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Power of Passive Income

Updated on December 17, 2011

What Is Passive

What is passive income and why is it important to us?  I would like to try and answer these question in this Hub because I believe that passive income is a very powerful way to create wealth.

According to Investopedia passive income is defined as earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not actively involved. As with non-passive income, passive income is usually taxable; however it is often treated differently by the Internal Revenue Service (IRS).

The Internal Revenue Service categorizes income into three broad types which are active (earned) income, passive income, and portfolio income.  The IRS defines passive income as income from trade or business activities in which you do not materially participate. 

I am not sure if you caught an important phrase in the definition just provided so let me repeat it.  "Income from trade or business activities in which you do not materially participate."  That is a powerful statement.

For a moment let's try to apply this statement to the reality of our life.  If you have a job and make an hourly wage then you are limited to the amount of money you can make.  Since you are only one person with a fixed number of hours in a day you are very limited to how much money you can make.  If your wage is $20 per hour then the very maximum amount of money that can be made each day is $480 per day ($20 x 24 hours).  However, we know that this is not realistic.  No one can work 24 hours a day.

Now let's consider another factor about our ability to work and make a wage.  If our employer cut our position or the business we work for is closed down our hourly wage or salary goes to zero -- immediately.  This is not a very good place to be in, but unfortunately many have found themselves in this exact position lately with the high number of layoffs and business closures.  Therefore, let's see how passive income can be used to help us in life.


The Power To Duplicate Your Labor

Passive income gives us the power to duplicate ourselves due to it's very nature...it is something we don't participate in.  We don't earn the income, but the income is earned from itself.  If we are to use a rental as our example the rental by virtue of the fact that it is a rental earns the income.  If you have a piece of property that is rented then it does not matter if you are sick in bed, on vacation, or doing something else your rental is generating rental income.

Let's assume that an individual has $2,000 per month in living expenses.  These expenses present themselves every month whether we work or not.  We have these expenses every month even if we only make $1,500 or $3,000 per month.  They are our living expenses.

We I get a job that pays $2,500 per month then I have earned enough money to pay for my living expenses, taxes, and possibly have a little left over.  But what if we go on strike?  What if we are laid off?  My ability to trade my time for money has just been eliminated.

The power of passive income is that I can create income that is not subject to these types of cutbacks and also have an income stream that is coming from multiple sources.  Think about it for a moment, if I have income coming from 20 rentals and one becomes vacant then I have only lost 1/20th of my income instead of 100% when my income comes from a job.

What if I create enough passive income to cover my monthly living expenses?  I have just built an immunity to financial cutbacks.  In fact, if I lose my job it won't affect me because the income that I don't participate in is still flowing.

Passive Income Gives You Control

Another powerful benefit of passive income is that it gives you control over taxation.  When you have a job and receive a paycheck the tax man gets his cut before you get yours.  You literally loose 20% of your purchasing power immediately.

When passive income comes in you receive 100% of the income and have the power to structure your tax liability.  There are many things that people can do in order to legally reduce their taxes.  While I realize that most people don't understand tax code, but there are many people who do.  Hiring a competent tax professional can literally pay for itself over and over.

If you want to live financially free the number one thing that you must do is gain control over your money.  One of the major expenses of life is taxes and if you can control the taxes you make you will have more money working for you to increase your wealth and monthly income.

Creating Passive Income with No Money

Personally I am a big advocate of owning real estate.  I once hear Dolf De Roos refer to a study that he did that stated that the richest people in the world have either made their money in real estate or hold their money in real estate.  Real estate is a powerful vehicle for creating passive income.

The poverty minded look at rentals as a risky business because renters are destructive to rentals.  The rich look at rentals focused on the cash flow the rental creates.  I have owned several rentals and have never had a renter cause damage to a property I own.  Buying property just like leasing property is profitable going in not coming out.  What do I mean by that?

You make your money when you buy the property not when you sell it.  Too many people buy property hoping to make money when they sell the property.  This is a wrong approach.  If you purchase the property correctly it is profitable when you obtain the property.  The same is true when you lease it.  Leasing to the right person is a decision up front not on the back end.  When we utilize proper management techniques we will make money.

I have heard a couple different real estate type people say that you may look at 100 houses for every one that you buy.  What does this tell us?  You have to find the right deal.  Every property I have purchased I have done without any of my own money down and each one had a positive cash flow when I purchased them.  Taking the time to increase your knowledge of who to buy will pay off big time over the long haul.

Passive income is an awesome way to increase your wealth and cash flow.  Don't limit yourself to trading your time for money.  Learn to duplicate yourself to create more wealth and either learn or hire someone to show you have to control your taxation.

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