The Passive Income Trap

As the Private CFO for elite professional athletes and entertainers, I spend most of my time reviewing numbers, and a lot of them. In my 30 years in the world of finance, I have seen just about everything that one can imagine. While I admittedly do not know (and will not ever know) everything, I believe that the knowledge that I have gained is incredibly valuable and I want my own legacy to be based on teaching of my clients, friends and family and help them to learn from my successes and even more so, from my failures.

I wear multiple hats on a day-to-day basis but try to define my value proposition around our ability to organize our clients’ lives and most importantly, taxes. The largest expense incurred by any US citizen who earns large sums of income will be taxes, bar none. I have built a team of experts around me to help to keep our clients in compliance and to minimize their tax liability by properly memorializing all the expenses and deductions that the US Government and the states that they perform in will allow.

On top of the tax planning and execution, we also help our core clients with managing their day-to-day financial lives and we spend a tremendous amount of time vetting businesses and other investment opportunities that they have been presented with. All our clients have a separate and completely independent investment advisor who handles their traditional investment management and who are tasked with growing their investment assets over time and I work with their teams to pull together the entire picture.

I have seen multiple fads and trends over the years ranging from Beenie Babies when I was in my 20s all the way to Crypto Currencies and NFTs in my 50s. And it is not just the fads that seem to boom and bust, I have also lived through several cycles in the stock market and real estate world that have tested the extremes on both sides. While no one can predict the future or time any market, I would say that there are several signs that present themselves that can be used as leading indicators as to when specific markets are at the higher or lower end of the cycle.

Without being too specific, the one buzz word that has come up most recently is the term of “passive income”. This term is very generic but what I have seen over the last few years is a social media explosion and this concept becoming what everyone is seeking. Passive income is a great concept, and there is no question that everyone needs it. But there is a tremendous amount of misinformation and even outright misrepresentation around this that has been swirling around social media that has become a driving force in how people manage their investments and just as important, their expectations.

My primary objective in writing this article is to educate my clients on how to avoid “passive income traps” and to provide real life examples to help explain why it is not as easy as it sounds. I also have a selfish motive for writing this article, as it has come to my attention that some of my clients have come to understand my role as the person who will help identify these passive income opportunities and bring these ideas to them. While I do crunch numbers, ask questions, and provide a crucial role in the due diligence process of anything that involves their money, I am not an investment advisor and I do not recommend any specific investments at all. With that being said, I will spend the rest of this article elaborating on the Traps of Passive Income.

The first area of concern is what people have come to define as passive income. Most people today are considering that the gross income generated is the same as the passive income they are receiving. I have watched video after video and seen how people have promoted what they have collected as the amount that they are making. This is not true, nor is it logical. Whether it is an Airbnb, a trucking business, a restaurant, or anything else that generates revenues, there will also be a tremendous amount of expense that is tied to the operations and often reduces or even eliminates the entire profit.

To expand on this, I have spent a lot of time calculating the numbers for houses through AirBNB and restaurants. Just to pull two specific examples, I want to walk through a sample restaurant and a house that was rented, just to provide some context. In the case of the restaurant, the gross receipts for this year will end up right at $1.3 million. That is amazing, right? Who would not want to generate better than $110,000 per month? That sounds like a great generator of passive income but now let’s look at the expenses. In a restaurant, there are 4 major costs. Labor, Food Cost, Cost of Alcohol and overhead. Of that $110,000, the tips and service charges paid to staff came in at $30,000 and the sales taxes (they just collect it and pay it to the city and state) was another $12,000. The food cost in the industry runs 25% to 40%, and they were at 30% or just under $33,000. Add to that another 25% of their sales for liquor for another $30k off the top. Then you have rent, insurance, supplies, maintenance and other fixed expenses that total up to another $20k per month. And we still have to pay out DJ, security, and other contractors who helped to drive those revenues, meaning

that there was no profit left over the owners.

It is not impossible to make money in the restaurant business but that usually happens when you are the one who is putting in the labor and when you have systems in place to track every penny. Despite all of these factors, you would be shocked at how many people will still pursue it. You will not make quick money and it will require you to invest substantial amounts of money up front and to keep it open and a tremendous amount of your time. Unless you are dead set on doing the work yourself, it will require you to pay a team of people to implement systems and watch over everything and with an industry wide failure rate of 85% within the first three years, it is very difficult to create true and sustainable profit.

The other example that I wanted to give was for a house that was on AirBNB. There is no question that there are people who have made money by using platforms such as AirBNB and VRBO. But many of those who have done it were early adapters, or people who did it when these short-term rental companies were new and quite frankly, much more speculative. On top of that, real estate prices were not as high, interest rates were lower, fees were less, and regulation was nonexistent. And even though I will not elaborate on this right now, I think it is very fair to say that the short-term investment market is one of the drivers of the elevated prices we see today.

Getting to the numbers, where the biggest mistake is made is using that daily rental number as a realistic number for the entire month. Let’s say that the daily rental rate is $500 for your rental property. It is easy to think that with 30 days in the month and at $500 per day you should make $15,000 per month, but this is almost never the case. First of all, the average occupancy rate for a full time AIRBNB in 2022 was 48% across the country. Even if you are in a great market, the highest estimate that I would use is 65% and that is not typical by any means. The result is that a more reasonable gross income number would be closer to $7,500 per month, but that is still not net income.

Out of the $7,500 per month you will need to also take out all of your expenses, starting with the platform fee and then the management fee. These both will typically be billed against the gross, with platform being around 15% of the gross booking and a management company will take another 15%. That means that you really are starting with a gross number of just over $5,000 before you pay your mortgage, taxes, insurance, utilities, maintenance, HOA and without the wear and tear that comes along with having strangers stay in your house. I do not include the cleaning fees because of that will typically be paid by the tenant.

If you decide that you want to manage it yourself and save the management fee, that is possible but do not underestimate the amount of work that will be necessary to pull this off. The people who rent your house will have no hesitation calling you at 1 am if the toilets are clogged, if the DirecTV goes out or even if they forget the code. They are paying customers and will expect to get the same service level as if they stayed at a hotel. If you were making $15k per month it might very well be worth the headache but if your mortgage, taxes, utilities and all other fees are conservatively as much as you are bringing in, you may have bought yourself a $3 per hour job in the end.

The second item that is misleading and therefore concerning is when an opportunity presents itself as passive but is not. I have seen videos of people who show how they have made millions in the trucking business. Not only are they not conveying the expenses that it took to get there, but they are also not disclosing the level of work that it took. Most successful companies have someone at the helm who has put in a tremendous amount of time and effort to make it the successful business that it is. But if you are going to be the one who works it, then the reality is that you are buying yourself a job, not passive income. Why is that important?

The difference between passive and active is much more complex than you would think. From the IRS perspective, an activity is considered Active if you spend more than 500 hours per year actively involved with the business. You can see that you would need to spend nearly 10 hours per week on average to meet the active definition. And it matters because if you are truly passive and do not meet that definition by the IRS, you will not be able to deduct operating losses from your regular income. I realize that this is pretty wordy, but here is how it impacts your wallet.

Let’s say that you have started a restaurant and the money that you invested was $500,000 to get it going. In addition, let’s assume that you are a professional athlete who is making $5,000,000 per year in income and hoping that this business takes off and generates income for you in the future. If you are truly active, it is possible that you could reduce the amount of income you made while playing from $5,000,000 to $4,500,000, a benefit that is provided by the IRS to encourage entrepreneurs. But, if you are passive and do not meet the requirements, even with everything else being equal, you cannot deduct this amount against your income, only against other passive income (income generated by other ventures that you are not active in).

Again, it is not that passive income is bad but in today’s world there is very little understanding of how you generate it. People think that they can buy a piece of real estate and put it on Airbnb, put their car on Turo when they are not using it, open a restaurant or start a franchise and just turn money. It really could not be further from the truth as there are so many elements that exist that must be managed and completed to get a business off the ground. Depending on the industry that you are in or the geographic area that you will be operating in, there are often licensing requirements by business, tax registrations, legal and accounting that must take place

and much more that come before you ever bring in your first dollar.

Even if you can find that business that you can buy or start that generates income in excess of the amount of expenses, and without you having to rely on a single person or yourself to work 80-hour work weeks to make it happen, there is another trap that must be avoided, which is the loss of compounding. I see so often that people are looking for the ability create passive income with the idea that they can spend the income that is generated. This may make sense if you are in the position where you must have the income now, and assuming you get past the other hurdles, this too could impact your financial future.

The most powerful financial tool that is available to every investor is the ability to earn compound interest. To better explain this concept, let’s assume that you had $1,000,000 that you were going to invest into that could produce a rate of return of 15% per year and that you were going to invest it for the next 20 years. In scenario 1, you collect the income, and you go and spend it on cars, clothes, houses, entertainment and travel. In scenario 2, you invest that $1 million for the next 20 years and you allow that money to be reinvested since you are wise and have planned to generate income from other sources. How much money will be paid out in each scenario and is there a difference?

Starting with scenario 1, your $1 million dollar investment is generating $150,000 per year and since you are spending it, you collect the same amount each year for the next 20 years. At the end of the 20 years, you have collected 20 payments at $150,000 each for a total of $3 million in interest earnings. Not bad. In scenario 2, the interest you collect in year 1 is the same $150,000 but now you plow the money back into the investment so that the $150,000 makes money. In year 2, you will be earning interest on $1,150,000 which is of course more. At the end of the 20-year period, the total interest earned is not $3,000,000, it is just over $15,300,000 or 5 times as much. That is the power of compounding interest.

You may say that this sounds great, but you must live and cannot wait that long to access your money and to let compound interest take effect. I understand and even in agreement with you on this. It would be impossible for a professional athlete to take every penny of their savings and to never touch it. But professional athletes and entertainers have a much longer retirement period than most. By the age of 35 you have already hit your peak earnings years and now must live off of the money you made in the last 8-15 years. This is why it is so important for you not to spend every penny while you are in your peak earnings years and why you must show restraint.

When you make millions of dollars per year, it is imperative that you take the largest portion of the money that you are making in these peak earnings years and save it to generate income well into the future. For an average American, to be at a savings rate of 10% to 15% of your before tax income will allow you to live and to save money for the future. A professional athlete on the other hand needs to save no less than 50% of their annual earnings to even have a chance! Of course, this is customized to every individual and needs to consider multiple factors. For example, if you are on your second contract and in your peak earnings years, this number could go up to 75% of your after-tax income. On the other hand, if you are a newly minted young athlete who is making the league minimum and just starting your journey, 25% might be a more

realistic number. Either way, it is imperative that in every year of your playing career that you are spending a significant amount less than what you are bringing in.

Once you have a well thought out budget and have identified the amount that you will be able to save, that is only half the battle as you will need to make sure that your money is earning enough to outpace inflation and to generate more than enough to live off in the future. You will need to have a well-diversified portfolio that consists of hundreds (if not thousands or even tens of thousands) different holdings that will allow you to maximize your returns while at the same time controlling your risk. That is much easier said than done, but it starts with a plan and being very thoughtful in working with an individual who has the expertise to create a financial plan and

budget and who can help you to invest your money.

The final trap that I would like to point out when considering a passive income play is the severe lack of liquidity. Checking and savings accounts, as well as money markets and Certificates of Deposit, have daily liquidity and when needed, you can get it out anytime and the value will be the same amount that you put in. With brokerage accounts (includes stocks, bonds, mutual funds, ETFs, etc.) you also can sell these at any time or take your money back, but it may be worth more or less than what you put in depending on the performance of the market. For example, if you put $1 million into an S&P 500 ETF, you can sell it any day or time and redeem your shares. If the market went down by 20% during this time, your $1 million would be worth $800,000, but you can still grab it.

In the case of most every passive income investment (ranging from investment real estate to trucking business, restaurants to cars on Turo), there is no liquidity. Sure, you can try to sell the asset anytime you want but there is not a guaranteed buyer and there is certainly no specific amount that you are assured to get back. This is why it is so important to limit the amount of money that you put into this type of investments when compared to your total investments. I lived through 2008 and yes, mutual funds and stock investments took a major drop, but with real estate there was no one to buy them at any price. Whether you are starting a business, buying a house with the intention of putting it on Airbnb, opening a restaurant or doing just about any other passive income opportunity, you do not have the ability to get your money back at any time, even if you are willing to accept less.

Does that mean that you cannot make money by buying rental properties, starting a trucking company, a restaurant, franchises, or other business opportunities? That is not what I am saying at all. There are certainly a lot of people who have done these types of investments and been successful. What I am saying is that you need to be very thoughtful intentional with everything that you do and look at the real potential profit and risk level of everything you might consider. If you truly want to avoid the Passive Income Trap, here are some essential steps that you should take a long time before you ever think about investing into anything:

1. Live well below your means.

2. Have a savings goal and strive to exceed it.

3. Create a financial plan and update it every year.

4. Set a cap on total percentage of your assets invested into non-liquid strategies.

5. Do extensive due diligence, both financial and legal.

6. If you are still interested, create a full business plan.

PMG Private CFO is a boutique accounting firm that specializes in working with professional athletes and entertainers. The firm was founded and is owned and operated by Aaron and his wife Laura Parthemer in Fort Lauderdale, FL. Laura was born in Nicaragua but moved the US at the age of 15 and has been living in South Florida for more than 20 years. She did her undergrad work at Florida Atlantic University and has been an integral part of PMG since its inception in 2016 while raising their 11-year-old son, Aaron Junior.

Aaron has worked in the financial industry dating back to 1994. Aaron was a Managing Director of Investments for three of the largest financial services companies in the world and in the past, he held his Series 7 and 4 other investment licenses, was a Certified Financial planner for more than a decade, was a licensed insurance agent and a Barron’s List Top 100 financial advisor in the US. In addition to his undergrad degree from Muskingum College in New Concord, OH, Aaron has earned specializations, professional designations and certifications from The Wharton School of Business at the University of Pennsylvania, The Ross School of Business at the University of Michigan, Music Business Management from the Berklee College of Music, and a Graduate Certificate in Accounting from The GEIS School of Business at the University of Illinois.