I hear the term ‘passive income’ thrown around a lot. But what does it really mean? Is anything that you earn outside your day job considered passive income? Let’s look at some popular things that are associated with the term.
Dividend Income From Stocks
First, one must come up with money to buy a share of a dividend-yielding stock. That probably took some work. But what’s so special about a dividend? There are two components of return from stocks – share appreciation and dividends. All other things held equal, when a stock gives off a dividend, the share price drops commensurately. For example, if the share price was $100 and it gave off a $1 dividend, the share price would then be $99. So it’s not like the $1 came out of thin air.
If you had 100 shares of a $1 stock, you could simply sell $1 and get $1 of cash and $99 of stock as well. In fact, sometime dividends are simply paid in the form of more shares of stock. The way I see it, if you think dividends are passive income, then you should treat any increase in share price as passive income as well. Coupon payments from bonds and interest from savings accounts would be in the same group.
I personally prefer to simply call all these things investment income and keep it separate, as learning about investments is more of a requirement nowadays, as opposed to an optional entrepreneurial venture like the other activities below.
Creative Works – Songs, Books, Patents
Let’s say you compose a song, or write a book. Every time someone plays your song, or buys your book, you will get a small fee. But what if you spent 1,000 hours writing that book, and you only earn a $100 each year from royalties? Is that really passive? Sounds like a lot of research and hard work to me. On the other hand, the Beatles will be making millions for their great-great-great grandchildren. When does it cross over to becoming passive?
Take blogging for example. You spend hours writing, reading, commenting, dealing with spam. Divide your advertising revenue by the hours spent, and if you’re really lucky, you’ll be above minimum wage. And then there still ain’t anything passive about it!
Real Estate Rental Property, Vending Machines, Car Washes
Another group with similar characteristics… You put up a relatively large sum of money upfront to pay for the rental property, vending machines, or car wash property and equipment, and after that you make money from rent, selling soda/snacks, and water/soap, respectively. But there is still work to be done. If you don’t manage your properties, restock your supplies, or maintain your equipment, things start falling apart fast. Even if you do all these things, there will always be the occasional breakdown or emergency to give you headaches.
My Alternative Definition For Passive Income
Now, I don’t doubt that many people make a ton of money with things like rental properties and writing books, with a relatively small amount of ongoing work. I’m still definitely interested in pursuing such activities! It should be obvious that I love making extra money on the side as much as anybody. But I don’t call anything I do passive income. I can’t really think of anything truly passive, besides maybe winning the lottery. So I suppose “passive” really just means “less work than other stuff”.
Accordingly, here’s my two requirements for me to consider labeling an activity as “passive income”:
If you only satisfy the top one, then it’s just a really well-paying job. If only satisfy the bottom one, you wouldn’t be using your time efficiently, which wouldn’t make it very passive at all. Would you agree?
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I understand how you view passive income is not exactly as passive as the word might mean. I think that passive income is income that is being generated whether or not you are actively involved on a daily/weekly etc. basis. For example, if I spend a bunch of days setting up a ringtone website and then just maintain it a few times a month or so it creates passive income for me. Passive income is “passive” in terms of it creating an income source in which you are not actively involved. If you are on vacation, you still make money. Obviously you should maintain it if you want it to be successful.
I think my problem is what is considered “actively involved” and what is “not actively involved”? An hour a week? An hour a month? It’s all so subjective and grey.
Is 5 hours a week active or not? Some would say yes, some would say no. Most would say it depends on how much money you’re making.
Part of this is just seeing people list things as “passive income” when I don’t think it is. Is taking a paid survey passive income? I sure don’t think so.
Say you own rental property. It goes smoothly, you spend maybe 20-30 hours a year on it for some years (mainly just depositing checks from tenants, etc). Then all hell breaks lose. You end up spending 500 hours on it. Then (from a tax stand point) it becomes active. Now if you’re the only guy involved in it, then it’s active (see http://taxalmanac.org/index.php/Material_participation).
As for the performing artist, they can claim active for performances of the song, but not for replays of recordings (he’s not actively involved with playing the recording). And for blogging, if you’re taking this as passive income on taxes, you need a new CPA!
One more thing, the stock and dividend thing: you’re wrong about the stock price dropping a dollar after the dollar dividend. Stock prices largely reflect future revenue and current assets. Unless the CEO woke up and randomly dished out a $1 dividend, the dividends (as long as they are announced dividends) should already be factored into the price.
I definitely agree with your formula, although I prefer growth opportunities. I’m more willing to make next to nothing for a while if I think it’ll pay off big.
I’ve read your blog for a while and I really find it interesting and even somewhat enjoyable since I’m a money geek. Thanks for all your work.
One passive income in my geographical area are interests in producing oil wells. They can be pretty risky but the passive income they produce is very nice.
Interesting article – I can’ wait to see the comments on this one!
I do not suggest at anytime that my passive income from dividend stocks does not take work. There is a lot of it – and some of it is ongoing. The passive piece comes in when even if I didn’t do this follow on work I would still receive dividends. Even he author of the book 4 Hour Work Week does not say passive income does not take work.
What we are really talking about, I beleive, is that you get this income away from the typical 9 to 5. Philosophically, I think people hate to be tied down to these corporate schedules and passive income is money they can earn without working within this framework.
Stocks usually drop by the amount of the dividend on the ex-dividend date. If it doesn’t, it’s due to other factors pushing the price up or down. Otherwise, I could easily just buy right before all the ex-dividend dates, sell on the next day, and make free money.
I have a friend who does in fact regularly skim dividends that way. You aren’t supposed to be able to do it and come out ahead of fees, but he’s not had any trouble doing it anyway.
Zack:
A company issuing a cash dividend has it’s stock price reduced by the exact same amount. Assets = Liabilities + Equity. Cash dividend reduces the Assets which in turn reduces the Equity. A stock dividend simply dilutes the Equity side.
That’s from a technical standpoint. In reality, the share price will often be bid back up to what people have locked in their minds as a fair price. Kind a like share prices tend to have heavier activity as the approach an whole dollar amount. People set stop/limits at whole amounts for psychological reasons.
-Wes
I’m not necessarily debating dividends as an investment method, just saying that any income from it seems just as passive as anything else.
Don, TallWes – Hmm… I may have a new activity for my Fun Money/Explore account at Zecco 🙂 It would be an interesting experiment to test out this “price resiliency” theory.
Call me doubtful that a corporate stock drops by the amount of the dividend. I know such a thing is essentially true for mutual funds. Since the bulk of mutual fund accounts automatically re-invest dividends, the number of shares outstanding increases but the asset value remains the same (all things being equal). This usually results in a drop in the NAV, or price per share of asset value.
However, you typically can’t re-invest dividends in more shares — Sharebuilder, DRIPs, etc not withstanding. Since the number of shares outstanding is constant and all other things being equal, the ask price should go up due to increased demand for shares. However, if the market likes the announced dividend, they will buy so they can get the dividend, driving the price up. After the dividend is paid out, some may sell causing the price to fall.
I don’t think that a dividend would necessarily cause a stock price to fall like it does to a mutual fund.
HI Jonathan,
E-loan just dropped their HYS rate to 5%, in case you don’t know.
Wes-
I know my basic accounting. The dividends will hit equity and assets. But you’re talking two different sides of the transaction. Companies shouldn’t be updating their books for changes in their own stock price. The only time the price of stock is the IPO or treasury repurchase. Why do we care what the companies book equity is (aside from return rates)?
The price will go back to what it should be because dividends are largely predictable. Is it possible to skim off of dividends? Absoltutely. It’s hard though. Any profit from playing with dividends is from psychological reasons, not predictable finance reasons. That’s why I don’t recommend it.
I’ve said this elsewhere and I think you’ve nailed it here Jonathan. Nothing is truly “passive”, just significantly more efficient. I think the goal of these “passive-income-hunters” is to have money generated with a minimum of their attention or while they are “out doing something else”.
This is different from the “I must there to generate” incomes like work. Of course, the hole in the whole formula is lead-up time. All of us “regular joes” working towards wealth actually have to put all kinds of effort down. We go to school to increase our hourly wage so that we can sock away more money every month. Then we spend tons of time researching our portfolio/business/real estate of choice in an attempt to track down the most efficient (and “fun”) method.
At the end of the day, we all retire with our investments funding our day-to-day activities. But we all know that this certainly wasn’t “passive”, we worked really hard for that money.
I mean, if I take a course and get a pay raise while still doing the same things every day, is that not “passive” income as well. I spent 100 hours on a course and that’s generating $1/hour 🙂
This whole “passive” thing is blurry, but I think that it’s best to describe it as large rewards today for all of the extra work you did yesterday.
I think you have TOTALLY misrepresented dividends here. I’m not going to go into all the why, there isn’t enough room in a comment, but this is absolutely not how dividends work. The equation assets = liability + owners equity is true for accounting, but not for stocks. Stocks are valued based on the perceived value of the company, not the company’s legal assets. A closer value might be Stock Value = Assets + Potential for Earnings + Market “Hype”. If a stock has assets of x,plus the capability of earning yearly income of Y, then the value should be more like x+(present value of an annuity of Y).
Your theory that a dividend payout of $1 will lower the stock by a dollar doesn’t hold. In fact if a stock is paying a dividend of 4%, and then stops paying it (by your theory ti should go up in value) in fact it will go down drastically, because it no longer has a guaranteed return of 4% on top of any appreciation.
Also when you say that some dividends are payed in stock, this is wrong. Usually they are reinvested in stock. Which is entirely different.
I generally like your blog but this entry puzzles me. It seems like you are just arguing semantics — with yourself!
Next time you write on this subject, I recommend you touch on the IRS’s point of view about passive income. That, at least, has practical applications.
In theory the shares should drop in the price the cost of the dividend, everything equal. The truth is much more complicated. If the stock market as a whole is moving up, that stock will probably be carried with that. Given the market has been trending up most of the time, most of the time buying and selling later works regardless of the dividend or not.
it’s just a word. it can be whatever people want it to be. i consider it making money off of money or inheritances or just gravy money that you dont need or rely on, if it comes it’s there, or the like, such as.
kinda like my passive spending is on fica and social security taxes, stuff i dont really watch or care about as it is out of my control but in my best interest to maintain
Hey Zack – Excellent information on the topic at hand. Thanks.
One point you make, however, seems to be contradicted by your source/web link:
Zack: “Say you own rental property. It goes smoothly, you spend maybe 20-30 hours a year on it for some years (mainly just depositing checks from tenants, etc). Then all hell breaks lose. You end up spending 500 hours on it. Then (from a tax stand point) it becomes active.”
But your link says specifically that this excludes rental activities, and is only applicable to the other sources of passive income. There is also an exception to the exception if you meet taxation requirements as a “real estate professional,” which landlord wouldn’t meet.
Hhmmm, I am not a trained journalist, and the lack of clarity in the above paragraph would seem to highlight this.
The term “passive income” tends to be used loosely to refer to many activities that are generating income for which the recipient was not materially involved in generating the income — like limited liability shareholders or partners who don’t participate in generating the partnership income. However, the IRS is more specific about what they deem passive income activities vs. non-passive activities, and those pertain specifically to type of income-generating activities are involved.
So, you’re definition of passive income is fine, so long as you convert it to IRS standards when completing your tax returns.
One also should consider the taxes in using this strategy. Because the shares are presumably held for less than year, the ordinary tax rate will apply, further reducing the effective return.
Return? If, as people are saying here, it’s going down by the amount of the dividend, then you’ve got a loss you can use to offset other taxes.
That’s a terrible explanation about the dividend, even Kramer could explain that better. Rewrite that paragraph.
You are also not including business ownership. Just because you own a business does not necessarily mean you work in the business. I know a lot of business owners who do not work in their business and earn passive income because they own a business like a restaurant they franchised. It is like the car wash or vending machine, just on a bigger scale.
You are not making free money when you buy and sell stocks. Don’t forget commission.
Is there a reason why you chose not to include business ownership?
For me passive income is only relevant for purposes of taxes. For example at the following IRS page http://www.irs.gov/taxtopics/tc425.html
If it weren’t for tax provisions, I don’t think the terms active and passive income would exist.
Passive income does not exist. Period. My economics teach said it well when he said “TINSTAAFL” – There Is No Such Thing As A Free Lunch
But it sure sounds nice and helps people sell a lot of books!
One comment on your “Net Profit/Hours > Wage” formula. I see this posted a lot and used as a argument against performing some activity if the benefit does not exceed your hourly wage wage, e.g. It would take you a full weekend to re-sod your yard (16 hours * $30/hr = $480), but you can hire it done for $250. Therefore you should hire it because your free time is worth more.
The problem is that I can’t just work more hours to make up that time. Any salaried employee in compensated for 40 hours/wk. Period. For me, this fact makes your formula a non-starter. Using the sod-laying example, I would do the work myself and consider that I was able to pay myself $250/16 = $15.63 an hour (tax-free!!). This might not be up to my “usual” salary, but it is still a marginal benefit. Plus the personal satisfaction of a job well done, getting some exercise, etc.
Also, I think people often ignore the fact that not spending is one of the most tax-efficient ways to put money in your pocket. At least until the IRS decides to levy a wealth tax. 😉
The IRS definitions mainly have to do with the deductibility of losses, in order to prevent abuse.
Lucas – I would agree that as well, I do lots of things that aren’t very efficient in that way. Housework, grocery shopping, walking the dog, whatever. But I also don’t call those activities passive income. 😉
Real Estate Rental Property, Vending Machines, Car Washes are businesses, right?. These are just the businesses more commonly associated with passive income. I mean, I have friends who work 7 days a week in the restaurant they own – I don’t think anyone would call that business passive!
Big fan of your blog, been following it for nearly two years but i rarely comment. However since this topic affects me first hand i’ll leave a comment.
So a couple of years ago I got into the creative industry business as a side hobby and now all my income comes from royalties from the work i’ve been doing these past few years. Technically I guess its a mixture between passive and active income because I’m still actively creating stuff, but at the same time I can leave for a week or even a month or more and everything will continue running fine without me, hence the passive income nature. I have complete flexibility with what i do, when i do it, no deadlines whatsoever… and since its something i love doing i have never considered it as being an actual job, afterall it did just start as a hobby. This year i’ve earned more than $150,000 and i am a full time grad student in a completely unrelated field. So I really believe that passive income is real and possible. My advice, find something you love doing and are good at, find a way to make money from it, and then work to be the best at whatever it is that you do.
I think some sales or MLM jobs have passive income – call it residuals. As an insurance agent I would make a sale and earn a commission, but then after a certain amount of time as long as that customer keeps the policy the company will pay a residual. Many insurance agents make $30,000-100,000 a year on residuals from work they did long ago (or those under their management did).
Similar for MLM… if a customer continues to buy or keep your service after the initial sale, or people in your “downline” sign up more suckers into the business, you make more money and often you never have contact with those people (if your “team” or organization is large enough).
That is passive income.
Thanks for the elucidation Phoenix and that definition makes sense. It never made sense to me to call all “extra” income passive. As Jonathan said there’s nothing passive about the amount of work involved in generating the (usually small) amount of income from writing.
Come on guest008, you have to give us more than that. What type of creative work do you do that generates $150.000 per year?
My goal is “automated mobile income” and I’m getting close. I mainly create web communities with hosted applications.
It seems that most things that advertise themselves as passive tend to be scams! All the earn thousands reading emails at home and those sorts of things.
James…
Good point!
Annuity sales are passive incomes over time. You sell a person an annuity once and reap the benefits for years to come. Once you sell an annuity, what else do you have to do besides keep your insurance license up-to-date?
How about we call it “echo income”? Basically, you plop down some input (work, cash, effort etc) in generally a lump sum, or series of spaced lump sums, and you get interest/dividend/receipts over time usually unlinked to the times you input your input….”Passive”/echo income to me means the direct link of “when I work, I immediately get paid” is unlinked.
I agree with the premise that this is not techinically “passive”, but its all desireous nonetheless. These “multiple streams of income” are very diversifying and key to financial freedom/independence in my mind….
I think you could get a management company to do the management of your property. Sure it will cut into profits, but anything left over would be indeed be passive. Of course this isn’t too much different than investment income.
I think you are over-thinking this. Here’s the simple definition of passive income: INCOME THAT WILL KEEP COMING NO MATTER WHAT YOU DO. Of course it takes work to accumulate the assets that will ultimately/hopefully provide you with passive income (unless you inherit them), but the income itself is passive if it will keep coming without you having to even be alive.
Take stocks/bonds–yeah you have to work to save money to buy them, but the dividends/interest flow into your account with ZERO work on your part after that (the hours you might spend analyzing your account balances online don’t count as work, because the income would keep coming whether you did this or not).
With rental real estate, it can be active or passive. If you must show up to collect rent, fix problems, etc., then it’s active income. But if you have a property manager doing that and you just lie back and receive checks in the mail monthly/quarterly, then it’s passive.
Creative works are the same way. If you have to go to concerts and perform in order to generate income from your song/dance/whatever, then it’s active income. But if you’re just collecting royalty payments in your account NO MATTER WHAT YOU DO, then it’s passive.
Jonathan,
If something is a hobby or interest that you would be doing for the sheer joy of it, as a hobby or interest, and it so happens to generate income on the side then that seems pretty passive to me.
However if the financial “payoff” shifts your behavior from how you might otherwise be spending your time, then one shifts from less-than-passive to more-and-more “active” income generation.
Thus, if blogging is what you really like doing, and would be doing it anyway as a hobby, and it takes you little time to set up banner ads, etc. then I’d consider it passive. But if you spend exorbitant amounts of time tweaking, fine-tuning, over-analyzing, then it boils down to a lot of hard work.
Then there are those of us to enjoy pain, hard-work, and over-analyzing without regard to financial reward. I guess if that is your case, you need a vacation!
I can’t believe there is even a debate here as to the definition and the mechanics of a dividend. Take a look at any finance book for the definition and implications.
Look at the historical price of GE
http://finance.yahoo.com/q/hp?s=GE
Yes there are other companies that don’t trend nicely with the GE but that’s just investors pricing it up or down.
From a technical standpoint, the share price (entity value) goes down by the dividend value.
It’s a mathematical formula, how can you guys debate it. I’m beside myself!
Hey Jared, any personal experience investing in oil wells? I am considering one now…. any advice on what to look for? It would be great to have someone to discuss this with…
Interesting article. What I’m curious about is — how does your equation change if there is no “day job” involved. For instance if you are a service professional and you wish to build in multiple streams of income (passive being a stream) — how do you say it is or is not worth it.
Truly there is time spent creating information products you sell, but once they are created, IF they sell, then it becomes passive. Like work once, earn later and often (hopefully).
I agree with you that the whole investment quadrant of money making is a different animal than what I regularly think of as “passive income” at least from a business person’s perspective.
The dividend paid will decrease the value of the stock. You may not see this decrease due to the normal market fluctuations that the stock experiences on a day to day basis. AND YES razmaspaz , I am calling you out, some companys DO pay dividends in the form of stock. Look up Allegheny ticker (Y). Pays a dividend in the form of stock.
I believe in passive income. I think any income producing activity in which you can remove yourself from its operations is a passive inceom source.
Hey Jamiel;
It’s still a matter of scale. What activity do you know of that doesn’t require some re-involvement? Bonds? Dividends? Business ownership? Home Rentals? Book sales?
I mean, what type of “operations removal” are we talking about here? Is one day / week passive? How about 1 hour / week? 1 hour / month? How about 1 hour / year?
I don’t know of any passive income stream that doesn’t require at least 1 hour / year if not 1 hour / month. At best we could define passive income as some source that operates productively with only small amounts of your involvement.
Even then it’s a matter of semantics and it’s important to impress that there’s no “free lunch”. There is no source of income that will continue indefinitely without your regular involvement.