Buying a rental property can be an excellent way to not only generate cash flow, but also to build wealth over time. However, it is important to know the advantages and disadvantages of owning a rental property and its influence on your financing and credit history. Investors need to understand how passive their rental income is and how they can make their job more passive.
What is passive income?
Passive income can be defined as the profit you earn even when you aren’t actively working. It’s everyone’s dream come true to get paid without doing any work! Everyone should include passive income as a key tool in their retirement plan. If you have passive income during your retirement years, you potentially could live as well as you did during your peak earning years. Passive income comes from investments, such as in rental properties, stocks, bonds, annuities, and other investments.
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Passive income in real estate
Passive real estate investing is a form of real estate investing in which you place your capital into a real estate venture that you will not have any direct responsibility for managing. If done correctly, rental properties can produce cash flow every month and greatly increase your rental income. You can passively invest in real estate in several ways, for example, by purchasing stock in real estate. You can also invest in Real Estate Investment Trusts (REITs), which are companies that pool investors’ capital to invest in large real estate deals. There are really two ways to invest in real estate:
1. Direct purchase of property and investment through indirect means. Which involves a larger up-front cost but generally higher potential returns.
2. Indirect investment can be made through real estate investment trusts (REITs) or tax liens but do not involve the direct ownership of the property.
You can also enjoy the benefit of passive real estate investing through a crowdfunding platform, where you have the option of finding deals, typically debt-based investments, which can pay you a fixed monthly payment over a predetermined time.
You can passively invest in real estate with several goals. You can invest for the passive income, or you can passively invest in real estate for growth, meaning for the appreciation on the properties and the profit when they are sold. You can also engage in passive real estate investing for both the ongoing income and the longer-term growth opportunity. In both cases, passive real estate investing is beneficial.
Related: How to Make Money in Real Estate Passively
How to generate passive rental income
The ability to generate passive rental income without tangibly participating in the business is quite appealing, because it gives investors the time to do other things. So how can investors generate passive income? By buying an income-producing rental property and becoming a landlord. Real estate rentals provide returns through three ways: equity, cash flow and tax benefits. The amount you make from each may change over the years, providing more passive income.
- Equity: This is the combination of appreciation and the amount of your mortgage paid off each month. Since property is a real advantage, it offers good protection against inflation and property prices, which generally increase by at least the annual rate of inflation.
- Cash flow: This is the amount of money you have left over every month, after all expenses paid and estimated tax debt is put aside. A lot of investors like to use the net operating income as cash flow but that’s not really cash in your pocket.
- Tax benefits: The tax benefit to real estate investing can also be a good source of return. The Internal Revenue Service (IRS) allows you to deduct depreciation as an expense every year. Since depreciation doesn’t actually involve you losing any cash, your taxes go down but you didn’t pay anything.
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Avoid Traps!
Being successful in generating passive income from real estate requires doing a great deal of homework beforehand so that you don’t wind up buying a money pit. A money pit will eat up all of your potential rental income and cost even more for constant repairs and make it harder to keep your rental units full. You can avoid them by doing your footwork and making your money when you buy. That means you visit properties, ensure the local market is strong, has sound long-term potential, and the local rental market is one that is favorable to landlords and property owners. If you have to compete to fill your units and pay high taxes in areas where potential rental income in limited, you made a bad business decision and will have trouble generating passive income from your real estate investment. But so long as the property and market are good, you can make good money!
The bottom line
Creating a passive income can help you out greatly in the future. If you want to retire early, having a passive income is a must. With passive income, you will have income coming in as long as you own the investment, without actively trying. Creating passive income may take more work, but it’s cushion you can land on, should you fall in the future.