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What Is Passive Income?

By Laura Agadoni · Jan 5, 2016 · Real Estate

What Is Passive Income?

Image courtesy of Flickr, Gerry Thomasen

Passive income is a great way to generate monthly income with little to no work on your part. In this article, you will learn what passive income is and how it applies to real estate.

Passive income is a term you might have heard of in connection with wealth building or possibly retirement income. It differs from active income, which is the regular salary you earn from your job and any bonuses, tips, and commissions you may receive. Passive income is money that you can count on coming in regularly, but it's money that you do little or no work to earn.

For example, interest you earn on money you have in a savings account is passive income. Other examples include royalties from a book you wrote, dividends you receive from stock, and lottery winnings. You probably did some initial work or used money that you were given or that you earned to make an investment, and now you sit back and collect the income.

The IRS definition of passive income for tax purposes differs from this broader definition of passive income. The IRS limits passive income to two sources: money you receive from rental property and money you invested in a business in which you are not an active participant. The IRS makes this distinction to limit what you can claim as passive losses on your tax return; you can claim passive losses only on what the IRS considers passive income.

Example of Passive Income from Rental Property

Owning investment property that you collect rent on is a perfect example of passive income because the money you earn is not a direct result of the amount of effort you put in. Although there is maintenance and management involved in owning real estate income property, it will still be considered a type of passive income.

How to Generate Passive Income from Real Estate

Earning passive income from real estate is not as easy as simply buying property, sitting back, and watching the cash roll in. Although the money you make is classified as passive income, there's a lot of work involved in the rental business.

Your work is lessened if you hire a property manager, but you still are involved in the business. And you should consider that the property manager takes a significant cut of your passive income, typically between 8 and 12 percent of the monthly rent, the very income you've worked so hard to achieve.

Here are some steps to consider if you wish to generate passive income from real estate:

1. Know Which Investment Property to Buy

It's essential that you pick the right property to earn passive income from real estate.

Start your search in a stable location. In other words, you want investment property to be in an already established area with a low unemployment rate. Buying in an up-and-coming area could work out well, too. But buying in a declining area is risky. You'll probably get a good deal, but you might have a difficult time finding renters. You want property in a spot people are moving to, not moving from.

Buying in urban areas with lots of amenities nearby is better than buying rental property way out in suburbia or in a rural area. Renters generally pick the place for its location. They like to be near work, restaurants, shopping, and public transportation. Being in a good school district, however, is a good selling point if you buy in the suburbs.

2. Make Sure You'll Make Money

You want to make money, not lose it. Note that if you do lose money, such as in the first year of owning, maybe due to renovations, you can deduct that loss on your taxes since rental property is passive income for IRS purposes.

There are many ways to determine the likelihood of whether you'll make money on a real estate deal. Note that there are no guarantees.

An easy starting point is the 1 percent rule. If you can rent the place for 1 percent of the purchase price, you might want to consider buying the property. For example, if you buy a house for $200,000 and you can reasonably expect to get $2,000 a month in rent, this might be a great deal for you. Look in your area to see what people are paying in rent for similar properties, or use an online site such as Rentometer.

Another way to determine whether the property might be worth investing in is to figure the cap rate, which is the annual return you can expect to get. Note that you probably want this figure to be at least 5 percent, and the higher the better. Here's how to figure the cap rate:

  1. Determine what you expect to get for rent each month, and multiply that figure by 12.
  2. Estimate your expenses: taxes, insurance, homeowners association fees, vacancy rate (about 10 percent of the annual rent), repairs and maintenance (about 5 percent of annual rent).
  3. Subtract your estimated expenses from your expected rental income. Let's say you will charge $2,000 a month for rent. Your expected rental income would be $24,000. If your expenses totaled $10,000, your annual net income will be $14,000. Next, plug in the cost of the house. Let's say the house costs $250,000. Here is the cap rate calculation: 14,000 divided by $250,000. This equals 0.056, or a 5.6 percent cap rate.

You can also figure the highest you'll pay for the property using the cap rate as well. If the lowest cap rate you'll accept is 5 percent, then the highest you'll pay for that property would be $280,000 (14,000 divided by 5 percent), so getting the property for $250,000 is likely to be a good deal.

Note that if you want to determine your cash flow, how much money you'll have left after all your expenses, you'll also need to include your mortgage payment when figuring your expenses. A good rule of thumb is that your mortgage payment should be less than 50 percent of the rent.

3. Study Best Landlord Practices

Screen all potential tenants to help ensure you won't wind up renting to a deadbeat who won't pay the rent. Do this by running a background and a credit check on all potential renters. Also, study the landlord-tenant laws for your jurisdiction to ensure you're doing everything correctly.

Real Estate Passive Income is More Hands On

As you can see, passive income is not really a passive activity, especially when it refers to rental properties. There is a lot of work involved in picking the right investment property, and you need to learn about being a landlord as well. But if you put in the effort, you can earn passive income through rental property.

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