Although most folks have heard of passive and active income, many don't understand how they differ or how to generate passive income! Most believe that the secret to accumulating wealth and achieving financial freedom is to understand how to generate passive income. Read more on this!
There are two types of income: passive income and active income.
Although most folks have heard of passive and active income, many don't understand how they differ or how to generate passive income! Most believe that the secret to accumulating wealth and achieving financial freedom is to understand how to generate passive income. According to Robert Kiyosaki, the best-selling author of Rich Dad, Poor Dad, “The key to financial freedom and great wealth is a person’s ability or skill to convert earned income into passive income and/or portfolio income.”
Passive income, like active income, is often taxed, but the IRS typically treats it differently. We'll talk about the advantages of getting passive income from real estate as well as the tax benefits of passive income.
If you work a full- or part-time job and receive a salary, commissions, or tips as payment for your services, you are earning active income. Other sources of active income can include self-employment income and compensation for materially participating in a business activity. In most cases, earning active income comes before making passive income.
Hourly wages are a traditional way of receiving active income, whether from part-time or full-time employment. Being paid hourly may have some benefits, one of which being the potential for an employee to work overtime, on weekends, and on holidays in order to earn more money. The salary received is a fixed amount of money for working a regular schedule such as 8 to 5, Monday through Friday. Employees who receive a salary are effectively trading 40 hours of their time per week in exchange for a guaranteed amount of active income.
Another type of active income is commissions, albeit the sum might significantly vary depending on the task. For instance, real estate agents often receive a commission for leasing properties ranging to one month's rent and a commission for selling properties in the range of 3 to 6 percent. However, those with straight commission jobs sometimes see their revenue streams fluctuate based on the season and the deals closed.
Tips are active income received based on the caliber of the service rendered. People who work in the food service and hospitality industries usually earn a fixed salary or hourly compensation in addition to receiving tips from pleased clients.
Two other forms of active income are consultancy fees and freelancing. People with highly sought-after, marketable skill sets, such graphic designers or software developers, sometimes launch their own freelance businesses and work as independent contractors for clients.
Passive income is typically earned by an asset that generates income but with which the investor is not actively involved. Usually, savings from sources of active income like earnings, salaries, or other payments are used to pay for the asset.
Investors do not pay Social Security or Medicare taxes on passive income, and they can lower their income tax burden by taking advantage of a variety of possible tax deductions, in addition to not having to work hours each day generating passive income.
There are other ways to generate interest income, such as by investing in bonds or putting money into a certificate of deposit. Sadly, many investments offer interest rates that are lower than the inflation rate. By investing in a security that generates passive interest income, an investor may actually experience principal loss.
Another possible source of passive income is dividends from publicly traded stocks. Apple, Nike, and Mastercard are a few popular blue chip companies that pay dividends. Company dividend payments, like interest income, might occasionally be low. In fact, as of June 2021, the S&P 500 Dividend Yield was 1.93 percent, down from the same point in the previous year's 1.35 percent. Being a silent partner in a business or real estate investment and receiving limited partnership earnings might be a more lucrative option to generate passive income with higher potential returns from recurring income as well as a share of the profits if and when the company is sold.
Naturally, higher returns often come with greater potential risks. Investors who invest money as a silent, passive partner in a limited partnership may run the risk of losing their entire investment. Real estate rental income frequently provides enticing risk-adjusted returns by generating passive, ongoing net income and the possibility of profit from increased property value when the property is sold. The Federal Reserve reports that the median sales price of homes sold in the United States has climbed by almost 67 percent since the 2007–2009 recession. Rents for single-family homes have also been rising.
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However, historically, there have been ups and downs in the real estate market. For instance, from the market top, which occurred at the start of the previous crisis, housing prices dropped between 2007 and 2009. Many homeowners during that time lost their houses due to bank foreclosures, real estate investor purchases of short sales, and REO property obtained from the banks.
Active, passive, or occasionally a combination of the two types of income can all be generated through real estate. Depending on an investor's strategy and whether the investment objective is to generate future income over the long or short term, many types of income can be produced. Real estate investors frequently hold down a full-time job to generate active income before reinvesting as much as they can to start generating passive income from sources like rental properties.
Real estate investors involved in wholesale and flipping sales want to make money quickly from their investments. Home flippers buy a property in need of repair for a low price, make any necessary repairs, and then resell the home for a profit to a buy-and-hold rental property investor or a buyer looking for a primary residence. Flippers make repairs as quickly as possible and then resell before market conditions change.
Wholesalers are experts at locating undervalued real estate, putting it under contract, and then assigning the purchase contract to an investor in exchange for a small wholesale fee. Networking with a real estate wholesaler can be a good way to find off-market deals with immediate equity once escrow closes and necessary repairs are completed. Active income generation in real estate is similar to working a full-time job in that it typically entails a high level of risk in exchange for the promise of a large reward. Active real estate income falls when homes are no longer sold for a profit or when prospects for wholesale contracts disappear.
Buy-and-hold investors generate passive income from real estate in two ways: recurring net income after tenant rents are collected and bills are paid, and potential profit from appreciation earned when a home is sold. Many real estate investors refer to passive income as "making money while you sleep."
Admittedly, political economist John Stuart Mill once said, “Landlords grow rich in their sleep without working, risking or economizing.”
To be fair, even when the day-to-day details of managing a rental property are delegated to a local property manager, earning passive income from real estate requires some work. A passive real estate investor, for example, reviews financial reports such as an income statement and cash flow report on a regular basis, visits remote investments owned out of state on a regular basis, and identifies new opportunities to scale up and grow a rental property portfolio. One of the best aspects of owning passive real estate is that an investor can devote as little or as much time to their business as they want. Active real estate investors, on the other hand, stop working when they stop getting paid.
That is why many real estate investors seek to generate passive income through their investments in real estate.
Another huge benefit of earning passive income from real estate is the favorable tax treatment that passive income receives. The IRS considers active income earned from working a job or fixing and flipping real estate to be earned income. Up to a certain level of income, earned income is subject to FICA taxes of Social Security and Medicare totaling 15.3 percent.
Passive income is not subject to FICA taxes, and there are several ways for an investor to potentially protect passive income from higher effective tax rates. Depreciation, repairs and maintenance, property management fees, mortgage interest payments, and property taxes are all common rental property deductions that a passive real estate investor can claim. The long-term capital gains tax paid when an investment property is sold is either 0%, 15%, or 20%, depending on the investor's taxable income and filing status. As a result, even if an investor is in the 32% federal income tax bracket or higher, the maximum capital gains tax paid is limited to 20%.
🟢 Better Financial Stability
🟢 Less Dependence on Paycheck
🟢 Easier Goal Achievement
🟢 More Freedom to Follow Your Passions
🟢 Location Independence
🟢 More Financial Margin
🟢 Lower Stress
Financial stability is one of the most significant stepping stones you can cross on the path to prosperity. To put it another way, you know you are on a really solid path if you can look at your financial status and know, with certainty, that you have the ability to withstand a big financial storm.
Even better than that, financial security is right around the corner if you can count on money coming in without having to work for every cent of it. And the more of that money you receive, the more secure and assured you will feel about your financial situation. When you do not have to work hard for every dollar you make, you have more time to unwind, consider the big picture, and make more sensible financial decisions, all of which contribute to your capacity to maintain financial stability. It's a charming little cycle, and it is one of the key reasons passive income is so crucial to personal finance.
Nothing compares to the stress of living paycheck to paycheck. And if that applies to you, one of the finest actions you can take is to increase your passive income. It should not come as a surprise that trading time for money occasionally seems a little daunting. Additionally, your life will feel lighter the further you can get from depending on your next income. One of the main advantages of passive income, in my opinion, is the ability to avoid living paycheck to paycheck. I also strongly advise generating some passive income streams if you are sick of scrimping and saving in order to get by till your next salary (believe me, I know how stressful that is).
Have you ever had the impression that you might reach your financial objectives much more quickly if you only made more money? That is yet another benefit of passive income. Whatever your financial objectives, you will reach them considerably more quickly if you create some passive income streams that enable you to generate cash at any moment of the day.
In a similar vein to abandoning the "paycheck to paycheck" existence, you will find yourself unexpectedly free to follow your passions or, for that matter, your dream career once you start receiving some passive money into your bank account. It is simple to get caught in a job you despise when you depend on your active income to make ends meet. After all, leaving a job is difficult enough. But it is particularly challenging to leave a job when you do not have enough cash on hand to pay your rent, which is due in two weeks. On the other side, if you have a consistent flow of passive income into your accounts, you have the freedom to pursue the goals that are truly important to you. Simply said, passive income gives you choices. Freedom also comes with those possibilities.
Similar to how active income often enables you to live and work wherever you choose. You do not have to work from a specific location since passive income does not require constant labor on your part. You could travel the world if you want to, provided you have enough passive income to support your lifestyle. And lots of folks do!
Many people believe that retiring can only be accomplished later in life. Retirement may not be as far away as you think if you create some passive income streams. If you like the concept of retiring young, your primary financial priority should be passive income. Passive income is crucial if you want to retire young, whether that entails creating a business that runs without you needing to be present, investing in the stock market, or a combination of several different income streams.
The more financial room you can provide yourself in your life, the better off you will be in terms of personal money. In other words, your financial life will be easier the more gap there is between your income and expenses. Building that financial margin is a whole lot simpler when you are bringing in a consistent flow of passive money each month.
Let us say, for example: Your monthly expenses amount to $3,000. Your monthly margin would be $1,000 if your active household income were $4,000 today. That is not bad, but if you add an additional $2,000 in passive income per month to the mix, your life will be much simpler.
There is a theme running across everything we have discussed thus far. It is easy to understand how passive income relieves your financial stress in a special way. Having passive income makes life substantially less stressful than it would be without it. It makes sense that passive income would assist to lessen your financial stress because it boosts your financial stability, margin, freedom, and so much more. Therefore, if your financial condition is making you feel a little tight, you may only need to give passive income a little more weight.
The amount of time and effort you can invest in passive income is not constrained, in other words, passive money can be generated whenever you choose, even while you are sleeping. Earning money is really exciting! Nothing compares to the satisfaction of realizing you made a few hundred dollars while you slept when you wake up in the morning. Additionally, you are more likely to continue making progress in your financial condition if you are enthusiastic about it.
Last but not least, passive income is crucial since it can help you become more financially stable. The more passive income you generate, the simpler it is to maintain consistency in your financial life, to continually increase savings to investing to giving.
One of the best and most crucial components of a stable financial status is passive income.
Let Vincere Tax guide you. If you have more questions, contact us. We are here to help, always!
For business tax planning articles, our tax resources provides valuable insights into how you can reduce your tax liability now, and in the future.
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