Passive Income vs Active Income: The Ultimate Showdown
It’s funny that I went to college and dental school to inevitably make money yet was never taught the difference between passive income vs active income.
After receiving my first tax return, it didn’t take long to figure out that earned or ordinary income from fixing teeth was the HIGHEST taxed income in the land.
But at that point in my career, I was as “green” as they come and didn’t think to ask my CPA if there was anything that could be done besides buying things that could be “written off.”
And as you know, tax deductions can only get you so far especially if you don’t implement other tax strategies.
I found out much later in my career (never too late to start) about how building a passive income stream is the key to reaching financial freedom.
Warren Buffett said it best, “If you don’t find a way to make money while you sleep, you will work until you die.”
He states, “The key to financial freedom and great wealth is a person’s ability to convert earned income into passive income and/or portfolio income.”
In this article, we’ll discuss what you should know regarding passive income vs active income.
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The Cashflow Quadrant
Before we get started comparing passive and active income, I feel that revisiting the Cashflow Quadrant is important as it points out where our “cash flow” or money comes from:
Most people are on the left or “poor” side of the quadrant including yours truly.
I started off as an employee working out of an endodontist’s office for two years. Next, I bought a building and started a practice of my own moving me to the self employed quadrant.
Even though I thought I’d made it big time being able to call the “shots,” little did I know the S quadrant pays the MOST taxes (self employed) along with other taxes.
Something else to consider. If you’re in the E or S quadrant, you trade your time for money (active income only). Active income is taxed much higher than passive income which is what those on the right or “rich” side obtain.
My goal for you is to go from the poor to rich side of the quadrant which will allow your money to work for YOU and not the other way around.
What Is Active Income?
As previously discussed, trading time for money produces an active source of income. This can be either in the form of commission, salary or hourly wage.
When I interviewed Grant Cardone on my YouTube channel, he recommended that we do everything we can to increase our active income and then invest in cash flowing assets (syndications, businesses, etc.) for passive income sources.
If you’re a doctor, focus on getting really good at your profession (marketing, sales, customer service, etc.) for the long term to increase your annual income as much as possible.
Think about it.
You’ve spent time, energy and a lot of money to get to where you are and your time is better served doing that one thing. When you start focusing on other things such as buying rental real estate on your own and becoming a landlord, your active income will eventually suffer.
Remember, if you want to earn passive income from investments, then you need to first invest the money you earn from your active income stream.
5 Examples of Active Income
#1. Hourly wage
Earning an hourly wage is one of the most common ways to earn active income from either part-time or full-time employment.
One of the potential benefits of being paid by the hour is that you may have an opportunity to earn extra money via overtime.
A salary is a fixed amount of money received for your efforts working a regular schedule.
An example would be someone that’s trading their time (40 hours) Monday through Friday in exchange for a set amount of money.
A commission is another type of active income typically based on the amount of “sales” brought in which can vary based on the job type.
Of all the types of active income, a commission is one of the best ways to make the most amount of money.
An example of this are real estate agents that earn a 3% commission. If they were to make a $1m sale, this would allow them to earn $30,000.
Tips are another type of active income mainly available for those serving other people (i.e. waiters/waitresses, hospitality workers, etc.).
They’re based on the level of service provided to the customer.
#5. Consulting and Freelance Services
Another form of active income are fees from consulting and freelance services.
If you possess a marketable skill set, then you’re in a great position to help other companies grow their respective business and generate more revenue.
- software developers
- graphic design
Also, if you’re an expert in digital marketing, social media, or business operations, you could offer consulting services to companies that need your help.
What Is Passive Income?
According to Investopedia, passive income is defined as:
Earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not actively involved.
In a nutshell, if you’re earning passive income, you’re doing so with little to no effort. You’re hands off.
All of the passive income I’ve received is from income-producing assets that I’m not actively involved with (syndications).
As previously mentioned, getting passive income streams still requires work which comes from active income. But, if you focus your efforts on something that will eventually generate money while you sleep, then it’s worth the wait.
5 Examples of Passive Income
#1. Rental income
Income from rental property is treated as passive income for tax purposes unless you’re considered a real estate professional. In that case, any rental income earned counts as active income but you can also use depreciation to offset your active income to reduce income tax liability (one of the main benefits of a real estate professional).
Owning rental property and receiving income from it doesn’t feel very “passive” as you’re having to deal with tenants.
But if you’re like me and invest in syndications as a limited partner, then rest assured as the general partners handle all the dealings that come along with owning property.
In most cases, taxes on rental income are paid based on an investor’s federal and state income tax bracket and generally don’t need to withhold payroll taxes.
#2. Private equity
Private equity (PE) refers to a group of funds that invest in or acquire private companies not listed on a public stock exchange.
They may also:
- buy out public companies
- take them private
- restructure them for potential future growth
Most PE investments require high capital requirements and are considered high risk. We invested in our first PE deal last year that had the typical 10 year hold but is going to be a good source of passive income for the long-term.
#3. Interest from investments
One of the most common ways people earn passive income is via the stock market with interest and/or dividends.
- Real estate investment trusts (REIT)
- Index funds
- Exchange-traded funds (ETFs)
- Dividend stocks
Traditional retirement accounts are popular as most people are focused on earning interest on investments to build up enough money to live off the interest for the rest of their life.
#4. Owning businesses
One of the hottest trends on obtaining additional income streams is buying businesses that cash flows.
The main benefit is that these businesses can be managed passively so the owner doesn’t need to actively engage in the day-to-day operations.
These owners fall into the “B” or Business Owner of the Cashflow quadrant which allows them to step away from the business while still enjoying the income that it provides.
- car washes
- vending machine routes
#5. Online course and Info products
My teenage son is currently learning one of the best skills that will take him far in life no matter his profession…”how to sell.”
Cutco knives have a program that teach sales and marketing to students in order for them to sell their products.
I told him that if he wanted to further his career as an entrepreneur, he could teach what he’s learning to other teens on YouTube or develop an online course to sell.
There’s people making good money selling online courses which eventually turns into a solid passive income stream.
The key is building an online following which can be done via an email list or social media platforms.
And once you have an audience and launch a course that teaches a valuable skill, then you could easily make tens of thousands of dollars per month.Join the Passive Investors Circle
How to Generate Income from Real Estate (Active vs Passive)
Real estate can generate active or passive income and is determined by what investment objective you have to generate income over the short term or long term.
An active real estate investor means that you’re taking a hands-on approach and is typically more time consuming dealing with tenant and or property problems as they arise.
Passive real estate investing is more of a hands-off approach with limited control and time commitments.
Let’s take a more detailed look between the two.
What is Active Real Estate Investing?
A wrist injury while snow skiing made me realize that I was solely depending on dental income (active) to provide for my family.
At that point I knew that I had to focus on acquiring additional income streams real estate was the best place to start.
At that time, I didn’t have an idea about the different ways you could passively invest so I thought I had to take the active route and become a landlord.
Active real estate investing involves searching and acquiring property, securing financing, maintaining and selling property.
Types of investments:
Typically active investors are involved with a higher amount of risk as they have to personally guarantee the loan.
For active investors looking to generate income over a short period of time, they’ll either get involved in flipping or wholesaling real estate.
#1. Fix and flip
This active investing strategy involves purchasing property in need of rehab for a below-market price and sell it as quickly as possible for a profit.
The shorter the time frame, the better.
Wholesalers are similar to a “middle man” in a transaction.
They’re experts at identifying undervalued property, getting it under contract, and assigning the purchase contract to an investor in exchange for a wholesale fee.
Networking with a real estate wholesaler can be a good way for finding off-market deals that may have instant equity once escrow closes and needed repairs are made.
Generating active income from real estate and working a 9-5 usually involves a high level of risk. If you can’t work then you don’t get paid.
If you’re not actively flipping properties or wholesale opportunities dry up, then active income from real estate goes away too.
What is Passive Real Estate Investing?
Passive real estate investing is completely hands-off and involves investing capital into real estate assets without being responsible for any of the day-to-day management.
Because of this, it involves much less risk than an active investment.
Passive real estate investing is great for the busy, high-income professional with limited time wanting additional streams of income.
The time factor is one of the main reasons I chose the passive route via real estate syndications which is a partnership between multiple investors (general partners and limited partners).
This group shares capital, skills, and other resources which allows them to gain purchasing power and acquire properties they couldn’t otherwise afford.
The project’s sponsor or general partner is responsible for everything such as:
- finding/acquiring property
- obtaining the financing
- daily management
- reporting back to the passive investors (limited partner)
Income from syndications are generated in two different ways:
#1. Recurring net income after rents have been collected and expenses have been paid.
#2. From the potential profit from appreciation earned when the property sells.
Most of the time this income is paid out quarterly in the form of distributions during the hold period (typically 5-7 years).
One of the best things about owning passive real estate is that an investor can spend as little or as much time as they wish on their business. On the other hand, when active real estate investors stop working, they also stop getting paid.
How Passive and Active Income are Taxed
Disclaimer: This NOT financial or tax advice. It’s best to consult an accountant to discuss your individual situation.
If you’re like most high-income professionals, then you’re probably paying close to 40% of earnings to the Internal Revenue Service. If something isn’t done about this situation then you’ll continue paying $0.40 for every dollar earned until retirement.
My goal for you is to work SMARTER.
Remember the Cashflow Quadrant previously discussed? Those on the right side of the quadrant focus on earning and living off of passive income.
Not only does it NOT involve their time to earn but passive income also receives the best preferential tax treatment.
Active income (aka “ordinary income”) is taxed the highest of all income and falls within the seven tax brackets ranging from 10% in the lowest bracket to 37% in the highest.
It’s also subject to FICA taxes (U.S. federal payroll tax) which includes:
- social security – 6.2%
- medicare – 1.45%
*If you’re self employed, then you must match your employee contributions and pay 15.3%.
Meanwhile, passive income is taxed according to the capital gains rules (see below for more detail) ranging from 0% to a maximum of 20%.
This allows you to shield income from excessive taxation when compared to the ordinary income tax rules.
One of the reasons that passive income is better than active income is that it’s NOT subject to the FICA taxes (payroll tax) previously mentioned.
Passive real estate investors get all the tax benefits an active investor gets.
Here’s a few examples:
Even though you’re not performing landlord duties as a passive investor, you continue to get full tax benefits. because you’re investing in an entity (typically an LLC ) that owns the property.
And that entity is disregarded in the eyes of the IRS (sometimes called “pass-through entities”).
And these tax benefits pass or flow through that entity to you (the investor).
One of the most common rental property deductions a passive real estate investor can claim is something called depreciation.
This benefit allows real estate investors to write off property over time. This allowance is due to the wear and tear and deterioration of the property.
Under current law, investors can use depreciation deductions each year from pre-tax income to recover the cost basis of a property over the calendar years in which they own the property.
3 Types of depreciation
a. Straight-line depreciation
Residential rental property owners can depreciate their property over 27.5 years.
For example, the annual depreciation expense of a single-family rental home with a value of $200,000 would be $7,278.00 ($200,000/27.5 = $7,278.00).
b. Accelerated depreciation
Usually real estate owners hire a group of engineers to perform a cost segregation study.
This study allows different building components to be depreciated over shorter time schedules of 5, 7, and 15 years by identifying the non-structural elements plus any land improvements.
Examples include flooring, cabinets, appliances and parking lots.
Investors receive more depreciation benefit upfront as accelerated depreciation creates large paper loss in the early years of ownership.
c. Bonus depreciation
Bonus depreciation allows investors to front load depreciation even more with less than a 20-year life immediately in the first year.
It doesn’t get much better than that!
#2. Capital gains tax
Whenever real estate is sold, the IRS gets their cut through a capital gains tax.
The amount of capital gains tax depends on:
- the length of time the asset is held
- your individual tax bracket
Here are the brackets and percentages based on the 2023 tax law:
- $0 to $89,250: 0% capital gains tax
- $89,250 to $553,850: 15% capital gains tax
- Over $553,850: 20% capital gains tax
Gains made from selling assets held for LESS than a year are called short-term capital gains and are taxed at the same rate as your ordinary income.
Gains made from selling assets held LONGER than a year are long-term capital gains and are taxed at lower rates than short-term gains and ordinary income. As noted in the table above, this can be anywhere from 0% to 20%, depending on your taxable income.
Why Is Passive Income Important?
The simple answer it TIME. There’s nothing more valuable than time as it’s irreplacable vs money. You can ALWAYS make more money but not time.
Passive income is created without you having to be physically present. If you have a passive income stream established, then you can make money 24/7.
But don’t misunderstand that building passive income can take years to build. There’s work that must be done and for most of it this comes from earning active income.
If you’re a doctor, then you’re paid for treating patients. You can then take that “ordinary” income and invest in cash flowing assets generating passive income.
You can’t be lazy and expect passive income to start rolling in. Nothing in life is easy and you must be willing to put in the work and effort up front. But if you’re consistent with this strategy, you could literally end up making money while you sleep.
Are You Ready For Passive Income?
Hopefully by now you can see how earning passive income can free up your time and allow you to live life however you want.
My favorite way to earn passive income is by investing in real estate syndications.
If you’re an accredited investor and want access to the deals I invest in, join the Passive Investor Circle below.Join the Passive Investors Circle