There are two different ways to generate income — active and passive. One is a time for dollars trade-off while the other is able to generate income without your direct involvement. There are many differences between these two types of income, and choosing one over the other doesn’t mean one is better than the other. Sometimes the choice is a personal preference, and sometimes it's out of necessity. In this article, we’ll go through the differences between these two types of income.
Hourly employees have a direct exchange of time for dollars. If the employee is not working, she does not earn anything. Salaried workers are similar but not as direct of a trade-off. However, salaried workers still exchange time for dollars. If they do not show up for work and put in a certain number of hours, they won’t get paid. Both are examples of active income. In addition to exchanging time for dollars, active income is also hands-on.
Direct real estate can be considered active income. Direct real estate is the purchase of a property by an investor. The landlord/investor must attend to tenant requests, finding new tenants when there are vacancies, property maintenance, improvements, taxes, and insurance. If the property was financed, loan payments would need to be maintained. The landlord has to put in time in order to earn any income. The exchange of time for dollars may not be as linear as with employees, but if the landlord isn’t attending to the property, it won't be easy to maintain any income.
Passive income doesn't require an exchange of time for dollars or that the investor be hands-on. Instead, someone else is doing all of the work. The passive income investor pays a fee for this convenience, which may be a management fee, salaries, or some similar type of fee.
From the above direct real estate example, the landlord can hire people to take care of his property or even hire a property management company. By paying someone else to maintain the property, the landlord removes himself from any daily involvement. He has also shifted from active to passive income. The landlord has freed up a lot of time to do other things unrelated to running the property but will still earn income from it.
Passive income can get very passive. A DST (Delaware Statutory Trust) is a great example. DST investors don’t have to worry about hiring anyone to maintain the property. They are not involved in any decision making. All of those responsibilities are delegated to the DST sponsor. Yet, the landlord continues earning from their DST investment, assuming all goes well with the DST. This is an example of the highest level of passive income — one in which the investment is hands-off and still generates income for the investor.
Passive income may sound great, but for some people, they enjoy getting their hands dirty and being involved in the business's day-to-day operations (i.e., active income). For others, being an employee may be out of necessity. Perhaps because they haven't gotten their investment business off the ground yet or were even involved in a failed venture and need an immediate source of income. Starting a business can be more difficult than finding a job, making the latter the path of least resistance for generating income.
Whichever one you decide on, there is no right or wrong. It can come down to timing (life situation and events) or unexpected opportunities.
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Hypothetical example(s) are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.
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