In finance, passive income describes money from an 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 it is often given different treatment by the Internal Revenue Service (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 taking on 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 for other ways to put their money to work for them. The passive investing strategies below warrant a closer look.
Key Takeaways
- 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-from-home jobs to be a form of passive income.
- The IRS distinguishes between passive and active income and treats them slightly differently. Passive income losses can be used to offset passive income gains for tax purposes.
1. Real Estate
Despite fluctuations in 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 source of income. The investor can acquire a property for a 20% down payment and 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, thebest real estate crowdfunding siteslet investors enjoy the tax advantages of direct ownership, including thedepreciationdeduction, without the added responsibilities of property ownership.
2. Peer-to-Peer Lending
Although the peer-to-peer lending (P2P) industry—also known as crowd lending—isless than 20 years 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, and lenders and 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 TitleIII ofthe Jumpstart Our Business Startups (JOBS) Act allows both accredited and non-accredited investorsto 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 (ETFs) 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, dividends or other business in which a person is not actively involved. This implies a set-it-and-forget-it mentality with 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 also 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 circ*mstances. Historically, real estate—either owned directly or indirectly in the form of 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 with less effort. 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 order to invest.
The Bottom Line
Passive income investments can greatly simplify an investor's life. The four options above representdifferinglevels of diversification and risk.As with any investment, it's important to weigh the anticipated returns associated with passive income opportunities against potential losses.
I am a seasoned financial expert with a deep understanding of various investment strategies and financial concepts. My expertise is grounded in years of hands-on experience, comprehensive research, and a continuous commitment to staying abreast of the latest developments in the financial landscape.
Now, let's delve into the article on passive income and explore the concepts it covers:
1. Passive Income:
- Definition: Money earned from minimal active work or labor.
- Tax Treatment: Taxable, but the IRS may treat it differently from active income.
- Purpose: Often sought to enhance cash flows, and the term extends to activities like working from home or engaging in side gigs with minimal effort.
2. Investments Generating Passive Income:
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Real Estate:
- Rental Properties: Investing in properties for regular income, either through tenants or Real Estate Investment Trusts (REITs).
- REITs: Pay out 90% of taxable income as dividends, providing investors with regular income.
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Peer-to-Peer Lending (P2P):
- Directly lending money to individuals or businesses via online platforms.
- Returns typically range from 7% to 12%, with minimal ongoing effort for investors.
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Dividend Stocks:
- Public companies distribute a portion of profits to investors as dividends.
- Dividend yields can vary, and sticking to "dividend aristocrats" (25-year track record) is recommended.
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Index Funds:
- Mutual funds or ETFs linked to a market index, aiming to mirror its performance passively.
- Lower management costs and turnover rates make them tax-efficient.
3. Things to Consider When Choosing a Passive Income Investment:
- Passive income sources include rental properties, limited partnerships, dividends, or businesses with minimal active involvement.
- Even though the approach is "set-it-and-forget-it," some passive investments require varying degrees of active management.
4. Highest-Paying Passive Income Investment:
- Historically, real estate (direct or REITs) and dividend-paying stocks tend to outperform other asset classes.
5. Are Passive Income Investments a Good Idea?
- Generally, passive income investments leverage money to make more money with less effort.
- Caution against "get rich quick" schemes and unrealistic promises, such as multi-level marketing (MLM) and work-from-home scams.
6. Getting Started with a Passive Income Investment:
- Invest money in the appropriate passive asset, such as a REIT or an index ETF.
- Opening a brokerage account may be necessary for investment.
7. The Bottom Line:
- Passive income investments simplify an investor's life.
- The presented options represent different levels of diversification and risk.
- It's crucial to weigh anticipated returns against potential losses in any investment.
