Summary: In this article, we’ll answer the question, is cash flow a passive income? You’ll also learn the definition of passive income and cash flow, factors that make an investment truly passive, and investing for cash flow versus investing for passive income.
The terms, “passive income” and “cash flow” tend to be loosely defined, especially in the investing world. There is conflicting information all over the Internet about whether cash flow is considered a passive income.
Hopefully, this article will clearly define what makes an investment truly passive and explain why generating monthly cash flow may not be as passive as you think.
Definition of Passive Income
The IRS defines passive income or activity as, “any rental activity OR any business in which the taxpayer does not materially participate.”
Essentially, passive income is making your money work for you. The difference between building passive income and saving money is that your money isn’t sitting around in a savings account, accruing almost no interest, and waiting to be used when needed. Your money is earning money through passive investments.
Definition of Cash Flow
Generally defined, cash flow is the total amount of money being transferred into and out of a business, especially as affecting liquidity. In terms of real estate, cash flow is the amount of money that goes into the property owners pocket each month after operating expenses have been paid.
What is a Cash Flow Investor?
Cash flow is generated when an investment is purchased and held onto long-term. Every month, quarter or year, your investment produces money or cash flow. Unlike capital gains investors, cash flow investors hold onto their investments to produce consistent, long-term income.
As such, cash flow investors don’t live and die by short-term market ups and downs. Instead, they’re looking for long-term trends, thus lowering potential risk of losing their entire investment when the market shifts.
What is a Capital Gains Investor?
A capital gain is a rise in value of a capital asset, such as an investment or real estate. The gain or increased value is realized when the asset is sold. Basically, buying and selling assets for profit.
Capital gains are more susceptible to market swings, and are taxed at a much higher rate than passive income. In fact, passive income is the lowest taxed type of income, which may be a reason it’s so sought after by investors.
One of my previous articles, “How is Passive Income Taxed?” provides more details about how different types of income are taxed.
Is Owning Rental Property a Purely Passive Investment?
The simple answer to this question is, no. While it may be considered by many to be a passive investment, it is not purely passive. Even if you hire a property management team to handle the day-to-day activities of a rental property, it still can’t be considered a purely passive investment. Rental property owners still need to take into account the time and money for repairs, maintenance, vacancy, etc.
The investor may not be going to the property to make repairs, but they will have ongoing communication and oversight of the team managing the investment property. Another factor that makes some real estate investments less passive, is the upfront work and time required to find and buy a rental property.
Can Investing in Rental Property Generate Monthly Cash Flow?
The simple answer to this question is, yes! While owning rental property isn’t a purely passive investment, it can generate consistent monthly cash flow. Rental prices have risen consistently in many locations around the country, and we expect this trend to continue along with rising inflation.
Is Cash Flow Really Passive?
Whether the cash flow generated from an investment is truly passive or not is a tricky question. Depending on how you look at it, investments producing cash flow without doing anything active to “earn” it, could be considered passive.
However, investors must also account for the time, work and money it took to set up a cash flowing investment. Most people had to do something very active, including a lot of upfront work, to enjoy the benefits of regular cash flow.
Renting out investment properties can generate monthly cash flow, but it is not considered purely passive income.
Purely Passive Real Estate Investments
Investing in real estate syndications or real estate investment funds (REITs) can be considered truly passive investments but do not generate recurring monthly cash flow.
Real Estate Syndications
A real estate syndication is a way for investors to pool their money to fund properties and projects bigger than they could afford or manage on their own. Basically a simple transaction between a sponsor or syndicate and investors.
The syndication or sponsor is responsible for finding a property that meets the investment objectives, performs due diligence, sets up financing, ties up the property in escrow and then creates an investment package or Private Placement Memorandum (PPM).
A PPM provides investors with all the details of the property, terms, investment projections, fees, payout and distribution details, risks, etc. The sponsor will then raise money from investors, often with a minimum investment amount and specified number of shares or spaces available.
Once enough money is raised from investors, the property is purchased, and the syndication manages and operates the investment property.
Because this type of investment is managed and operated entirely by the syndication company, it can be considered a truly passive income strategy. The only “activity” investors do is decide which project they want to invest in.
Depending on the syndication PPM structure, investors can receive a cash return on their investment every quarter or annually.
Real Estate Investment Trusts (REITs)
A real estate investment trust is similar to mutual funds, except they hold individual properties in a trust, rather than stocks and bonds. An REIT buys and manages real estate properties using money pooled by investors, much like a real estate syndication.
Unlike syndications, REIT investors don’t know the exact property or properties their money is funding. REITs often invest in commercial real estate like, apartment complexes, office buildings, hotels, etc.
Most REITs are publicly traded stocks, which make them more liquid than many other real estate investments. REITs are also considered to be a passive form of real estate investing.
Passive Investing for Cash Flow
Two popular ways to passively invest for cash flow include, peer-to-peer (P2P) lending and dividend stocks.
Peer-to-Peer (P2P) Lending
Peer-to-peer lending, also known as lending clubs, use your money in the form of personal loans, and investors earn money on interest, just as banks or other lenders would. P2P lending is considered a passive, income-producing investment.
Dividend Stock Investing
A dividend is a payment made by a corporation to its shareholders. Investing in a dividend stock essentially means you’re buying shares in a company and is considered a passive investment. Most companies pay cash dividends to investors every quarter or three months.
There are many opinions around whether cash flow is a passive income. While there may be a blurred line for some, regarding what is considered truly passive income, there are different options for both the passive and cash flow investor.
How much time, money, energy and work you’re willing and able to put toward your investments is entirely up to your individual circumstances and financial goals. If you are busy raising and providing for a growing family, you may not have the time to participate in anything other than purely passive investments.
Or you may have the time to do some upfront work, in order to generate recurring, monthly cash flow. And eventually turn your “active” investments into a more passive income strategy, with the right pieces in place.