Allow your mind to wander and let’s paint a picture. Imagine working really hard at something, and then ending up being rewarded for the rest of your life? Think of an extreme workload at the start, then exerting minimum effort for a long time. It might sound like someone is trying to catfish you. However, this is a legitimate source of income that could work for you. (It probably will, because it is pretty easy for you to take part in.)
The little daydream is something known as “Passive Income.” Don’t get ahead of yourself; don’t start looking through car dealerships and yacht club memberships just yet. It would be better if you understand what passive income is and helpful advice to help you get started. Also, you will find that there are considerations, when it comes to passive income. (Nothing is ever easy, unfortunately.)
What is Passive Income?
Passive income is income that is generated on a regular basis from a job that you’ve completed once. For example, if you write a book, you only have to write the book one time. However, it continues to earn money each time it sells. The money that the book earns each time it sells is considered passive income. Because you only have to do the work once to continually get paid, passive income is something that everyone should try to attain.
Todd, Tresidder, a financial coach and retired hedge fund manager, states “many people think that passive income is about getting something for nothing. It has a ‘get-rich-quick’ appeal, but in the end, it still involves work. You just give the work upfront.”
Active Income vs. Passive Income
Theoretically, your income is approximately the same amount, more or less, no matter where you work. However, if you plan on being financially independent (or insanely rich), passive income beats active income every day of the week.
Active income is the money that you generate directly from your current efforts. You will need to keep working to continue earning money. Simply put, your efforts are directly proportionate to the amount of money you make. So, if you do not work, you will not make money. (If you’re not a best-selling author or a YouTuber, you understand what this is all about.)
Passive income, on the other hand, is income that does not require active work, on your part. The cash will continue to flow for years to come. (You are probably imagining a river of cash flowing through your hallway. That’s pretty much the idea, only less dramatic.) The main idea of passive income is achieving financial freedom and growth, while playing Candy Crush all day. (Doing nothing and getting paid is every person’s dream.) Passive income is a form of investment, where you put in a lot of active work upfront and relax on a long-term paid vacation. (Ferrira)
Types of Passive Income
There are three different types of passive income that you can generate. These types are: self-charged interest, rental properties, and no-material participation in a business. Each type of passive income generates money in a different way. Simply put, there are different ways to do next to nothing and still make money. (The lesson of the day is work smart and not hard.)
You will find the difference between each type, and more importantly, what they mean. Once you fully understand the different types, you will be able to make a decision. You can ask yourself, “Which type of passive income is most suitable for me?” (Make an educated guess, instead of flipping a coin.) (Chen)
Partnerships take loans and act as a pass-through entity by the owner, which is a business that reduces the effects of double taxation. In that case, the interest income of the loan to the portfolio is considered as passive income. According to the Internal Revenue Service (IRS), “certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity deductions if the loan proceeds are used in a passive activity.” (Internal Revenue Service)
Your mind must be reeling, since it all sounds like nonsense. In a nutshell, when a corporation takes out a loan, the interest income from the loan is your passive income. You will be able to earn money from using the interest in your loan for passive activities. (The show must always go on, even if you do not understand the plot.)
The second type of passive income is rental properties. It is pretty self-explanatory. Whatever you are thinking it means, you are right. Rental property passive income means that you own a housing unit and other people are renting it out. (Gremlins count as tenants, too.)
However, if you work in real estate, then you are putting effort in your work. This would count as active income. If you generate income from leasing land, then it also does not count as passive income. Additionally, if you are renting your housing unit to a company that you work with or for, that does not count either. (The loophole to renting your space to your place of business, is if the lease was signed before 1988.) Our good friends, the IRS clarify that it makes no difference “whether or not the use is under a lease, a service contract, or some other arrangement.” (Internal Revenue Service)
‘No Material Participation’ in a Business
No-material participation in a business means that you generate income from the earnings of the company you invest in. If you invest funds into a company and agree on a percentage of the earnings, then that counts as passive income. The only catch to the investment is that you do not participate in the business in any way, shape, or form. (Like, hanging back and chilling is such a hard thing to do, right?) If you offer any assistance or management with the company owner’s, then you will be providing “material participation.” In that case, you are actively working. (Just smile, wave, and think of what you’ll do with your percentage.)
The Internal Revenue Service (IRS) is very interested in everything passive income. According to the IRS, standards for material participation include:
- “If you’ve dedicated more than 500 hours to a business or activity from which you’re profiting, that is material participation.
- If your participation in an activity has been “substantially all” of the participation for that tax year, that is material participation.
- If you’ve participated up to 100 hours and that is at least as much as any other person involved in the activity, which also is defined as material participation.” (Internal Revenue Service)
Tips on How to Make Passive Income Work for You
Whether you’re investing in real estate or building a website, check out these tips to learn how you can make passive income work for you. These three pieces of advice are short, but to the point. (You are not expected to become a financial mogul in three months, but they did not build the Eiffel Tower in a day either. The one in France and the one in Vegas.)
When you’re building streams of passive income, you can’t go at it full tilt. With this type of income, the work that you’re doing now pays you in the future. So it’s work that you need to do, in addition to the work that is paying you now. (Otherwise you’d go broke.)
Instead of investing all of your energy into creating a massive stream of passive income quickly, start small. (Like really small.) That way you can maintain a good balance between passive and active income. For example, your goal might be to own several residential properties that you can rent to others. In that case, don’t go full-on Batman and purchase multiple properties at once. Purchase homes one at a time. Once you have your first property rented, and some money coming in, move onto your next property. By working at a slower consistent pace, you’re more likely to achieve your long term goals. (Remember the children’s story about the rabbit and the turtle? Be the turtle in this scenario.)
Re-Invest Your Money
Remember, your passive streams of income are working for you, even when you aren’t working. To keep the pace steady over a long period of time, you need to continually reinvest the money that you earn. (It is impossible to invest money and have it continuously flow out; this is not the Fountain of Youth.)
The way you invest the money is completely up to you. While you may choose to invest the income from your real estate investments in stocks and bonds, someone else may choose to invest in a start-up company. The key is finding investment opportunities that will help you reach your long-term financial goals.
Each person, with or without a financial background, has the opportunity to invest. You could invest in anything you find promising. (If you like board games, then just think of investments as a round of Monopoly. You need to think big and think ahead.)
You should never put all of your eggs in one basket, especially when it comes to passive income. If one thing fails, you don’t want to lose everything. So when you’re looking for possible passive income streams, look for several options. The easiest way to do this is to look for passive streams of income that complement each other.
For example, maybe you decide to start a blog. The advertisement money earned from the blog would be one stream of passive income. You could then write a short e-book to complement your blog. The money earned from your e-book would be a second passive income stream.
The more passive income you earn, the more freedom you gain. So take the time to build several well-earning passive income streams. That way, you can eventually replace your active income stream altogether.
Overall, passive income is a good thing. Actually, it is a great thing. You will be able to make money without having to work. (It may sound like an oxymoron, but it really is a legitimate source of income.)
Passive income is a source of income that comes from work that you have completed once. You will need to work in the beginning. After that, there are only sandy beaches and fruity drinks for you. There are three types of passive income: self-charged interest, rental properties, and no material participation in a business. Self-charged interest is receiving interest from a loan through a company. Rental properties mean owning properties and renting it out to other people. No-material participation in a business means investing your money in a company or entity, receiving a percentage of its earnings.
While you are browsing through passive income sources and finding the right one for you, make sure to stay in touch with the IRS. (They’re really big on the whole passive income topic.) As you consider generating passive income, it is best that you start small. Don’t buy a whole neighborhood, so that you can rent it out. (Small steps, just like Neil Armstrong.)
You should also continue re-investing your money. Once you receive a taste of passive income, do not stop there. Keep investing your money, so that you can earn more. Finally, it is best if you diversify your passive income portfolio. Invest in a local bakery and in a garage, maybe a YouTube channel or an e-book. (You can make millions by doing just that. Yes, millions, just not right away.)
Choosing your source of passive income is a delicate task, so make sure you take your time. No one ever lost money because they thought too much before making a decision.
Chen, James. Passive Income. 12 02 2021. 24 06 2021 <https://www.investopedia.com/terms/p/passiveincome.asp#types-of-passive-income>.
Ferrira, Nicole Martins. 23 Passive Income Ideas To Build Wealth in 2021. 02 06 2021. 24 06 2021 <https://www.oberlo.com/blog/passive-income>.
Internal Revenue Service. “Publication 925, Passive Activity and At-Risk Rules.” 23 04 2020. IRS.gov. 24 06 2021 <https://www.irs.gov/pub/irs-pdf/p925.pdf>.