Imagine a situation where you invest in rental property, then sit back and watch the earnings stream in while someone else worries about fixing the plumbing. Is it that easy?
Well, it depends. It’s possible to earn steady money from rental property after investing some up-front money and time. After that, you can let someone else manage the daily headaches while you earn income and reap some tax benefits. Or, you can maintain an interest in a limited partnership capacity, keep your distance on the day-to-day tasks, and also call it passive income for tax purposes.
Passive but earning
Passive income is generated when you are involved in a business and earn income but not as an active participant. The most common passive income comes from rental properties, limited partnerships, or ventures with a silent investor.
Passive income businesses such as rental property investment generate certain benefits that make them attractive. For one, the earner doesn’t need to be physically present and directly involved to generate income.
As a result, they may have more flexibility to earn from multiple properties or profit from a different business altogether. But to succeed, the investor may prefer to be more involved in the property.
Passive versus active
In tax terms, the level of material participation in a business defines it as passive or active. Some businesses are still considered passive even if the owner is partially involved. It’s important to consult a tax professional to determine if your rental business will generate active or passive income, and what tax breaks and deductions can be taken for your business.
Generally speaking, rental property investment is considered passive except for these scenarios defined by the Internal Revenue Service. For example, exceptions include if the rental property owner is a real estate professional, if the rental is leased out on a very short-term basis, or if the property is mainly used for other purposes.
Property types
Typical rental properties that are used for passive income generation are single-family units such as condos, as well as duplexes and other properties with multiple units. These can be secured with a residential loan, whereas apartment buildings, also popular for passive income, can be gotten with a commercial loan.
Mixed-use developments and industrial complexes are additional examples of rental properties to invest in and generate passive income.
Up-front work
For your rental business to succeed and generate predictable income over time, it’s important to invest your time at the beginning to ensure a sound business plan and viable rental property. You may want to take an active role in choosing the property and investigating the local market before making a purchase or investment.
This process will take considerable research and assessing of real estate trends, rents paid for similar properties, and typical tenants who will seek out such a property, as well as the property’s long-term viability and its likelihood to attract a steady stream of appealing tenants over time.
You, or a trusted third party, should also develop a well-informed business plan to sustain oversight of the property. This will address expenses for property management, marketing, tenant contract management, materials and equipment, furnishing of the units and lobby, regulatory and safety compliance requirements, necessary utilities, vendors such as cleaning service and building maintenance, and any regular repairs.
If you are only involved as a limited partner, possibly alongside other investors, then your interest in the property is distanced from the daily operations, but you will benefits from the state, local, or federal tax breaks, and receive proceeds from rents once they start rolling in.
Mistakes to avoid
To ensure a steady stream of passive income in the future from your rental property, it’s important to head off any potential hiccups at the start. Here are a few common mistakes to keep in mind.
Since the real estate market can fluctuate and affect your property’s appreciation, make sure you will have enough cash flow at all times to cover your expenses and still generate income.
Even though your goal will be to become less involved over time and benefit from “passive” income, you should still treat the property as a small business and pay close attention to details, especially at the beginning.
One example of this is tenant screening. It may be tempting to go easy on potential tenants in a rush to fill the building, but good tenants with steady jobs and credit profiles are key to your property’s longevity. Excellent screening measures are key when vetting those applicants.
Rent collection and strictly enforcing other contractual obligations is another way to ensure you are earning a steady, predictable cash stream. Flexibility in these areas can only lead to problems and inconsistent income.
You might prefer to hire employees or a management company to handle such day-to-day operations, particularly if you can afford it. How much time you willing to put in will determine how passive your income really is in the end.
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