on its first day of trading! The company is now worth over $100 billion. What a home run for Silver Lake Partners who invested in Airbnb in April 2020 at a $18 billion valuation.
The Power Of Outside Influence
Fearing public scrutiny and the negative implications of a pandemic made me overly conservative. In general, it's better to be conservative than aggressive when it comes to financial forecasting. However, not by this magnitude.
I've always thought I wasn't easily swayed by public opinion. Given my track record of telling the truth versus telling people what they want to hear, the truth should win. But this gross miscalculation of passive income definitely shows I am still affected by what others think.
Therefore, going forward, it is better to be more private about my passive income goals. With a new political ideology in 2021 and beyond, it may be more important to go stealth than ever before.
My Taxes Are Going Up
You might be thinking: Why are you blaming yourself for your passive income miscalculation when the real estate crowdfunding distributions would have happened regardless?
The answer is that real estate crowdfunding is only one source of passive income. Further, passive income is only one source of total income.
As a Financial Samurai, you must create financial buffers for your financial buffers. Each financial buffer protects you from harm's way.
A global pandemic is a clear example of a random exogenous event that could have obliterated your finances if you weren't properly prepared.
Harm can only reach the final stage (you) after a series of unfortunate events. Even then, you still have a fighting chance to win against misfortune.
In addition to my passive income sources, I sometimes earn corporate consulting income. Further, I constantly earn active income from Financial Samurai. The occassional consulting income and active online income are considered my supplemental retirement income.
Every year, I sit down and work on my passive income forecasting. I estimate how much passive income I expect to earn and figure out how much supplemental retirement income is needed to fill the gap.
Earning supplemental retirement income is important for retirement longevity since interest rates have collapsed. Until this day, I still don't know any early retiree who withdraws at 4% or who doesn't early supplemental income.
Wasting Time And Mental Health
Besides paying more in taxes than I needed to, the worst part of inaccurately forecasting my passive income is the time and mental health aspects. After all, of the best reasons to retire earlier is more happiness!
Because my passive income estimate was much lower-than-expected, I spent more time generating supplemental retirement income to fill my perceived gap than necessary. The time I spent trying to generate supplemental retirement income could have better better spent with family or healthier activities.
This is why eventually entering a decumulation phase is important. You don't want to die with a ton of money, or else that means you spent way too much time and stress trying to make that money.
There are worse things than making more money and having to pay more taxes than expected. However, it's important to be more precise when it comes to financial planning. The government goes after income, not wealth.
Finally, with better passive income forecasting, you may feel less stress and anxiety. When the world is falling apart, the natural instinct is to cut costs and work harder. And that's exactly what I did in 1H2020.
However, had my passive income estimates been more accurate, I would have been less stressed. At least I was thinking clearly enough to call the stock market bottom in March with a logical post.
How To More Accurately Calculate Your Passive Income
The steps to improve your passive income forecasting should be pretty obvious. But sometimes things need to be spelled out as reminders.
1) Keep a monthly record
The more regularly you can keep track of your passive income, the more accurate your forecast will be come the end of the year. Making an annual forecast at the beginning of the year and then seeing how things turned out a year later precludes you from making adjustments intra-year.
You must diligently add up all passive income streams by month and compare whether they are on track to meet your annual forecasts. You need to also add up all active income streams to come up with a total income.
Once that's done, compare the total income to your desired income and adjust accordingly. Since I made an error in my passive income forecasting in 2022, I've been much more diligent in estimating my future passive income for tax minimization.
One trick to be more diligent in your forecasting is to do your own taxes every year. This way, you manually see what is coming in and out. You also do calculations on some long-term capital gains tax examples to help you realize the most opportune time to sell assets.
2) Track initial investment dates
For rental income, the income streams should be relatively consistent each month. For stock and bond income, the income streams should at least be relatively consistent each quarter. But for private equity investments that have long investment periods, it's vital to keep a record of when your initial investments were made.
For example, if you invested in a private equity fund in 2021 that says it plans to invest for 10 years, circle 2031 in your calendar. Better yet, give yourself a heads up starting in 2028 that you might start seeing distributions from your fund. This way, you can better plan your income streams for the next three years.
In my case, in 2017, I should have started creating monthly calendar reminders at the end of 2019 that distributions are likely coming in 2020.
3) Create at least two passive income estimates
You should create a conservative and realistic passive income estimate. Creating a blue sky estimate is nice, but it may do more harm than good. A blue sky estimate might lead you to undershoot on your passive income goals, which would reduce your chances of living your best life.
A conservative passive income estimate will help motivate you to generate supplemental active income. A realistic passive income estimate will help throttle your active income activity and better manage your tax liability.
Feeling Good Is What Having Passive Income Is All About
The pandemic has made the majority of us feel worse due to heightened uncertainty. When stocks are getting crushed, your job is at risk, and you're afraid of getting sick, it's natural to feel more anxious.
If you are like me, you like to take action during a bad situation to try and make things better. Being able to take action is why I prefer real estate over stocks. However, this constant desire to take action can produce an unhealthy amount of stress and unhappiness.
The goal of passive income is to save you time from work and provide more financial peace of mind. Therefore, please do your best to accurately predict your passive income streams. Once you do, your life should get better.
Our New Passive Income Goal
Going forward, I will have two or three sets of passive income estimates to account for different scenarios. Further, I'm going to throttle my public passive income estimates to avoid unnecessary criticism.
Biden has said $400,000 is the income level deemed rich enough for higher taxes. Therefore, any household earning less than $400,000 should be acceptable by society. However, based on my observations, it seems like $300,000 is the household income limit before people start getting upset.
As a result, I'm going to keep my passive income goal below $400,000 if tax rates are going up. Anywhere between $250,000 – $350,000 is enough passive income to provide for a family of four in San Francisco or Honolulu.
It is also a large enough passive income figure where we can continuously save or reinvest 20%. However, if we have another kid, our passive income goal may increase again. I hope this will be OK if circumstances change.
2024 Passive Income Breakdown
For 2024, here is my latest estimated passive income streams by type. I've decreased online savings, stocks, bonds, and my severance negotiation book income. My passive income was tracking to be about $380,000, but I sold a bunch of stocks and Treasury bonds to pay cash for a house.
I've added a new rental income stream and I have increased my real estate crowdfunding passive income. I'm hoping this is a more accurate passive income forecast than last year. Although, estimating distributions from my private funds is still going to be a challenge.
If the economy continue to recover, there should be a natural increase in passive income as dividends, rents, ad business increase. However, I still plan to invest another $250,000+ a year to try and generate more passive income.
Favorite Passive Income Investment Today: Real Estate
The multi-decade trend of working from home and relocating to lower cost areas of the country is intact. Therefore, I continue to be an investor in the Midwest and South where valuations are cheaper and cap rates (net rental yields) are much higher.
My favorite platform is Fundrise, where you can own a diversified fund of real estate suited to your situation. They have diversified private eREITs for investors to gain real estate exposure. With over $3.3 billion in assets under management and 500,000+ investors, Fundrise is doing very well. For most investors, investing in diversified funds is the way to go.
For accredited investors, CrowdStreet offers a way to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. These cities also have higher growth potential due to job growth and demographic trends.
If you are a real estate enthusiast with more time, you can build your own diversified real estate portfolio with CrowdStreet. However, before investing in each deal, make sure to do extensive due diligence on each sponsor. Understanding each sponsor's track record and experience is vital.
I got another massive $122,000 real estate crowdfunding distribution in July 2022. But I expected more passive income given we're past the 5-year mark of the funds. In all, I've invested $810,000 in private real estate across multiple funds and individual deals.
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