Passive Income 101: How To Generate Passive Income

Key Takeaways

  • Passive income is a form of earnings that requires little to no effort.
  • Benefits of passive income include tax breaks, retirement savings and having the financial leverage to pay off your mortgage.
  • Find out how to generate passive income, both inside and outside of real estate.

What would you do if you had more time on your hands and less worry about financial obligations?

Generating passive income is a popular strategy employed by investors as a way to create long-term wealth. With less financial obligations to worry about, investors are able to use their freed-up time to pursue individual aspirations. Continue reading to learn how to generate passive income, including general methods and real estate strategies, so that you can also be on your path towards financial freedom.

Before you start earning passive income of your own, however, let us explore what passive income means, as well as some of its benefits.

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 Internal Revenue Services (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 that 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 from which services were performed—similar to a job.

Some active income examples include traditional employment or running a business. For real estate investors, their income is considered active if they are heavily involved in their projects, such as in wholesaling, prehabbing or rehabbing. Some passive income ideas include interest income, stocks, and bonds. While many real estate investors favor passive income rental properties or investing in Real Estate Investment Trusts (REITs), they are not the only options available; there are several ways to earn money without over-exerting yourself.

Some of these activities may require a little bit of effort during the set-up phase, but the key difference between these active and passive activities is the amount of effort and involvement required. This is one of the key aspects that draw investors to passive income; however, there are several other benefits that are worth noting.


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What-is-passive-income

The Benefits Of Investing In Passive Income Real Estate

Along with generating continuous streams of revenue void of extensive activity, passive income provides a variety of advantages over traditional investments methods. For example, an investor who generates passive income through real estate might experience the following benefits:

Tax Breaks

One of the biggest perks that passive income provides comes in the form of tax deductions. Rental property owners get to claim depreciation losses by writing off the cost of the property over the life 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.”

These tax breaks obtained from passive income can significantly improve your bottom line.

Retirement Fund

Many view passive income as a powerful strategy for growing retirement funds at a faster rate.

Although it may take more work than investing in the stock market, securing multiple revenue streams can help eliminate long-term concerns about running out of money during one’s retirement years. It is also a means of providing financial assets for future generations. In addition, rental income will typically keep up with inflation—sometimes even outpacing it.

Your Mortgage Gets Paid

One of the greatest perks to earning a passive income is being able to pay off your mortgage. For example, a rental property investor can use their rental income from tenants to pay off the mortgages on those properties. In an ideal situation, they would even have income left over each month. This can be extremely beneficial, as not having to pay a mortgage out-of-pocket can free up your finances, as well as help you tap into the liquidity of your investment much faster.

Now that you’ve learned about some of the advantages of earning passive income, let’s dive into how to make passive income in various ways.

How To Generate Passive Income

Although the opportunities are endless, some of the most popular ways to generate passive income include investing in real estate, the stock market, or generating interest income through bonds and certificates of deposit (CDs.) One could also invest in a wide array of securities at once through the use of something called mutual funds.

The stock market provides a channel for individuals to purchase shares of public corporations. Once they purchase these stocks, they are entitled to earn dividends based on that company’s financial performance. Those who choose to invest in the stock market typically manage a portfolio of stocks from different companies to help diversify risk.

Bonds and CDs are prime examples of how individuals can earn interest income passively. Bonds are notes by the federal government or corporations as a way to raise funds. Members of the public can invest in bonds with the promise that they will be paid back in full, with interest. The bond amount, interest rate and payback time frame are pre-determined, which allows investors to calculate exactly how much they will earn back before even making the investment.

CDs are issued by banks with fixed interest rates and withdrawal dates. These accounts can be compared to a traditional savings account, but typically offer much higher interest rates. These rates tend to increase with the term length, and are a viable option for those looking to earn interest income.

Mutual funds are yet another passive income strategy that should not be ignored. Thought of as one of the lowest-risk retirement savings vehicles, mutual funds represent a large pool of money that is invested into portfolios of various securities. Fund managers—such as mutual fund firms, brokerages and banks—will carefully select these portfolios in a manner that delivers long-term growth and solid pay-offs; all while minimizing risk as much as possible. Most places of employment will sponsor a 401(k) program, which employees can use to invest in mutual funds as a way to save up for retirement.

Real estate represents a robust category of passive income options that deserves a discussion of its own. Two popular passive income strategies amongst real estate investors include rental property and REIT investing. The following examines the inner workings of each strategy, and how they apply to today’s passive income techniques:

Rental Property As Passive Income

When someone mentions investing in passive income through real estate, rental properties are one of the first methods that come to mind. Investors can choose between investing in single-family properties, as well as multi-unit properties like duplexes and apartment buildings. Allocating a property as a vacation rental in popular tourist destinations is also an attractive option. Although there is an initial cash outlay required to acquire these properties, the investor can generate rental income to help pay off the mortgage. Once the mortgage is paid off, they are free to continue earning rental income indefinitely, or even refinance or sell the property as they please.

To be effective, these investment properties must be purchased at the right cost to produce cash flow on a monthly basis. To make your property investing experience truly passive in nature, consider hiring a property management company that can oversee anything from screening tenants to responding to maintenance issues. Be sure to check out our guide to buying a rental property like a pro, as well as this breakdown of how to calculate cash flow and other important rental property calculators.

REITs As Passive Income

If you are interested in earning a passive income through real estate but don’t want to deal with researching, purchasing and maintaining real properties on your own, then perhaps you would enjoy investing in a real estate investment trust.

REITs are an investment vehicle that allow both small and large investors to purchase ownership in income-producing real estate ventures comprised of commercial real estate. This can include anything from apartment and office buildings to mixed-use properties. Similar in nature to mutual funds, REITs are managed by experts who specialize in creating portfolios of real estate, while minimizing investor risk as much as possible. These trusts provide investors with regularly-paid dividends. While REITs are generally traded on major stock exchanges, there are also public, non-listed and private REITs. Find out more on REIT investing for beginners.

Other Ideas For Generating Passive Income

Rental property and REIT investing—as well as mutual funds, bonds and stocks—are just a few prominent examples of passive income investing, both inside and outside of real estate. Over the years, investors have identified a myriad of inventive ways to generate passive income. Review some of the methods below to see which ones best resonate with your interests:

  • Become a peer-to-peer lender: Peer-to-peer lending and crowdfunding platforms allow investors to connect easily with individuals who need help financing business ventures, special projects, or the purchase of real estate. By lending funds to these individuals, investors can earn back the loan amount plus interest over the term of the loan. There are many crowdfunding websites available that allow investors to contribute funds to projects and business ventures, as well as invest in real estate debt.
  • Turnkey property investing: A turnkey property is one that is ready to be rented in its current state; there’s no need for any additional work to be put in. Investors can purchase a turnkey investment property and rent it out, which gives the benefit of not having to pay for repairs or rehabbing.
  • Write an e-book: Are you an expert on a certain topic? If so, consider putting your knowledge to paper by publishing an e-book or recording an audiobook. According to Business Insider, financial blogger Sam Dogen reportedly earned $36,000 in royalties from his e-book in the past year.
  • Establish your blog as an authority: A blog is also a great space to share your expert knowledge and earn some residual income on the side. By sharing your expertise i in the form of blog posts, you’ll have the opportunity to establish yourself as an authority in your particular niche. As your audience grows, you’ll be able to direct more traffic to revenue-generating advertisements that are placed throughout your site.
  • Buy an existing business: Buying an existing business can be a great way to reap the benefits of being a business owner, without having to deal with start-up costs. An online business is a less risky option, as you won’t have to deal with overhead costs or physical assets.

For even more ideas, check out our list of 16 passive income ideas that work.

Summary

If you were wondering how to generate passive income the way an experienced investor would, you now have plenty of options to consider. For beginner investors, it should be known that the success of these passive income strategies is contingent upon your ability to mind due diligence. Before committing to any one type of passive income strategy, one should always spend time conducting research, examining options and verifying market conditions. As a beginner, one of the best ways to prepare is by consulting an experienced investor. Although you’ll initially need to put in some sweat equity before you can generate income passively, it’s the only way to ensure that you can make sound investment decisions.

Can you think of other creative ways of how to generate passive income? Feel free to share below:

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Real Estate Investing Strategies
Real Estate Investing Strategies
Real Estate Investing Strategies
Real Estate Investing Strategies
Real Estate Investing Strategies
Real Estate Investing Strategies