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.
1. Real Estate
If you own a number of apartment buildings or office buildings, each unit will bring you income every month. Once you have acquired enough real estate and stable tenants, you will build up a large enough income stream to replace the income from regular employment so that you can retire (no matter how old you are) whenever you want.
In addition, you will also accumulate a huge source of untapped wealth. If for some reason you need a big cash infusion (e.g., to pay unexpected medical bills or take a trip around the world), any rental property represents a virtual ATM: You can borrow against the equity or sell a property to get the money you need.
Learn more about how to make money from rental properties.
Those who do not want to manage rental properties can invest in real estate investment trusts (REITs) instead. Investors receive 90% of their taxable income as dividends from REITs. Dividends are taxed as ordinary income, which can be a problem for investors in higher tax brackets.
A REIT is a real estate trust. This is a company that owns hard property assets and rents them out. The types of property are quite varied. For example, you can invest in REITs that own rental homes, apartments, or commercial real estate. There are also REITs that own hotels and resorts.
A middle ground can be found through real estate crowdfunding. Both commercial and residential properties are available for equity and debt investment. Unlike REITs, crowdfunding offers tax benefits associated with direct ownership, including depreciation deductions, without the additional liabilities associated with owning real estate.
Learn more about how to invest in REITs.
2. Dividend Stocks
Dividend stocks provide steady income streams for investors. They come with regular dividend payments, sometimes big enough that people can actually live off their dividend checks.
Though many dividend stocks fall into the blue-chip category, other types of stocks (like value stocks) may offer consistent dividend payments as well. These stocks make a good addition to fixed-income portfolios, as they also provide the opportunity for share-price growth.
The dividend yields of different companies can vary significantly, and they may also fluctuate from year to year. Investors who aren’t sure which dividend-paying stocks to choose should stick to those with the “dividend aristocrat” label, which means the company has paid out dividends for at least 25 years.
3. Index Funds
With index funds, you can follow a benchmark that everyone uses-and they aren’t limited to popular benchmarks. Virtually every kind of investment is tracked by an index, from micro-cap stocks to South American stocks to natural-resource stocks. These funds allow you to invest in both growth and value stocks, giving you maximum diversification.
These factors translate into lower management costs and lower turnover rates for investors, resulting in more tax-efficient investments than many other types.
Vanguard founder and indexing guru John Bogle claims that index funds will beat 70 percent of managed funds over time. If this claim is true, that means there are plenty of funds out there that can outperform the index.
4. Exchange-Traded Funds
The opportunity to use exchange-traded funds to achieve your investment goals always exists. In this case, you can look for an ETF that invests in dividend stocks. You will continue to receive dividend payments, and the fund offers built-in diversification. When choosing dividend investing ETFs, look for yield and choose the funds with the highest yields. Many investors may choose a mix of both. You can invest in ETFs while investing in specific companies such as IBM.
5. Peer-to-Peer Lending
Although the peer-to-peer lending (P2P) industry (also known as crowdfunding) is less than a decade old, it has grown exponentially. Direct lending to an individual or business is done by connecting lenders and borrowers through online platforms such as Prosper and LendingClub. An investor typically receives 7% to 12% returns and has to do very little after funding the loan.
Compared to other types of investments, peer-to-peer programs generally have fewer barriers to entry. You can invest in peer-to-peer loans for as little as $25. Both accredited and non-accredited investors can invest through crowdfunding under Title III of the Jumpstart Our Business Startups Act, but each P2P platform has its own eligibility requirements.
Considerations When Choosing a Passive Income Investment
Passive income is income earned through a leased property, limited partnership, or other business that is not actively managed by the owner. Investing in these businesses can lead to a “set-it-and-forget-it” mentality. However, some passive investments still require active management or attention.
Real estate is an example of this. It is important to maintain investment properties and deal with tenant issues. In addition to insurance, landlords often need to maintain safety and other standards.
Relative portfolio weights for passive index investments also need to be adjusted and rebalanced over time as stocks within an index rising and fall. The frequency or timing of rebalancing must be determined by the investor.
Which is the Highest Paying Passive Income Investment?
Depending on various circumstances, passive investments will vary over time and from year to year. Historically, real estate (either directly or indirectly through REITs) and high dividend stocks have outperformed other asset classes.
Should You Make Passive Income Investments?
Passive income investments allow you to use the money to make money instead of working for it yourself. That makes them a good investment. However, beware of offers that are 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-at-home models. You may end up spending money on them.
How To Start with a Passive Income Investment?
If you have money to invest in a passive asset, such as a REIT or index ETF, you can allow your money to begin working for you. For you to transact and hold your investments, you may need to open a brokerage account.
Investing in passive income can make an investor’s life much easier. The four options listed above offer varying degrees of diversification and risk. With passive income options, investors must weigh the expected returns against the risks.