Passive Income: a Primer

The Truth About Passive Income

The Holy Grail of financial independence is passive income. Most people have heard of and chase after it whether they know what it is or not. They dream of sipping cocktails on a yacht while hundred-dollar bills rain from the sky. Wouldn’t that be great?

How do we get there though? Most Americans work some kind of 9 to 5 job. Do that long enough and you’ll realize there is something missing. That something is usually progress. Oh sure, when you start a new career, you might make rapid gains in the first quartile of your wage range, but then things taper off. When they do, reality creeps in and it occurs to you that you don’t want to be doing this in your 60s and 70s.

The solution to freedom from work is passive income. The name can be a little misleading though and this has led to an excess of bad information about it. Let’s take a look at what it is, what it isn’t, and why it’s important.

What Passive Income Isn’t

The best way to understand passive income is to start by looking at what it isn’t. We don’t call it “passive” because it’s truly passive. Stupid, right? Well, no. We call it passive income because it is a counterpoint to active income.

Active income is just that. When you are earning active income, you are trading time for money in a linear fashion. It doesn’t matter if you have a salary, an hourly wage, or make a commission. It doesn’t matter if you commute two hours or work from home. When you are earning active income, you are giving up time now for money now. As soon as you stop working, the money stops coming in.

A common analogy for this is carrying buckets of water. Imagine living on a deserted island. You need water so you take a couple of buckets down to the river to collect some water. Throughout the day, you use the water so the next day, you have to go get some more.

What Passive Income Is

By comparison, passive income is building a pipeline from your hut to the river. Before we explore that, though, there are two distinct definitions of passive income that we need to know about. There is the IRS definition and there the less strict common usage of it.

Publication 925 of the US Tax Code covers passive income. While it’s important to know once you take the plunge, it’s as much of a snoozer as it sounds. So that you don’t wander off and start watching cat videos, I’ll just give you the nuts and bolts.

Keep in mind that these are just the nuttiest nuts and boltiest bolts. If you have an actual, financial reason to know the particulars, I strongly encourage you to read all of Publication 925. With that out of the way, here it is. The IRS considers passive income to be:

  • Trade or business activities that you don’t materially participate during the year, or
  • Rental activities, even if you do materially participate, unless you are a real estate professional

Once again, there’s much more to it than that so I encourage you to do your own research.

The informal definition of passive income is a little murkier. It isn’t get-rich-quick schemes, it isn’t side jobs or gig work, and it isn’t completely free of effort. There I go again, talking about what it isn’t. The core concept of passive income – write this down – is setting up a system that produces revenue on its own. Usually, it is actually a system of systems, but that is a story for another time.

This system can come in a variety of shapes and sizes. It could be Henry Ford’s production line or the gobs of technology that makes an ecommerce store work. The important thing is that, once it is set up, it only takes a little effort to keep it going.

That’s where the murkiness comes in though. Without understanding its relationship with active income, people accuse passive income of being fool’s gold. When you’re trading time for money, you work and you get paid. Rinse, repeat. When you are building a system – a pipeline of water – you usually do a mountain of work up front with little or no pay. Then, down the road, it’s the exact opposite. You’ll be making money (hopefully a lot of it) with only a little work.

At no point in the process will it be completely passive. If you are investing, you need to keep up on your investments, the market, and the financial environment your investments are in. For a business, there are a million little things you need to do to steer the ship. If you run a website, you need to monitor it, your hosting service, your ad agency, etc. You get the idea.

Why is it Important?

If you’re lucky, you’ll live long enough to get tired of carrying buckets. It’s then that you’ll look back and wish you’d snipped off a little free time here and there to build some kind of business asset. That isn’t the best time to start but it is better than not doing it at all.

If you only know the world of having a job, you will probably stumble a few times when you try to get off the ground. That’s ok. You’re building a skill. When you get it, you’ll have it forever. Like Benjamin Franklin said, if a man empties his purse into his head, no thief can take it from him. The skill of building passive income is worth at least as much as the income itself.

In conclusion, I’d like to leave you with this thought: When is the best time to plant a tree? Ten years ago. When is the second best time to plant a tree? Right now.

While passive income will never be one hundred percent hands-off, it is still worthy of the name. By coming up with an idea and putting in the work, you can create a system that will produce revenue with little maintenance. After you’ve done it once, you can do it over and over again. Between the income from your system and the knowledge of how to do it, you will be financially independent. From there, the world is your oyster.

Leave a Comment