Back when an average 40-hour-per-week job would support a family of five with a house, a car or two, and annual vacations, passive income was a luxury. Only entrepreneurially-minded investors devoted time or money to create passive income streams.
Today, passive income is a critical component of any investment strategy, particularly for people looking for financial freedom.
Let’s take a closer look at passive income, including:
- The definition of passive income,
- Why passive income is so important,
- How to generate passive income, and
- Potential pitfalls and challenges you could encounter along the way
What is Passive Income?
Passive income is money earned without a direct correlation to your active effort. Rather than trading your time for money, passive income allows you to earn money while you’re engaged in other activities, like raising a family, traveling, and even sleeping!
Rental properties are a common example of passive income. Once you invest the time and effort into acquiring a property, making it market-ready, and securing qualified tenants, you earn monthly rent without actively working on the property (minus property maintenance issues that come up occasionally).
It’s worth noting that the IRS has its own definition of passive income vs earned income. According to the IRS, passive income is either 1) Trade or business activities in which you don’t materially participate during the year. 2) Rental activities, even if you do materially participate in them (unless you’re a real estate professional). The distinction is important because earned income is taxed as ordinary income, according to your tax bracket, while passive income is typically sheltered by tax breaks (like asset depreciation) before being added to your taxable income.
Why Passive Income is so Important
Passive income is a critical component of financial planning for today’s investors because it provides:
- Diversification of income to mitigate economic risks. Passive income gives you an additional revenue stream, reducing reliance on a single source of income like a traditional job. This can protect against financial setbacks like job loss or economic downturns.
- Financial protection in case you need to stop working unexpectedly. If you become sick, injured, or mentally unwell, your passive income could allow you to stop working without sacrificing your ability to earn a living. Similarly, passive income can provide money to live on if you need to stop working to raise a family or take care of family members in need.
- Reduced financial stress during retirement. Passive income can supplement retirement funds, helping maintain a comfortable lifestyle in your golden years.
- More time to spend on things you love. With money coming in regularly without active effort, you can spend more time with family, traveling, or pursuing other passions, greatly improving your quality of life and reducing stress.
- Financial freedom. When your passive income covers your living expenses, you’re free to do as you like. You’re not tied to a job, so you’re free to relocate and build the life you want, independent from employment.
- Wealth accumulation. If your passive income doesn’t need to be used on living expenses, it can be reinvested to generate even more income, compounding wealth over time. This could even build generational wealth for your family.
How to Generate Passive Income
Let’s explore some of the many ways to create passive income streams.
1. Dividend Investing
Stocks that pay investor dividends provide regular payouts, typically on a quarterly basis, based on the company’s performance. Rather than actively trading stocks to earn profits on the sales, you hold your dividend-paying stock and collect your dividends as they are disbursed.
The primary downside to this approach is that you need to invest a large amount of money to generate enough in dividends to live on, in the hundreds of thousands of dollars. This strategy also requires some knowledge of the stock market to open your investment account and choose your stocks.
2. Being a Silent Partner in a Business Venture
Investing in a business as a silent partner could entitle you to a share of the company’s profits without any involvement in the day-to-day operations.
The big downside is that this is risky. Nearly half of new businesses fail within the first five years. Even if the business survives, it could take years to become profitable, and there is a high margin of error when projecting future income from such a venture.
3. Creating and Selling Digital Products
E-books, courses, software, apps, and digital templates can be created once and sold many times over, generating ongoing passive income after the initial effort of creating the item(s).
The primary downside is that it could take months or even years to build your digital product. This work is often done without pay and without any guarantee of how much the final product will generate. You may also have to create new products regularly to keep the income stream flowing.
4. Royalties from Intellectual Property
Like selling digital products, royalties allow you to earn fees earned in perpetuity for work created once. Unlike selling digital products, royalties typically don’t require your direct involvement in the sale or distribution of the product. For example, actors, musicians, artists, and inventors often license their work to be distributed by a third party. This third party handles the individual sales and remits the agreed-upon share of the proceeds to the creator periodically.
Unfortunately, the barrier to entry can be high. Securing a position with a network of publishers, marketers, and/or distributors (or establishing your own) can be difficult.
5. Real Estate Investing
Creating passive income from real estate is likely the most viable option for most Americans. Passive real estate investing is incredibly flexible. Our article on creating passive income from real estate lists seven different ways you can use real estate for passive income, including:
- Long-term rentals: Renting units to long-term tenants.
- Short-term rentals: Renting units to vacationers, relocators needing a cash pad, or others who won’t stay in the unit long.
- Note investing: Lending money directly to homebuyers, essentially replacing a mortgage lender and collecting monthly mortgage payments plus interest from the buyer.
- Hard money loans: Issuing short-term loans with high interest.
- Real Estate Investment Trusts (REITs): Investing in companies that own income-producing real estate and share profits with investors in the form of dividends.
- Real Estate Crowdfunding: Investing in a real estate deal with lots of other investors, earning either a set rate of return or a share of the profits
- Real Estate Syndication: A sophisticated form of crowdfunding in which all investors become members of the entity that owns the real estate.
Generate Purely Passive Income with Gatsby Investment
Gatsby Investment is an experienced real estate syndication sponsor that empowers investors to create purely passive income.
With our syndication projects, you can invest in a range of residential real estate deals, including single-family house flips, multi-family developments, and multi-family rentals. Whichever type you choose, your project will be professionally managed by a team of experts, allowing you to earn potentially double-digit returns without investing any of your own time or effort in the property.
Learn more about investing with Gatsby today and start building the passive income streams that will fund the lifestyle of your dreams!