Passive income is one of the three most recognized types of personal income–joining active income and portfolio income. The word “passive” in this case refers to the relationship between the income and the person receiving it: it is a passive relationship, or one might say that there is very little relationship at all.
Unlike active income, which is directly connected to duties performed or services rendered, passive income is regular income derived from sources upon which the recipient has little direct influence. It can be ownership of or partnership in a rental property, or investment in a dividend-bearing stock.
The goal of a passive income stream is to create a constant income boost without requiring any action on the part of the investor. Although some research and thought goes into developing a passive income stream, the hope is that it eventually requires nothing from you beyond checking your bank account balance from time to time as your wealth grows.
Passive income is for people who understand that “time is money” and that any time spent creating income is a cost factor.
While you don't need to actively work for this type of income, passive income is usually taxed just like active income. However, some types of passive income are less "passive" than others. The IRS has rules about how "passive" you must be for income to be considered passive.
Passive income may be derived in various ways, from S corporations (for the sophisticated investor) to direct investment in a business, to eBay sales. Somewhere in the middle of this spectrum is real estate investment, which is a perennial favorite.
Real Estate as Passive Income
Because of property maintenance, repair, and rental relationships, real estate may seem less passive than other forms of passive income. However, rental property income is still considered passive by the IRS. This is true even if you pay frequent attention to the property condition, renters, and rental agreement details. In addition, you can reduce your tax liability by listing deductions related to your passive income property.
There are exceptions to when real estate investment counts as passive income. These include the following:
You are a real estate professional.
Payments from a rental property constitute a majority of your annual income.
You own a business, and lease a facility to your business. This is NOT passive income even if you list the rent paid as income on your tax return.
Management Groups and REIT's
One way to obtain passive income from real estate is to invest in a management group or REIT (real estate investment trust).
A management group, simply, manages or oversees real estate properties. An investment agreement with a management group may offer you regular income with no involvement in the operation of the group. This is a prime example of passive income.
An REIT is a company that owns, operates or finances income-producing real estate from a wide range of property types. REITs have a tax-exempt status because by law, they must pass at least 90 percent of their taxable income on to shareholders.
Investing in a REIT is like investing in a mutual fund. As a stockholder, you receive a share of income from the properties involved.
As an REIT investor, you are likely to be a member of a very large group of investors, and the income received through interest or dividend share will be affected by the number of shareholders involved.
If you are already invested in a 401(k), an individual retirement account, or a pension plan, it is possible you are already indirectly investing in an REIT. However, a direct investment in an REIT, rather than one that occurs as part of your retirement portfolio, will earn more direct income, which you will receive on a regular (i.e. monthly, quarterly or annually) basis.
Pros and Cons of Real Estate Investment
Investing in real estate is almost always a good idea. Only in dire recession periods does real estate drop in value.
On the other hand, it may be difficult to keep track of investment properties and income earned from those properties. Make certain you are dealing with a reputable real estate investment firm. Investing in real estate can also create a more complicated tax return.
The value Is in the Process
The search for passive income is valuable in that it requires little or no work from you. If the income truly is passive, it feels like “found’’ money.
Kent McDill has been a professional writer his entire career, spending 20 years as a sportswriter in Chicago before transitioning to business writing. He has written specifically about personal finance since 2013. He has four children and resides in suburban Chicago.