In finance, passive income describes money from a one-time investment that continually generates income flows, without requiring the investor to monitor or actively adjust their holdings. Passive income, like active income from working, is taxable, but often is given different treatment by the IRS. For instance, passive losses can be used to offset passive gains.
Aside from the difference in tax classification, many individuals seek passive income to bolster cash flows, and the term has grown in common parlance to include activities like working from home or side-gigs that require little effort (even though they may be taxed as active income).
Some ways to generate passive income involve becoming a limited partner in a partnership. However, ordinary individuals can look to other ways to put their money to work for them. The passive investing strategies below warrant a closer look.
- Passive income describes money earned from doing very little active work or labor.
- Some investments that generate passive income include rental real estate, dividend stocks or funds, and limited partnerships.
- Passive investing in stocks involves replicating a broad market index, and is sometimes called indexing.
- Some people may also consider side-gigs or work-at-home jobs as a form of passive income.
- The IRS distinguishes between passive and labor income, and treats them slightly differently. Passive losses can be used to offset passive gains for tax purposes.
1. Real Estate
Despite fluctuations over the recent years, real estate persists as a preferred choice for investors looking to generate long-term returns. Specifically, rental properties can furnish apartment owners with a regular income source. The investor can easily acquire a property for a 20% down payment, then install reliable tenants who keep the money flowing.
Those who don't want to manage rental properties can look to real estate investment trusts (REITs) instead. REITs pay out 90% of their taxable income as dividends to investors. On the downside, dividends are taxed as ordinary income, which may be problematic for investors in higher tax brackets.
Real estate crowdfunding presents a middle-ground solution. Investors have their choice of equity or debt investments in both commercial and residential properties. Unlike REITs, crowdfunding lets investors enjoy the tax advantages of direct ownership—including the depreciation deduction, without the added responsibilities of property ownership.
2. Peer-to-Peer Lending
Although the peer-to-peer lending (P2P) industry (aka crowdfunding) is just over a decade old, it has grown by leaps and bounds. It is defined as the act of directly lending money to a person or a business entity, where lenders and the borrowers are connected via online platforms such as Prosper and LendingClub. Returns typically range from 7% to 12%, and there's very little the investor must do after initially funding the loan.
P2P programs generally have fewer barriers to entry than other types of investments. For example, investors can fund loans with investments as small as $25. While Title III of the Jumpstart Our Business Startups (JOBS) Act allows both accredited and nonaccredited investors to invest through crowdfunding, each P2P platform has its own set of participation requirements.
3. Dividend Stocks
Dividend stocks are one of the simplest ways for investors to create passive income. As public companies generate profits, a portion of those earnings are siphoned off and funneled back to investors in the form of dividends. Investors can decide to pocket the cash or reinvest the money in additional shares.
Dividend yields can vary significantly from one company to the next, and they can also fluctuate from year to year. Investors unsure about which dividend-paying stocks to choose should stick to the ones that fit the dividend aristocrat label, which means the company has at least a 25-year track record of paying out substantial dividends.
4. Index Funds
Index funds are mutual funds or exchange traded funds linked to a particular market index. These funds aim to mirror the performance of the underlying index they track and are passively managed. Therefore, their underlying securities don't change unless the composition of the index shifts. For investors, this translates to lower management costs and lower turnover rates, which makes them more tax-efficient vehicles than many other investments.
Things to Consider When Choosing a Passive Income Investment
Passive income is earnings from a rental property, limited partnership, or other business in which a person is not actively involved. This implies a sort of set-it-and-forget-it mentality that can take place among these investments. However, many passive investments still require some degree of active management or attention. Take real estate, for example. An investment property must be maintained and issues with tenants must be addressed and rectified. Landlords must also often maintain insurance coverage and meet safety and other standards.
Passive index investing, too, requires some attention because as different stocks rise and fall within an index, the relative portfolio weights will need to be adjusted and rebalanced over time. How frequent or at what point to rebalance must be determined by the investor.
What Is the Highest Paying Passive Income Investment?
The best passive investment will vary over time and from year to year depending on various circumstances. Historically, real estate (either directly held, or indirectly in the form of real estate investment trusts (REITs)) and dividend-paying stocks have tended to outperform other asset classes.
Are Passive Income Investments a Good Idea?
In general, passive income investments allow you to use money to make money -- putting your money to work instead of yourself. In that sense, they are often a good idea. However, beware of pitches that sound too good to be true or "get rich quick" ads that promise easy money with no effort, such as multi-level-marketing (MLM) and other work-from-home schemes. Some of these will end up costing you money.
How Do You Get Started with a Passive Income Investment?
If you have money to invest, purchasing the appropriate passive asset, whether it be a REIT or an index ETF, will allow it to start working for you. You may need to open a brokerage account in such a case in order to transact and hold your investments.
The Bottom Line
Passive income investments can greatly simplify an investor's life. The four options above represent differing levels of diversification and risk. As with any investment, it's important to weigh the anticipated returns associated with passive income opportunities against potential losses.