Jun 18, 2021

What to Know About Passive Income

The concept of passive income has become explosively popular in the past few decades because its fundamental idea—making money without much, or any, ongoing effort on your part—holds obvious appeal.

Passive income has become so attractive that a cottage industry has evolved around the concept, with many self-help books, blogs, and gurus evangelizing about it. Unfortunately, on the darker side, many folks are out there pushing “get rich quick” frauds or pyramid schemes in the name of passive income. You might approach even legitimate proponents with skepticism: sometimes it seems like they’re telling you to earn passive income by preaching to other people about passive income.

However, passive income is real, and many wealthy people earn passive income to some extent—owning a rental property is a classic example. Many passive-income businesses require a large amount of capital to start: they’re the epitome of the “spend money to make money” aphorism. But with some creativity and research, there’s probably a passive income stream you could establish that fits your budget.

What Is Passive Income?

Passive income is an income stream that requires no work to maintain once it’s established. Rental properties, investments, and earning interest from capital are common examples of passive income. You could also create something—like a patent, book, or YouTube video—that earns money from royalties or ad revenue.

In your research, you might find that the definition of passive income becomes flexible—maintaining a rental property, storage space, or blog might not require 40 hours a week of work, but it is usually far from completely passive.

The IRS Definition

The Internal Revenue Service, however, has a clear definition of passive income and how money earned through “passive activities” is taxed.

“There are 2 kinds of passive activities,” the IRS says: “Trade or business activities in which you don’t materially participate during the year [and] rental activities, even if you do materially participate in them, unless you’re a real estate professional.”

The IRS offers a 7-question test in Publication 925 to determine if you are materially participating in your passive income stream. As a general rule, if your participation in the activity is regular, ongoing, and substantial, the IRS doesn’t consider it a passive activity.

Why Establish a Passive Income Stream?

The most obvious appeal of passive income: it can be a way to earn money—maybe even a living—that doesn’t require ongoing work.

The biggest advocates for passive income usually praise it as a way to preserve your time, arguably the most precious asset we have in life.

“Passive income is quite possibly one of the most important and central ways that the rich get richer,” blogger Robert Kanaat writes. “It’s how you detach your ability to earn from the time that you do have in a day.”

If you set up an income stream that isn’t active, you can—in theory—spend your time doing what you really want to do instead of working.

Importantly, passive income is different from a retirement fund. You might have property, savings, or investments set aside for retirement, but it’s best not to view this as income because you shouldn’t touch this money until you reach retirement age.

Benefits of Passive Income

Once established, a passive income stream leverages your capital, investments, property, invention, or creation to put money in your pocket over a long period of time.

“If you’ve ever heard the term ‘making money while you sleep,’ no truer words have been spoken,” Kanaat continues. “With passive income, you do make money while you sleep. You also make money while you’re awake. It’s automatic and simply keeps coming in.”

Passive income can save you time and energy. In many cases, you can manage your passive income stream from anywhere. Even if you have a full-time job, you can figure a way to earn passive income on the side to diversify your revenue and mitigate any emergencies like the loss of a job or medical issue.

Challenges With Passive Income

With many passive income arrangements, you must put up a large amount of start-up capital, like buying a building with rooms to rent out or investing in someone else’s business. In most cases, the passive income is earned off already-existing money.

Even ideas that don’t require a big up-front price tag usually demand some sort of investment from you, like a spare room to rent through Airbnb or the time required to write a well-visited blog.

Additionally, you should watch out for any passive income system that seems too good to be true.

“Don’t fall for any passive income ideas that promise a quick return or require huge amounts of money up front,” Ramsey Solutions suggests. “They will sabotage your other financial goals. Look for ideas that are steady, profitable, and trustworthy. Do your research.”

Even if nothing fraudulent is afoot, a passive income stream can still fall through. A rental property might require expensive repairs, or your great YouTube channel might never take off. Some hot passive income ideas, like blogging, were feasible a decade ago but are hard to monetize now, especially in the always-changing digital sphere.

Examples of Passive Income Businesses

As mentioned elsewhere, real estate rentals and investing are the most well-known examples of passive income. Operating a storage facility or short-term rental are also popular choices, as are vending machine or ATM businesses.

“Make money online” remains a perennially popular internet search, with many of the queries related to passive income. Earning money from a blog, YouTube channel, self-published book, Instagram account, email newsletter, or online course is possible, although building an audience can take years.

Think creatively, understand your skill sets, and consider what you bring to the table. Maybe you can houseplant-sit, offer up a shed as storage, or sell firewood after cutting down a tree. Even if it isn’t totally passive, there’s probably a way you can make money while you sleep. 

About the author

Barry Eitel
Barry Eitel
Barry Eitel has written about business and technology for eight years, including working as a staff writer for Intuit's Small Business Center and as the Business Editor for the Piedmont Post, a weekly newspaper covering the city of Piedmont, California.

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