Passive income requires more effort than its name implies, but it provides financial freedom and when done well, can even replace your 9 to 5 salary as it did for me.. This article tackles the major points you need to know before getting started: investment options, how to find them, and tips for success.
Kent Ritter is an experienced multifamily investor and operator helping you to build real wealth through real estate syndication. Learn More
What Is Passive Income?
Passive income refers to money earned from an investment that does not require your direct and active management, such as dealing with tenants and fixing broken toilets. Some call passive income mailbox money because investors need to do nothing other than cash a check.
You can generate passive income in many ways. For example, programmers receive passive income from the apps they sell on the app store, and digital designers earn passive income by selling template downloads online.
Real estate provides nearly endless opportunities for passive income. Investors get many of the perks of real estate ownership, like tax advantages, steady returns, and virtually guaranteed appreciation, on terms that work for the individual.
Options for Generating Passive Income from Real Estate Investments
Passive investing in real estate makes it accessible to nearly everyone, regardless of the amount of money in their pocket or spare time they might have. Gone are the days when the only way to make money from real estate is to own a second property and be a landlord. Now, that is only one of many options.
Real Estate Syndication
Real estate syndication investors reap the benefits of rental property ownership, such as regular cash flow, appreciation, and tax savings while avoiding many of the pitfalls. Syndications are companies that own, manage, and then sell income-producing properties—and they receive the bulk of their financing from passive investors called limited partners.
The limited partners have the up-front labor of finding and researching a syndication, but do not have the input or responsibilities regarding its operations, but once you find a sponsor you trust and who performs well, you can build a long-term successful relationship.
Throughout the syndication’s property ownership, limited partners receive the repayment of their capital contribution plus returns of around 15 to 25%, depending on the project’s success.
Real estate syndications do require an up-front investment from passive, and often accredited investors, which is usually $50,000. The other thing to consider is that syndication projects typically last for several years, meaning investors’ funds are inaccessible during that time.
Real Estate Investment Trusts
Real Estate Investment Trusts (REITs) pay substantial dividends, so they are a frequent tool for creating a passive income stream. REITs are publicly or privately traded companies that purchase and manage income-producing real estate. Investors buy shares of these companies with the hopes that the REIT is profitable, and as a result, pays dividends.
REITs must pay no less than 90 percent of their taxable income to shareholders to maintain the REIT designation. The IRS, ever one to muddy the waters, classifies REIT dividends as portfolio income which is taxed at the capital gains rate rather than as passive income.
We should point out that REITs don’t offer the same tax advantages as directly owning real estate and they move with the broader stock market, so you don’t get the safety of portfolio diversification with this option. On the other hand, they are liquid so a benefit is you can sell at any time.
Many REITs exist, and the first step to narrowing them down is identifying the type of property one wishes to invest in. REITs often specialize in a specific property type, like medical office space, hotels, or storage facilities. As such, investors should carefully research the target industry of a prospective REIT and be informed of the risks and rewards of that particular market.
REIT Exchange-Traded Funds
Where REIT investment requires the research and selection of specific REIT companies, REIT Exchange-Traded Funds (ETFs) allow investors to earn dividend returns from that ETF’s select group of REITs.
A professional fund manager cultivates and manages an ETF, and each one will include many types of real estate, making them a great way to add diversity to a portfolio. For example, Vanguard’s real estate ETF (VNQ) holds over 180 different REITs. Other real estate ETFs focus on REITs that invest in mortgages rather than equity. One such is VanEck Vectors’ Mortgage REIT Income ETF (MORT).
Like the REITs that ETFs focus on, REIT ETFs dividends are taxed as capital gains.
Rental Property Ownership
In another twist, the IRS considers income from investment properties, whether single-family homes or multifamily properties, to be passive income. Of course, anyone who ever dealt with a tenant or repaired a property might think otherwise, but the designation leaves more money in the owner’s pocket.
As new property construction cannot meet the demand of an ever-growing population in the United States, rental properties are likely to remain in demand.
Directly owning an income-producing property presents a couple of challenges:
- The upfront cost can exclude many.
- Despite being taxed as passive income, rental income often becomes labor intensive for owners who handle the property management and tenant responsibilities themselves.
Real estate syndications address these concerns.
Non-accredited investors sometimes have more success finding real estate projects through crowdfunding platforms like Fundrise, Arrived Home, and Groundfloor. Most crowdfunding sites offer more opportunities for accredited investors, but they increasingly add options for the non-accredited.
Crowdfunding platforms connect investors with projects which have lower minimum capital contributions than real estate syndications. Depending on the platform and project, investors can participate with as little as $10.
Some crowdfunding sites simply connect investors with:
- Shares of an income-producing property
- Or provide short-term loans to projects.
There is a significant downside to these platforms as there is little-to-no vetting of the sponsor, so, as always, caveat emptor.
Real estate investment usually focuses on the earning potential of improvements, but the land itself can be a source of passive income. Of course, the most lucrative possibility is the purchase of oil or mineral rights, but investors with some knowledge and willingness to network can profit from the ownership of agricultural land.
Not only do agricultural landowners benefit from an appreciation of the property value, but they also get regular rental income from the farmer leasing the property. Because the farmer needs the land to perform well and specifically, the lessee is usually responsible for care and upkeep of the land.
Ways to Find Real Estate Investment Opportunities
The difficulty of finding a promising investment can quickly temper motivation and desire to start passive investing. Here are some things to consider.
Know Your Accreditation Status
Due to SEC restrictions on non-accredited investors, accredited investors are eligible for more projects and are desirable to project sponsors. Accreditation comes from earned income exceeding $200,000 for the past two years, a net worth of over $1 million, excluding the primary residence, or certain professional licensures.
Find more information about SEC requirements in Regulation D.
Contact Syndication Sponsors Directly
While accredited investors may receive solicitations regarding syndications seeking limited partners, the 506(b) syndications, open to non-accredited investors, are not permitted to publicly advertise.
Real estate investing podcasts are a great way to not only learn more about opportunities but get a feel for a specific sponsor and see if they’re investing style and track record meets your requirements. You may want to go to conferences, or visit your local multifamily networking events, which can be easily found on sites like Facebook and Meetup.com
Tips and Strategies for Generating Passive Income
Nearly anyone can step into the world of passive income to improve their quality of life, making it one of the most thrilling components of investing. There is no one-size-fits-all strategy for getting started, but there are several universal points to get off the ground.
Do Not Shortcut Research
Passive as a descriptor can be very misleading and even dangerous. Passive investment opportunities are not sure things and require the same level of research one would put into any transaction.
Remember that as an investor, your capital contribution funds someone else’s project. Whether that project comes in the form of a REIT, a syndication, or something on a crowdfunding site, the investor must evaluate the potential for success; and that often hinges on the experience of the people behind the project.
Know the Time Commitment
Time spent on an investment is time that you could use on other profitable endeavors, and money made inaccessible by investment could make money elsewhere. Then again, a 15-25% rate of return might be worth the time committed.
When considering projects that require a long-term commitment of funds, investors must be sure that they can spare the money, in the case of an emergency or otherwise. When dealing with REITs or ETFs, investors can usually pull their money quickly and with no penalty. On the other hand, with syndications, passive investors may not be permitted to withdraw funds at all.
Consider Investing Through a Self-Directed Roth IRA
Roth IRAs are funded with after-tax dollars, and the assets of the Roth IRA grow tax free until withdrawn. Unfortunately, the IRS restricts the type of assets in employer-sponsored and individually established Roth IRAs, therefore they cannot be used to purchase real estate. Self-directed Roth IRAs (SDIRAs) have no such limitations.
The account owner manages the SDIRAs and can have a much wider array of assets, including real estate. The account owner can purchase and operate an income-producing property through the SDIRA. As long as the owner keeps the gains in the account and avoids prohibited transactions, the profits will continue to grow tax free.
Earn Passive Income with Your Investments
Few things are as appealing as an additional source of income each month or quarter. Whether you are looking to create a vacation fund, plan for retirement, or completely replace your job, passive income is one of the best ways to meet that goal. Learn More.