Passive income has long been heralded as the end goal of the good life — the dream of sipping drinks on a beach as your bank account grows. Earning money while you sleep and abandoning the modern work week sounds appealing, but it’s elusive for a reason: it’s not as easy to achieve as many would like you to believe. From rental properties to affiliate marketing, numerous avenues claim to generate passive income. But the truth is a little more complicated.
It helps to understand what passive income actually is. It’s generally defined as earnings derived from ventures in which you are not actively involved. It can come in many different forms: rentals, partnerships with limited participation or business activities where you do not materially participate. The IRS has specific criteria for determining material participation in a business or rental activity, generally based on factors including the time spent on the activity, your role in decisions and whether you have significant involvement in the business.
What are the most common forms of passive income you are likely to hear about in our modern economy?
1. Rental Properties: Owning real estate properties and leasing them out is a classic example of passive income. However, the due diligence needed to ensure you buy properties leading to positive cashflow and solid long-term appreciation is not automatic. Landlords know how managing tenants, maintenance and property issues can demand significant time and attention, even if you employ a property manager.
2. Dividends and interest from portfolios: Investing in dividend-paying stocks and interest-bearing securities can provide passive income. While dividends may arrive without active involvement, managing your portfolio, researching stocks and staying informed about market trends require ongoing effort. This can also be delegated to a financial advisor, but this decision will also require due diligence and come with an added expense.
3. Affiliate marketing: Promoting products or services and earning commissions through affiliate links is another popular form of passive income. But building an audience, creating content and maintaining marketing require consistent work and creativity. You can’t make money in this area unless people care what you have to say.
4. Digital products – Selling online courses, e-books or software can be a profitable modern method for generating passive income. However, developing, marketing and updating digital products require a constant investment of time and resources.
Despite its allure, true passive income is often misleading. There is always an initial level of effort and investment when starting any value-creating enterprise. Whether you’re creating a pro forma for a potential rental property, building a website for affiliate marketing, or creating digital products, the initial setup demands substantial time and resources. After your initial push of startup resources and time, there will always be some level of ongoing maintenance. Whether that entails being a landlord, updating your digital products or keeping up with market trends, you will need consistent effort to sustain and grow your income streams.
Finally, passive income streams are not immune to market fluctuations, economic downturns or industry changes. Stock dividends may decrease, rental vacancies may last longer than expected and affiliate marketing niches can easily become oversaturated, impacting your profits. They are also subject to regulatory frameworks and legal obligations. Landlords must adhere to tenancy laws, affiliate marketers must comply with advertising standards and stock investors must navigate tax regulations, all which evolve from year to year.
While such income streams can offer financial freedom and flexibility, the effort is anything but passive. Making that income sustainable requires careful planning, ongoing effort and subject matter expertise which you need to consistently foster. Most likely, it will also require some professional help by experts in those areas. Rather than expecting your income to flow effortlessly, you should approach passive income ventures with diligence, resilience and a willingness to adapt to changing circumstances. Just as there is no such thing as an investment without risk, there are no passive income streams which lack a material amount of capital or effort — usually both. Anyone who tells you different is selling something!
Zach Harney is a wealth advisor at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to Zach Harney, 2340 Garden Road Suite 202, Monterey, CA 93940 or email zach@montereypw.com.