Passive Income – Naughty or Nice?

As we start this series of posts on the classic (and sometimes controversial) topic of Passive Income, it’s worth taking a bit of time to agree on what we’re talking about when we use the phrase.

It seems there’s a massive misunderstanding around whether passive income is to be aspired to or or something to be suspicious of. It’s an innocent enough phrase but why does it evoke such strong opinions both for and against?

What’s the reality behind passive income? As with most things in life, taking the time to understand something is usually well worth the effort.

I suspect there are two key reasons for this lack of understanding:

  1. There is no simple definition of what passive actually is and how it can be attained, and therefore a lot of confusion around the whole subject.
  2. The phrase has, like several others, been used and associated with “get rich quick” schemes. The idea put out to the unwary is that passive income is a way of getting money for nothing and often for no financial commitment, which is highly appealing but ultimately doomed.

To try to address both of these reasons let’s get down to some proper definitions.

The most succinct definition of passive income I have found, from trading website ADVFN is: “Income (such as investment income) that does not come from active participation in a business.”

Often the best place to look for definition of income types ought to be from the tax man. In the UK passive income isn’t a category for tax purposes, but you can get a feel here for what HMRC considers passive income.

But according to the US tax service there are three types of income:

  • Active income
  • Passive income
  • Portfolio income

Active income is when you trade time for money. A regular Job.

Dictionaries can’t quite decide in some case the difference between passive and portfolio income.

According to Investopedia, US passive income is “Earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not materially involved.”

And portfolio income is “income from investments, dividends, interest, royalties and capital gains. Portfolio income does not come from passive investments and is not earned through normal business activity. Typically, income from interest on money that has been loaned does not count as portfolio income.” – Investopedia, again.

(It’s somehow reassuring to know that the simple phrase passive income seems equally misunderstood on both sides of the Atlantic!).

Nevertheless, all agree that the difference between active and passive (or portfolio) income is whether one is materially involved in generating the income.

Some income is more passive than others.

In reality there is seldom black-and-white active or passive income – most income is somewhere on a scale between the two…

What about property income ?

Since we’re on a property blog, this is an excellent question. If you’re a landlord and working directly in your business are you getting passive income? I would say not quite – its somewhere on the scale : semi-passive. If you’ve delegated out all the work to managing agents, what then? Still not 100% passive but getting closer.

If you’ve invested in a fully-managed purpose-built student property ?

Or invested in property bonds or crowdfunding?

Again these sit on the scale of semi-passive, especially when you include the due diligence and research needed before making the investment. It’s hands-on, “do-once” work, but work it certainly is.

And in the end

In conclusion, I would suggest that a stronger investment goal than the Holy Grail of pure passive income is to create income streams through investments that are leveraged by other peoples time (lettings agents, good brokers, investment researchers) and perhaps also other peoples’ money (for example secured loans and mortgages).

I’ll leave you with an example of semi-passive property income: Purpose-built student property is a proven “done-for-you” model. Once you’ve carried out your due diligence and own the student suite, there is literally nothing to do for years –  except receive your net rental income (which compares very favourably with labour-intensive buy-to-let).

Don’t take my word for it – see for yourself some passive income in action…