Music to an investor’s ears comes in the form of residual income. For those in real estate, it’s commonly referred to as passive income — and the allure is easy to see.
This concept involves straying away from traditional investment vehicles and career paths, and encouraging a less hands-on approach to earning monthly income. More or less, passive income grants investors with financial freedom by automating revenue streams with minimal effort, and providing the one thing that can neither be purchased or saved: more time. With more time and less worry on financial obligations, passive income aims to create long-term wealth that will last for years rather months, freeing up investors to pursue their other aspirations.
While this notion of earning money with the least amount of effort seems unfathomable for most, it’s a simple tactic used by almost every successful real estate investor I know. The following will provide the foundation for getting started with passive income, and the benefits it exhibits over traditional investment methods.
What Is Passive Income
Passive income is defined as earnings that require little to no effort on the part of the person receiving them. In essence, it’s a form of residual income — not a second job. According to the IRS, passive income activities include:
- Rentals, including both equipment and rental real estate, regardless of the level of participation;
- Businesses in which the taxpayer does not materially participate on a regular, continuous, and substantial basis.”
It should be noted there is a major difference between passive and active income. The former refers to earnings from which the individual is not actively involved, while the latter is income for which services were performed — similar to a job. For investors, active income pertains to wholesaling, prehabbing and rehabbing.
The most popular passive income strategies for real estate investors are rental properties and REITs (Real Estate Investment Trust). The following examines the inner workings of each strategy and how it applies to passive income:
Rental Property: To be effective, these investment properties must be purchased at the right cost to produce cash flow on a monthly basis. In addition, profit margins must be large enough to incorporate the costs of repairs as well as a professional management service to oversee it, which will then entitle it as passive income.
Another option for investors is turn-key properties. These investments are already rented and managed by a property manager, helping to alleviate the initial costs and effort involved. When done correctly, a rental property will generate ongoing cash flow until the day it sells.
REITs: REITs are an investment vehicle that allow small and large investors to purchase ownership in income-producing real estate ventures comprised of commercial real estate, from apartment and office buildings to mixed-use properties. Very similar to mutual funds, REITs provide investors with revenue streams commonly referred to as dividends that are paid regularly. While REITs are generally traded on major stock exchanges, there are also public non-listed and private REITs.
For beginner investors, the success of these passive income strategies are contingent on existing factors: the state of the real estate market. Like any investment, beginners should conduct their due diligence before investing time, energy and money into any investment vehicles.
The Benefits Of Investing In Passive Income
Along with generating continuous streams of revenue without any form of labor, passive income provides a variety of advantages over traditional investments methods. These include:
Tax Breaks: One of the biggest perks that passive income provides comes from deductions. For investors, this tax break comes in the form of depreciation losses which can be written off the cost of the house over the lifetime of the loan.
According to the IRS, “You begin to depreciate your rental property when you place it in service. You can recover some or all of your original acquisition cost and the cost of improvements by using Form 4562, Depreciation and Amortization, (to report depreciation) beginning in the year your rental property is first placed in service, and beginning in any year you make improvements or add furnishings.”
For real estate investors, these tax breaks obtained from passive income can significantly improve your bottom line.
Retirement Fund: Because your nest egg isn’t going to grow itself, earning passive income can be a fantastic alternative to building one’s retirement fund. Although it may take more work than investing in the stock market, this source of income will eliminate long-term worries about running out of money when retirement age hits, as well as providing a financial asset for future generations. Additionally, rental income will typically keep up with inflation — sometimes even outpacing it.
Mortgage Gets Paid: Alas, the greatest perk of them all: getting paid to pay off your mortgage. Combined with additional income, rental properties enable investors to use the tenant’s money to pay their mortgage. This can be beneficial up front, as investors will eventually have access to the liquidity of this investment when it is either refinanced or sold.
The first step to investing in passive income is due diligence. In order to avoid potential money pits, investors will need to take a long-term approach to researching and examining potential investment properties and REITs to ensure they are both sound long-term potential. Investors will also need to examine the local rental market to verify that rental demand and rent prices align with their investment. Another form of due diligence I recommend is speaking with a professional. Along with gaining firsthand insight into the market, investors can leverage the experience of a professional to sidestep any potential pitfalls and mistakes that could be looming. Making passive income isn’t easy, but it’s so worth it.
Are you interested in earning passive income?