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What does passive income in real estate investments mean?

What does passive income in real estate investments mean?

When talking about passive income and real estate investments we want to differentiate it from active income and portfolio income. We are really talking about the income you earn from rent charged to your tenants of real estate that you own.

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What is active income?

Any income that you receive from performing a service is active income. This includes wages, salaries, tips and commissions. Essentially any income from a business in which there is material participation and is what most people earn when they work a standard 9 to 5 job.

What is portfolio income?

This is any income earned in your portfolio of investments and includes interest, dividend and capital gains. Royalties received from an investment property is also considered to be portfolio income. Most portfolio income is taxed at a lower rate – dividends and capital gains for example.

What is passive income?

The technical definition used by the IRS is any earnings derived from a rental property, limited partnership or other enterprise in which a taxpayer does not materially participate. So naturally this includes any rent you collect from real estate that you own. Passive income can also include a revenue stream that takes some work to set up but is then profitable in perpetuity. Examples may include royalties from a book that you wrote or a song that you composed. You may also own a part of a limited partnership but don’t participate in the daily activities of the business – this too would be considered passive income.

Typically, passive income as it relates to real estate refers to rent charged to tenants of property that you own. You may have gone to a lot of trouble in the beginning – finding and renovating the property, not to mention marketing to reliable tenants – but the rent you earn month after month is what most people consider to be passive.

Why build passive income?

One goes to the trouble to build passive income so as to increase your personal wealth. There are only so many hours in a day and you cannot work actively for all of them (at least not for too many days in a row). Being able to earn income whether you are awake or asleep means that you can increase your personal wealth without having to trade hours for dollars.

You may have a full-time job that you love and that pays well. Good for you. But if you could earn a little more without doing anymore work, or taking time away from your job or family life, it would allow you to live a different lifestyle (a bigger home, a few more vacations, save for your kid’s ivy league education) or engage in more philanthropic work in your community.

There is really no limit to how much extra can be earned with a passive income stream. Usually it is not a get rich quick scheme, but one where you gradually increase your returns over time. So long as your passive income is cash flow positive this will offer you increasing levels of financial security that is not tied to your time. Imagine being able to afford to take time off to care for a loved one if they get sick without decreasing your income.

Best options for passive income:

  • REITS: Real Estate Investment Trusts are sort of like a mutual fund that owns and manages property. It earns revenue from renting out the real estate that it owns, pays its managers and the remainder is profits. You can purchase shares on the open market very easily and since the fund is managed by professionals you don’t need any special knowledge or skills to own it.

    Your method of passive income would be from receiving dividends paid out from the profits earned on the shares that you own.

  • Crowdfunding: This is a way of putting together investors with developers who are in search of cash. By gathering a large audience of potential investors from online and social media sources developers can showcase their projects and attract capital. Many investors can each chip in a relatively small amount that when taken together amount to a large sum, large enough to allow the project to go ahead

    For many projects you must be an accredited investor to participate. This means that you need to be a bank, pension plan, insurance company or an individual who is a sophisticated, experienced investor with a very high net worth. Individuals must earn more than $200,000 annually and have a net worth in excess of $1 million (not including their primary residence).

    The SEC has since the passing of the JOBS act in 2012 made it possible for retail investors to participate in crowdfunding opportunities.

  • Private Real Estate Fund: This is a type of crowdfunding in the sense that the investors are pooled together to purchase real estate. Investors earn a portion of the profits generated from the real estate investment and their shares are backed by the real estate owned by the fund. This is considered to be more secure than a REIT were you simply hold shares of the trust company and are not backed by the real estate in the trust.

    One of the benefits to retail investors in a private real estate fund is that it can help to reduce the risk in their investment portfolios. These private real estate funds are managed by professionals which can also bring a level of security to the retail investor. In the past there were high minimum investment amounts that are required – on the order of $250,000 but they would prefer in the millions. Now however there are some funds that allow retail investors to buy in with as little at $50,000 which makes these types of investments much more attractive.

Which gives you better returns on investment? The short answer here is, it depends. Each REIT and crowdfund and private equity company are different. There will be different market niches and business plans set out by the general managers of each company as well as different strategies employed by those companies.

With a REIT your investment is not backed by the real estate owned by the trust and to me this seems like a major negative. Without the security of knowing your investment is safe, backed by the real estate itself, you have the possibility that your shares may one day be worthless. On the other hand, REITs trade openly on the public markets and have to disclose financial information as required by law. Unlike real estate it is very easy to buy and sell as these shares are very liquid.

Crowdfunding is not as liquid as trading on the open market. Depending on the fund it may also be difficult to get involved if there is a very high minimum amount required to participate. Returns can be very lucrative but there are no guarantees. Usually when you are ready to exit your position you have to sell your shares to existing shareholders which may make it difficult to realize your profits.

Private real estate funds can also present a wonderful opportunity to share in the profits generated by the professionally managed projects. Investors have their funds invested directly into the real estate and backed by that property which greatly increases the security. When you exit your position, you offer your shares to existing shareholders before they become available to anyone else.

To be able to determine which is the best for you requires you to do your due diligence. Investigate the options that are available to you and also determine the type of investor you want to become. Your search for passive income begins with research and you will be rewarded if you put in the time.

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