Earning passive income from real estate investment appeals to many Americans. With a passive income stream, you can continue making money without working. Passive income can help you generate wealth and work toward your financial goals. Though there are many ways to build passive income, investing in real estate can be an effective strategy.
If you are new to passive income and real estate investing, this guide will help you understand the meaning of passive income and how you can earn it from real estate.
Read on or skip to a specific section:
- What Is Passive Income?
- What Is Passive Income in Real Estate?
- The Benefits of Earning Passive Income Through Real Estate
- How to Make Passive Income in Real Estate
What Is Passive Income?
The definition of passive income is income you make without needing to do active work or participate in an ongoing manner. You earn income without trading your time for cash, as you would with a job. Of course, passive income does not translate to no work. Often with passive income streams, there is upfront work involved to set up the investment. However, once your investment is established, you do not have to continue participating to earn money.
What Is Passive Income in Real Estate?
To earn passive income in real estate, you can invest in various opportunities, each with a varying degree of involvement. How passive the income source will be depends on the type of investment you choose and your strategy. Many investment options do not require you to be actively involved on an ongoing basis, which is why real estate investment is so appealing to investors.
Some examples of real estate investment include the widely known strategy of purchasing properties to rent out to a tenant, but there are other, often more passive, investment options.
The Benefits of Earning Passive Income Through Real Estate
We all need to earn a living, and as such, many of us are often looking for ways to increase our cash flow. Even if you have a 9-to-5 job you love, no one can deny the appeal of earning money while you sleep. Passive income can be used to:
- Achieve your financial goals
- Fund your retirement
- Grow your emergency fund savings
- Fund your next vacation
- Pay for your child’s college tuition
- Replace your income from your job
- Pay off your debts
- Reach financial freedom
Many hope to develop enough streams of passive income to eventually replace their active income sources so they can enjoy financial freedom. Along with financial freedom, passive income can offer a tax benefit. Three types of income are subject to income tax:
- Ordinary income: The most common income source is from a regular job. If you receive a W-2 from your employer, your income will be taxed as ordinary income. Typically, of the three income types, this is the highest tax bracket.
- Portfolio or investment income: Portfolio or investment income is earned through capital gains. Capital gains are earned from the sale of a property or investment for a value greater than the initial cost basis. This type of income is not taxed the same as ordinary income and is typically taxed at a lower bracket, though this may vary depending on how much you earn from either source.
- Passive income: Passive income is usually taxed at the lowest bracket due to the tax advantages the IRS offers, depending on how the income is earned. For instance, passive income from rental properties may be taxed differently than passive income earned from dividends.
Further, another advantage of investing in real estate is that you can leverage your investment into more streams of income. If you purchase a rental property, you can save up money from the income you generate to use as a down payment for another investment property. Building equity from these properties enables you to develop a long-term strategy to help you reach your financial goals. Additionally, the more properties you buy, the more quickly and easily you can grow your investment portfolio.
To enjoy the benefits of real estate investment, you should develop a sound business strategy. This includes managing your properties, assessing the market, your current savings and the different types of real estate investment options.
How to Make Passive Income in Real Estate
In real estate, there are many different options for passive income. Some of the most common passive income sources include REIT dividends, ETF dividends, crowdfunding, rental properties and performing mortgages notes.
1. REIT Dividends
A real estate investment trust (REIT) is a company that pools money from investors to purchase, manage, or act as a lender for commercial real estate properties. A REIT must pay at least 90% of its taxable income to shareholders to receive the tax advantages granted from the REIT designation.
If you are just starting to look for passive income options, a REIT can be an excellent place to start. Generally, the upfront cost of investing in a REIT can be low, and returns can be high relative to the rest of the market and most companies that pay dividends. You can easily make your purchase through a brokerage account.
Keep in mind that though you can earn passive income from REIT dividends, the IRS does not tax these dividends as passive income. Instead, the income you earn from REIT dividends is usually taxed as ordinary income. However, dividends may also be taxed at a different rate depending on whether they are qualified and if they are allocated to capital gains, return of capital, or ordinary income.
REITs are one of the most passive of the real estate investment strategies, as you can regularly make money through dividends and your investments will be managed by the trustees.
REITs also allow shareholders to expand and diversify their real estate portfolios, gain access to quality management, and invest in assets that they may not be able to afford on their own.
To qualify as a REIT, a company or institution must distribute a minimum of 90% of its taxable income to its shareholders. However, these distributions are usually taxed at a higher rate because they are considered ordinary income. This is why some investors may invest in a REIT through a Roth IRA, where they can grow their earnings tax-free.
2. ETF Dividends
Another popular way to increase your cash flow is through a real estate exchange-traded fund (ETF). With an ETF, you can receive returns and diversify your holdings across many types of real estate property. Instead of buying individual shares of a single REIT, investing in an ETF means your fund manager will identify which REITs are suitable to invest in and use your money to purchase groups of REITs.
Though you can choose from countless publicly traded REITs, this can make your choice intimidating. ETFs choose the REIT for you and pool many together. This strategy enables you to benefit from professional management and diversification. Before deciding, evaluate an ETF based on its management history and reputation.
Similar to REIT dividend income, the income you earn from real estate ETFs will be taxed as investment income at the capital gain tax rate, depending on whether the dividends are qualified or unqualified. Regardless, ETFs are still considered more tax-efficient than options like stocks or mutual funds.
A relatively new option for generating passive income is real estate crowdfunding. As an investor, you can participate passively in funding a real estate property. For example, you may be one of several investors pooling your funds so a third-party sponsor can buy and manage a real estate investment property.
Returns from crowdfunding opportunities can vary depending on the investment opportunity and what structuring your sponsor arranges. Some will pay preferred returns annually, quarterly, or monthly, while others offer a split of the future profits from a disposition or sale of the property. Others offer a combination.
If you want to invest in crowdfunding opportunities, review each opportunity carefully. Not every crowdfunding investment will provide you with regular payouts, and you will not be guaranteed returns. If the sponsor or the investment fails to perform as projected, your returns may fall far below what you expected.
Crowdfunding can help you start investing in real estate, as the barrier is relatively low. For a small amount of money, you can begin investing via a crowdfunding website for a small amount of money. Other real estate investment options require significantly more capital upfront to start investing. A crowdfunding platform also offers convenience and better facilitation for many investors when it comes to due diligence, paperwork, and ease of identification.
When you choose a platform for your real estate crowdfunding and decide how much you want to invest, you can expect to earn income from the properties the sponsor owns and manages. As a result, this is considered one of the most passive sources of real estate investment.
4. Rental Properties
Perhaps the most well-known example of real estate investment is the purchase of a rental property. You can invest in rental properties in several ways, but most strategies fall under either residential rental property investment or commercial rental property investment.
In these main categories, you can find various investment types that can allow you to earn rental income, such as an apartment complex, single-family home, duplex, office space, or industrial building. You can also choose to hold a long-term rental or a short-term rental:
- Long-term rental: With a long-term rental, you lease the property to a tenant for a longer period, such as a few years. If you want a long-term rental, you may want to consider investing in commercial real estate properties.
- Short-term rental: With a short-term rental, you lease the property to a tenant for a shorter period, such as a month, a week, or even a night. If you want a short-term rental, you may want to consider investing in residential real estate properties as a traditional home rental or as an Airbnb or vacation rental.
No matter what type of rental property you want to hold, you will be earning rental income the same way. You will lease the unit to a tenant, and your tenant will pay you rent. In an ideal situation, your rental income will exceed the expenses associated with the property, netting you a positive cash flow. For instance, if you charge rent of $1,000 per month and the expenses are $500, your net cash flow would be $500 a month. Yearly, this equates to $6,000 of passive income.
Of course, not all rental properties are passive. The more involved you need to be with the rental property, the less passive it is as a source of income. Whether you choose to be the active landlord or hire a third party to manage your property will determine how passive it is as a stream of income for you. For instance, depending on your involvement with the property, short-term rentals may be considered active income and taxed accordingly.
Additionally, keep in mind that investing in a rental property can come with higher barriers, as it typically requires much more capital upfront than other types of real estate investment. Before you purchase a property, you may also want to research real estate values and trends in the location where you want to buy. This may mean making a purchase outside of your town or even out of your state.
5. Performing Mortgage Notes
You can also make passive income through real estate investment by buying a performing mortgage note. Performing mortgage notes are one of the most advanced real estate investing methods, so they tend to be less popular and less discussed than other investment methods. Still, a performing mortgage note is a viable form of passive income.
Mortgages and notes are separate contracts that lenders use to loan a borrower money to buy real estate. In the promissory note, repayment of the debt is outlined, while the mortgage offers the lender security by using the property as collateral if the buyer defaults. Every month, the buyer pays the lender interest and principal in the form of a single payment. Along with paying for the principal and interest, the buyer is also responsible for paying for insurance, taxes, and maintenance.
With a note, lenders have relatively no ongoing participation beyond collecting the monthly payment and keeping records of the payments and debt balance throughout the repayment period. For example, if the monthly payment is $700 a month, the investor can collect and keep nearly all or all of the $700. This depends on whether the investor opts to pay an optional and nominal fee to a servicer each month.
An investor can buy an existing mortgage note from another investor, typically at a discount, or create a new mortgage note from a property they already own via owner financing. Income from a mortgage note isn’t taxed as passive income and is instead considered to be interest income. Any interest you collect on a loan in a given tax year will be taxed as ordinary income.
With this passive income strategy, there is always the risk of nonperformance, or default. Default risk refers to the possibility that a borrower may not be able to pay back their loan. If this happens, you will not receive your expected returns. This likelihood is part of the reason why nonperforming notes are often available at a significant discount.
6. Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust, or a DST, is another popular option for passive real estate investing. A DST is a legal entity that offers more flexibility for investors looking to receive passive income from several potential earning strategies, such as:
- Rental income
- Operation of the trust
- Proceeds from the sale of the properties
In a DST, investors own fractional interests in one or multiple properties within the trust that they may not be able to afford on their own. These property holdings might include industrial properties, senior housing, student housing, multi-family apartments, and self-storage facilities. Generally, DSTs are ideal for investors who desire lower minimum investments, more portfolio diversification, and other benefits that align with direct property ownership without having to act as property managers. In some cases, DSTs may also offer limited liability and annual depreciation write-offs as additional advantages.
Another important benefit of DSTs is that these trusts may qualify as a replacement property during a 1031 exchange. This means investors can defer capital gains tax on the sale proceeds if they meet all requirements and qualifications.
To invest in a DST, however, you must be an accredited investor, which means meeting certain net worth or annual income thresholds. Likewise, as fractional owners, DST investors do not maintain control over property management decisions. This type of passive income investment is also not very liquid, so it may not be ideal for investors who prefer being able to pull their money out quickly.
7. Tenants in Common (TICs)
A Tenants-in-Common (TIC) structure allows multiple investors to pool their resources and acquire legal ownership of real estate investments. Investing in a TIC is similar to investing in a DST, apart from some property ownership requirements. These investors act as co-owners of real property assets but can hold unequal stakes in the property.
Investors in a TIC can source and obtain properties themselves or rely on a sponsor. They often hire a professional management company to operate the properties and deal with the day-to-day responsibilities.
TICs have a limit of 35 investors, and all members must unanimously approve all decisions. In addition, all TIC co-owners must share the expenses, debt, and income distributions — which are proportionally based on ownership.
TICs can also be used in a 1031 exchange. Investors may choose from multiple TICs as a 1031 passive income strategy, allowing them to reinvest their proceeds into like-kind properties and assets. This can help diversify their portfolio or occupancy type. If two or more investors in the TIC decide to purchase another property through a 1031 exchange, this is known as a joint TIC exchange. Investors may consider this option for the potential for lower minimum investment thresholds.
Learn More About the Investment Opportunities 1031 Crowdfunding Offers
There are several benefits of developing a passive income stream from real estate investments. You can fund your retirement accounts, replace your active income sources and grow your savings for vacations, emergencies, home maintenance, and college tuition. Anyone can benefit from earning money in their sleep, while on a beach vacation, or during leave from work.
At 1031 Crowdfunding, we can facilitate passive real estate investing. We have more than eight decades of combined experience in real estate, and our platform has performed a combined total of $2.4 billion in real estate transactions. Our management team has the experience required to navigate this burgeoning industry, and you can choose from private real estate funds, public non-traded REITs, and Delaware Statutory Trusts (DSTs). Register for an account with us today to learn more about how we help our clients.
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