Making money while you sleep might seem like a dream, but passive income makes it possible. Whether you are investing in an asset that pays you regularly, or building a business that allows you to be hands-off while still earning income, there are many ways to collect income while kicking up your feet.
To be sure, passive income usually doesn’t start out that way, and may require a decent amount of effort to build the business or investment into an income-generating machine. But creating a passive income stream allows you to earn regular income with minimal effort going forward.
What Is Passive Income?
Passive income is the ability to earn income from an investment or business without requiring much of your time or effort. If you want to get more specific, the IRS classifies passive income (according to publication 925) as:
- “Trade or business activities in which you don’t materially participate during the year.
- Rental activities, even if you do materially participate in them, unless you’re a real estate professional.”
Passive income typically comes in the form of interest payments, dividends, or business income. It can also come from rental income from investment properties.
While your job requires you to show up and participate, passive income does not. Your job is also limited in the fact you can only work so many hours, or that your salary for the year is set ahead of time. Outside of bonuses or commissions, most jobs only pay a specific rate. Passive income ultimately offers you the ability to rely less on your job for income, and can help you hit your financial goals sooner, such as retirement or buying a home.
Bottom line: Passive income is passive. It requires (almost) no participation on your part to earn it.
How Does Passive Income Work?
Passive income pays out regular income to investors or business owners without daily participation required. It typically starts with an initial investment, whether it's money, or time and effort, or both.
The goal of that investment is to create a business or investment strategy that pays you regular income, even if you don’t get out of bed in the morning. This could be collecting monthly rent from a portfolio of rental properties, or earning quarterly dividends from stock investments. It could also mean owning a percentage of a business and collecting regular distributions.
Passive income can typically be done outside of your day job, and as your passive income grows, it may ultimately be able to fund your lifestyle, or allow you work flexibility by paying for your necessities.
Different Forms of Passive Income
There are three main types of passive income; business income, rental income, and investment income.
If you are looking to build passive income with a business, the goal is to create systems that allow you to step away from the business and still collect income automatically. Examples of passive business income include:
Building an online business. If you build an online business, such as a blog, you can generate traffic and earn money by partnering with advertisers. Over time, you may be able to step away from the day-to-day work of the business, while continuing to generate income.
Becoming a partner in a business. If you join a business as a limited partner, you can collect payments without materially participating in the day-to-day activities of the business.
With rental income, you can purchase a residential or commercial property and collect monthly rents as income. While being a landlord requires a bit of work, this can become a passive activity by outsourcing property management and maintenance duties. Obviously, buying a rental property requires an up-front investment to purchase the property, as well as possible repairs to prepare the house for tenants.
With investment income, the goal is to invest in assets that distribute regular payments, such as dividends or interest. Some examples of passive income investments include:
Rental Properties: When purchased in the right location at the right price, residential and commercial real estate are an exceptional way to generate passive income. They require more hands-on work than other asset classes, and they also require considerable initial cash outlays to get started. But the rewards can be well worth the effort. For example, our company founder, Paul Tracy, has been buying rental properties in Austin, Texas since 2004. Thanks in part to an influx of major companies like Tesla, Apple, and Oracle, Austin real estate prices have skyrocketed 42% in the past year alone. It took 18 years and a tremendous amount of up-front work, but Paul now generates $300K+ in passive income each year from his rental portfolio.
Dividend stocks. Some companies pay a quarterly dividend to shareholders.
Crowdfunded real estate. If you don’t want to buy a house or commercial property, but want access to high-quality real estate deals, real estate crowdfunding sites offer the ability to invest without being a landlord. Minimum investments are as low as $100, and most deals regularly pay out dividends earned from monthly rental income.
Certificates of Deposit (CDs). CDs are investments that pay interest in return for locking up funds for a predetermined length of time. Some CDs allow interest to be paid out monthly, making this a simple way to create passive income.
Bonds. Investors can lend a company or government money by purchasing bonds. In return, investors receive interest payments. Interest rates are quite low on U.S. Treasury bonds, but they are basically risk free.
Looking for the best interest rates? Check out our guide to CD accounts and the best rates.
Which Passive Income Is Best?
Finding the best passive income source depends on your financial goals, initial investment capital, and time available. For some, investing in real estate may offer a great return in the form of monthly rents and appreciation. Rentals also offer some unique tax benefits as well. This requires a large up-front investment, and may require a decent time investment as well.
For those with little money, starting an online business may be a good way to build a passive income stream. While the costs are lower, there will be a significant time investment to build an audience and partner with advertisers to create income. If you have the time, building a business can turn into a great source of passive income.
Investing in dividend-paying stocks, certificates of deposit, bonds, or crowdfunded real estate may be a good way to create recurring income with little effort. This requires investing money you don’t necessarily need access to for a while, but may be the simplest way to earn passive income.
You can invest in real estate without the headaches. Check out the best crowdfunding sites.
How Can I Get Started?
To get started earning passive income, you need to understand how much money you have to invest, and what skills you may possess that can translate into a business idea. While some opportunities require more money than others, most passive income strategies require some effort on your part to get started.
First, pick a passive income strategy from one of the three categories; business, rental, or investment income.
Next, figure out the costs associated with the opportunity.
Finally, put together a plan for how you will build the income stream, such as investing regularly, setting aside time for a business, or getting pre-qualified for a rental home mortgage and finding the best rates.
Looking to create passive income? Check out our best 44 passive income ideas you can start today.
References:
https://www.irs.gov/taxtopics/tc414
https://www.irs.gov/pub/irs-pdf/p925.pdf
