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May 5, 2014
Active income vs. Passive income
May 7, 2014

As you build up your savings and envisage your future passive streams of income, here are some of the common ones. The numbers are arbitrary and meant just to keep track of the number of common streams.

(#1) Interest

The two most common passive income streams are interest and dividends.

Interest can come from a variety of sources but the two biggest are from your interest-bearing deposit accounts (like a savings account) or loans, either to individuals (peer-to-peer lending or private notes) or companies (bonds, notes).

Interest is not super sexy to think about but it’s also something that requires very little effort. We make sure we put any savings into a high yield savings account and then never think about it again. It’s like getting cashback on a credit card — you pick the card once and just get a small drip in return.

(#2) Dividends

Dividends are payments from investments and partnerships. When you start, most of your investments will be in the stock market and you benefit from qualified dividends and their favorable tax treatment. As you expand your portfolio, you may enter into partnerships that make payments.

The holy grail of dividends is qualified dividends because they’re taxed at long-term capital gains rates, which is usually much lower than your ordinary-income rate. Not all dividends are qualified and the ones that aren’t will be taxed like interest.

(#3) Capital Gains

You earn capital gains from the sale of investments. This is passive in the sense that you may spend time researching companies but you don’t necessarily “work” in the company to earn. It’s also something that is lumpier in the sense that you pick and choose when you realize capital gains (or losses).

We consider capital gains as a passive income stream even though it’s so lumpy because you can turn a holding into a stream by simply selling shares from time to time. It’s not a stream in that it offers yield with no reduction in principal but it is a stream.

(#4) Royalties

Royalty income is income you earn when others borrow or use your property. This could be something you purchased or something you created. An author may write a book and a publisher will print, distribute, and sell that book. The author gets a percentage of each sale as a royalty and it’s a well-understood system.

If you are not the creator of the work, you could buy the work from the creator and license it to others. For example, you could buy the music rights to a song and then license it for use to others.

With the rise of ebooks and self-publishing, I’ve known several writers who have built up a library of books for sale on Amazon that create a nice side income without day to day effort. The beauty of that type of business is that you build a following and each person who discovers one of your works is introduced to an existing library.

(#5) Rental income

When you own real estate, you can earn rental income from individuals or companies who rent the space from you. This can be residential as well as commercial property, with different rules for both.

Many years ago, this meant owning the property yourself. With the rise of crowdfunding platforms, smaller investors can own just a fraction of a property along with other investors. You can use this as a way to diversify your real estate portfolio without putting too much into one investment.

This is especially fascinating in the area of investing in farmland. Farmland consistently increases in value and offers a cashflow component that may be appealing to investors.

(#6) Business income

This one may be a little deceptive in the sense that it’s not necessarily “100% passive.” If you own a business, some portion of your business income will be passive in the sense that you aren’t personally laboring to earn every dollar the business brings in. You are building something that generates income without active work, like a website or the sale of information products.

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