Unfair Advantage -The Power of Financial Education (9 page)

As you know, there are crooks and tax cheats in all quadrants. Don’t be one of them. It is too easy to have great advisors and play by the rules—the rules of the rich in the B and I quadrants.

Different quadrants attract different people, generally people with the same values and attitudes. People in different quadrants also speak a different dialect, even though it is the same language. For example, employees often say, “I deserve a raise,” or “I want more flexible hours.” A self-employed person might say, “I can’t find good help,” or “I’m the best.” An entrepreneur in the B quadrant might say, “I need a new president,” and “How do we raise the capital to finance the new project?”

One way to meet like-minded people is to attend classes or seminars, join clubs, or simply study and learn a new vocabulary. Soon you will meet new friends.

Exercise:
List the six people, outside of work and family, with whom you spend the most time and then determine which quadrant they are in. Since friends are mirrors, this should give you a reflection of yourself.

This does not mean you should dump your old friends, of course. It means you should meet new people and expand your world if you want to change your life.

What Is Wrong with a Job?

FAQ

What is wrong with getting a job, working hard, saving money, buying a house, getting out of debt, and investing for the long term in a well-diversified portfolio of stocks, bonds, and mutual funds?

Short Answer

Taxes.

Longer Answer

The harder you work, the more money you make and the higher percentage you pay in taxes. There is no tax relief for hardworking employees. The primary way to pay less in taxes is to earn less.

If you want to earn more and pay less in taxes, you need to change the type of income you work for.

Explanation

There are three types of taxes for the following three types of income:

1. Earned income (or ordinary income): highest-taxed income
   

2. Portfolio income: second highest-taxed income
   

3. Passive income: lowest-taxed income, possibly zero.
   

Earned Income

People who have a job or are self-employed work for
earned income.

People who save money have their savings work for
earned income.

People who get out of debt pay off their debt with
earned income.

People who buy a house pay for that house with
earned income.

People who have traditional retirement plans, plans such as the 401(k) in America, have their retirement money work for earned income.

Get my point? People who follow Pavlov’s dog’s financial training—getting a job, saving money, buying a house, getting out of debt, and investing in traditional retirement plans—pay the highest taxes, even if it is their money that is working for them.

Repeating earlier material in this chapter:

1. The harder
   you work for money,
   the more you pay in taxes.
   

2. The harder
   your money works for you,
   the less you pay in taxes.
   

3. The harder
   other people’s money works for you,
   the less you pay in taxes. In fact, you may pay nothing, zero, zip, nada, in taxes.
   

Without financial education, most people work for earned income, and so does their money in savings and traditional retirement plans. They pay the highest taxes possible on their labor and their money.

With a little financial education, at least their money (savings and retirement plan) could work for portfolio or passive income, income that is taxed at lower rates.

Professional Answer from Tom Wheelwright

There is a reason that the tax law rewards those who make their money and other people’s money work for them. It’s simply because these are the people who invest directly in the economy. The government wants us to invest in the economy to create jobs, housing, and opportunities for others. With a little financial education, anyone can learn how to make the tax laws work in their favor. After all, these are not inadvertent loopholes in the law we are talking about. They are intentional benefits for business owners and investors.

Portfolio Income

Portfolio income is, in most cases, known as capital gains in the investment world. Generally,
capital gains
are achieved when you
buy low
and
sell high.
In the stock market, a person can
sell high and buy low,
aka shorting a stock, and achieve capital gains, a profit.

Most people who invest are interested in capital gains. Investing for capital gains is not really investing. It is technically
trading,
which is why it receives a different tax status.

Trading is buying something in order to sell it. Traders do not really want what they have purchased. Traders are no different than a dress-shop owner who buys dresses at wholesale and sells the same dresses at retail. This is why most traders are in the S quadrant, and many are taxed accordingly.

During the real estate bubble, most real estate flippers imagined they were investors. But they were really real estate traders: buying low, sometimes fixing the property up, and selling to a greater fool. These flippers gave true real estate investors a bad name. All these amateurs did was ratchet up prices, muddy the waters, and make a lot of noise about how much money they were making, in the process drawing into the market greater fools than themselves.

The problem was that they were going after capital gains, aka portfolio income, As stated in chapter one, going for capital gains is no different than gambling. At the height of the market, between 2006 and 2007, meek and mild checkout clerks at supermarkets left their timid ways and began flipping properties. Today, we have a crisis simply because people do not know the difference between
capital gains
and
cash flow
(as it is known as in the investment world), or
portfolio income
and
passive income
(as it is known in the accounting world).

Fin Ed Definitions

Investment world Accounting world

Capital gains = Portfolio income

Cash flow = Passive income

Kim and I invest 90 percent of the time for cash flow, aka passive income. When we do invest for capital gains, aka portfolio income, we are extremely cautious, because we know it is gambling.

If you have played our
CASHFLOW
game, you may have noticed that the investment opportunities vary between capital-gains and cash-flow investment deals. A smart investor knows the difference, not only because of risk, but also for taxes.

Very Important Lesson:
A person with a high financial IQ knows how to convert different incomes for maximum tax efficiencies. For example, convert earned income into portfolio income and/or passive income. Unfortunately, employees tend to work for earned income and then save for more earned income. They may be highly educated, but they do not know that there are differences in incomes, and they don’t know how to convert incomes. Most traders, people who buy and sell stocks or real estate, tend to convert portfolio income into more portfolio income (capital gains) so they never escape the tax rules.

The conversion of income was an important lesson rich dad taught his son and me. That is why his real green houses and real red hotels were important to him. It was through his real estate investments that he converted his earned income into portfolio or passive income. Through his business and investments, he was converting taxable income into non-taxable income. My poor dad, a PhD in education but without financial education, worked harder and harder for taxable income and then saved and invested for more taxable income. He also thought playing
Monopoly
was a waste of time, and that I should be doing my homework so that I could get a good high-paying job and work and save for more earned income.

A subtle, yet important lesson designed into the
CASHFLOW
game is how to convert earned income into portfolio or passive income. The next time you play
CASHFLOW,
notice the conversions of income. Many people miss this important lesson.

Real-Life Investment

In real life, during the insanity of the real estate bubble, we made a lot of money investing for both cash flow and capital gains on one project. The project was approximately 400 units in Scottsdale, Arizona, an affluent city close to Phoenix. At the time, the units were apartments being converted to condominiums. Kim and I took a deep breath, looked at the insanity of the market, and planned our exit strategy: selling 400 condos. (We tend to dislike condos as investments, and so we definitely planned to get rid of them).

We invested with six other investors, $100,000 each, raised a lot of cash via bank loans, converted the apartments to condos with a lot of paint and landscaping, and sold the project out in a year. The real estate market was so hot that people were lining up to buy these well-priced units in a great location.

Kim and I got back our $100,000 and made a little over $1 million in a year. When the project was sold out, and with the assistance of a tax-planning expert, we placed that million into what is known as a 1031 exchange, which means we paid zero taxes and invested the $1 million in capital gains, aka portfolio income, into a 400-unit apartment house in Tucson, Arizona. The million dollars was free money, and tax-free, and today the 400 units produce cash flow, most of which is tax-free because it is passive income coming from real estate.

Technically, Kim and I have a 400-unit apartment house for free, producing passive income every month, tax-free. When the real estate market crashed, we raised rents because more people were renting than buying. Again, we made sure there were stable jobs in the area because real estate is only as valuable as the jobs in the area.

In the next chapter, the chapter on the unfair advantage of debt, I will explain how we got that $1 million back, also tax-free. In other words, our $1 million was returned to Kim and me and was moved into another project. Our entire 400-unit project is completely free, simply because we use debt to get our money back. Even with a free 400-unit apartment house, we receive about $8,000 a month, also almost tax-free. Eight thousand dollars a month is not a lot of money but, without taxes, it is the same as having a job working for $12,000 a month.

Again, please remember that I do not write to brag, because bragging is not cool. I write to explain and inspire some of you to increase your financial education. Also, we did not start at this level. Kim, our partner Ken, and I all started small and dreamed big. Like rich dad, we are always studying, learning, and earning. Financial education and real-life experience is the key. We have no plans on stopping. At this stage in our educational development, why stop? Life is too much fun.

Why Not Stocks, Bonds, or Mutual Funds?

One reason why we usually avoid stocks is because real estate is too easy. On top of that, the tax laws and the use of debt as leverage are different. Another reason that I will get into later in the chapter on risk, is that I have more control over real estate than I do on stocks.

Does this mean you should not invest in paper assets such as stocks, bonds, mutual funds, and ETFs?

The answer is no. If you love paper assets, become the best paper-asset investor you can be. The Rich Dad Company has courses on paper assets because they are an important asset class. The issue with paper assets is control over risk. Once a person knows how to control risk, paper assets can be a fabulous way to secure lifelong wealth.

Personally, I have taken and continue to take classes on paper assets. The reason I take paper-asset classes is because the principles of investing are the same, which means that the principles apply to all assets. It is through classes on paper assets, especially technical analysis and options trading, that I have learned how to be a better businessperson, real estate investor, and predictor of the future.

One disadvantage of paper assets in the United States is tax-deferred capital gains, portfolio income. Years ago, it was possible to 1031-exchange stocks and to defer capital-gains taxes. That tax loophole was closed for paper assets but kept open for U.S. real estate investors.

Professional Answer from Tom Wheelwright