Passive income is an important factor in building wealth and achieving financial freedom. While there are dozens of ways to earn passive income, real estate is among the top. But what is passive income in real estate? This article explains what passive income is, why you would want to create or earn it, and five ways you can earn passive income in real estate.
What is passive income?
Passive income is any income made without active, ongoing participation. Essentially, it's income you can earn without having to physically trade your time for money like you would with the active income you make through a job.
Don't be fooled by its name. There is work involved in creating passive income; it's just primarily upfront work. Once the business or investment is established, you don't have to materially participate to make money.
Why build passive income?
Everyone needs to earn a living. Even if you love your job, it's nice to be able to make money while you sleep, play, vacation, or work. You can use passive income in several ways:
- Fund your retirement plan.
- Reach your financial goals.
- Send your children through college.
- Grow your savings.
- Replace your active income.
For many, the ultimate goal is to create enough passive income streams that eventually, their passive income surpasses their earned income creating financial freedom. Beyond allowing the freedom of earning money without having to constantly work for it, passive income provides an added tax benefit. For those who don't know, income tax is collected on three types of income:
- Ordinary income.
- Investment or portfolio income.
- Passive income.
Ordinary income, the wages earned from a regular job, is the most common form of income. If you earn a W-2, then your income is taxed as ordinary income, which is usually the highest tax bracket out of the three types of income.
Portfolio income is money made through capital gains, which is the sale of an investment or property for more than the original cost basis. Portfolio income is taxed differently than ordinary income, often at a lower tax bracket, although this can vary depending on the amount of income earned from either source.
The Internal Revenue Service (IRS) offers tax advantages to income that is earned passively, making it by far the lowest taxed income of the three.
How can you earn passive income in real estate?
Fortunately, real estate offers multiple passive activities to invest in. Let's dive into five of the most common ways to earn passive income in real estate.
Real estate investment trust (REITs) are publicly or privately traded companies that pool investors’ money to acquire and manage multiple commercial real estate properties. Companies designated as REITs are required to pay at least 90% of their taxable income to shareholders in exchange for certain tax benefits granted by their REIT designation. This typically makes the dividend returns higher than most other stocks.
REITs can be a great starting point for creating passive income because they are a relatively low upfront cost, can easily be purchased through a brokerage account, and provide high dividend returns.
It's important to note that REIT dividends are a way to passively earn income but are not taxed as passive income by the IRS. Income earned from REIT dividends is actually taxed as portfolio income using the capital gain tax rate.
Real estate ETF dividends
A real estate exchange-traded fund (ETF) is a popular method of earning cash flow because you still receive competitive dividend returns while diversifying your holdings across multiple commercial real estate (CRE) property types. Rather than having to buy individual shares of one REIT, when you invest in a real estate ETF, a professional fund manager determines which REITs to invest in and uses investors’ money to buy baskets or groups of REITs.
There are hundreds of publicly-traded REITs, making your investment choices slightly intimidating. There are far fewer real estate ETFs to choose from, making it easier to decide where to invest.
Like REIT dividend income, income from real estate ETFs is taxed as portfolio income using the capital gain tax rate. Nonetheless, it's still a viable form of passive income.
Real estate crowdfunding is a relatively new opportunity for creating passive income. If you are an accredited investor, you can passively participate in funding a real estate property as one of several investors pooling their funds together for a third-party sponsor to purchase and manage an investment property.
Returns vary in crowdfunding opportunities depending on the specific investment opportunity and structuring the sponsor has arranged. Some pay preferred returns monthly, quarterly, or annually, others provide a split of future profits from the sale or disposition of the property, and some offer a combination of both.
If your goal is to build a passive income stream, carefully review each investment opportunity. Not all crowdfunding investments will provide regular payouts to investors, and returns are not guaranteed. If the investment or sponsor fails to perform according to projections, returns can be far less than expected.
When most people think of earning passive income in real estate, rental activity is likely the first thing that comes to mind. There are dozens of ways to own or invest in rental properties, but in general, they fall under two main categories:
- Residential rental property.
- Commercial rental property.
Within those main categories are multiple different investment types that produce rental activity, such as a single-family rental, apartment complex, industrial building, office space, or fourplex, to name a few.
There are long-term rentals, where the property is leased to a long-term tenant, or short-term rentals, where the property is leased on a short-term basis, such as nightly, weekly, or monthly.
Regardless of the rental type, rental income is earned the same way -- by leasing a unit to a tenant who pays rent. Ideally, the rental income exceeds the property's expenses, creating positive cash flow. For example, the rent on the property is $1,600 a month, and the expenses are $600 a month. Your net cash flow (before a mortgage) would be $1,000 a month, which equates to $12,000 in annual passive income.
It's important to note, however, that not every rental property is passive. The more involved you are on a continual basis, the less passive it is. You can either be the active manager (less passive route) or pay a third-party management company to maintain and manage the property for you (more passive route). Either way, rental income is considered passive income in the eyes of the IRS.
Performing mortgage notes
Finally, you can create or earn passive income in real estate by purchasing or creating a performing mortgage note. This is often viewed as a more advanced method of real estate investing and is, therefore, less popular than the other methods discussed today. Nonetheless, it's a valid form of passive income.
A mortgage and note are two separate contracts used by lenders to loan a buyer money to purchase real estate. The promissory note outlines the repayment of the debt, and the mortgage secures the lender using the property as collateral in case the buyer defaults.
Each month the buyer pays the lender a monthly principal and interest (P&I) payment. The buyer is responsible for maintaining the property, paying taxes, and having insurance. The lender has relatively no ongoing participation in the note other than collecting the monthly P&I payment and keeping proper records of payments and debt balance over time.
If the monthly principal and interest payment is $850 a month, the investor is able to collect and keep all, or nearly all, of the $850 (depending on whether the investor elects to pay a nominal and optional monthly servicing fee to a third-party servicer). Investors are able to buy existing mortgage notes from other investors, often at a slight discount, or create a mortgage note from a property they own using owner financing.
Income from mortgage notes is not taxed as passive income but is classified as "interest income." Interest collected on the loan in the given tax year is taxed as ordinary income.
It's important to understand that while the income you can earn from the above real estate investment strategies is passive, there is still work involved. A lot of work goes into reviewing an investment opportunity, finding a qualified investment opportunity, or getting an investment to perform as intended. No matter what form of investing you choose, it's imperative you conduct thorough due diligence on the process, including understanding how to analyze each investment opportunity, what goes into owning and managing the investment, and the tax implications of that strategy.
Real estate can open up a number of passive income streams, allowing you to reach your financial goals without trading your time for income. Keep exploring the various avenues of investing so you can determine which passive real estate income activities will work best for you.
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