Does Passive Income Really Exist?

One of the things I’ve always wondered is if there is such a thing as passive income?  You know like the perpetual motion machine, set it and forget.  The Wikipedia link I referenced gives some examples of passive income and how the IRS defines passive income.  My argument, just like perpetual motion, is that true passive income does not exist and is lore of late night infomercials.  No investment is set it and forget, so it can’t be passive.  Ask the investors of Bernie Madoff how that worked out.  I would argue there is residual income – income that continues for a period of time after the initial investment of time and/or money. Residual income will continue for awhile – it could be days, months or years, but eventually it will stop producing income unless you actively maintain it.  No product or service has an unlimited life, and therefore eventually needs maintenance or updating.

In reality most investments require a decent amount of research, preparation, and work to get going.  Even though the IRS defines it as such, investing in the stock market isn’t passive. How many hours of research was needed before you are invested in your first stock?  How many books did you read?  Who did you talk to about investing?

Then there is the monitoring and maintenance.  Even when investing in stocks you need to keep informed with the company and read their financial statements.  What once was a great business can go sour.  A rental property eventually needs repair.  As an entrepreneur your goal should be to minimize the effort needed and automate daily operations as much as possible.  The best you can strive for is your business generates income while you sleep. That’s the best you can do.  Meaning unlike a job or a consulting business when you get paid by the hour, you have a business that can generate income when you aren’t physically there.  In the online world this means:

  • Ad banner based web site (i.e. a blog)
  • Selling a product or service online

I’ve seen people mention blogging as passive income and chuckle at the mention.  If it’s so passive why does it require a decent amount of time to create articles, maintain the web site, and read/comment on other blogs?  While it’s nice to think an article you write will reap riches forever, the reality is:

  • Technology changes.
    Using the reference of a blog, search engines change their algorithm.  Back when I first started in the Internet industry the way to the top of a search engine was just repeat the keywords on your web page.  Right now links and back links is what’s currently popular with the search engines.  I suspect in the future social media will play a much bigger weighting in search engine results. This means your content and SEO strategy would have to change.  What got you to the top of the search engine results won’t in the future.
  • There are competing businesses
    Your income generating scheme exists in a somewhat free market.  You don’t live in a vacuum.  If your product or service develops a decent amount of income, don’t you think others will figure this out and start competing?  Competition reduces the profit margin of other businesses in that same industry, which reduces your residual income.
  • You need others to produce
    A business needs people to produce output.  The work either needs to be done directly by you, or you pay someone else to do it.  Since this investment was supposed to be “passive” you’ll hire others to do the work.  This eats away at your net profit.

Unless you are a trust fund baby, you must initially produce earned income before you generate residual income.  Any income producing business idea either needs money or effort and usually both.  If it’s money you are investing, in some shape or form it was originally earned income.   To take this discussion one step further – it can be argued a loan is just stealing from future earned or residual income and using it now.  The trick is compounding your earned income multiple times. Let’s use an example: Your earned $100,000 after taxes from your job.  You take that earned income, and invest in Lending Club notes.  On average Lending Club users generate 9.67% APY, so that means you would earn approximately $9,670 annually.  For the sake of simplicity let’s not discuss taxes or fees.  You can either take the $9,670 and either reinvest it (into other Lending Club notes or say a new business) or consume it by buying a nice home theater system.  If you reinvest it, you are compounding your initial earned income.  In most cases if you consume it the asset isn’t generating any income.

Bottom line, every investment needs constant effort to monitor and maintain.

Readers: What is your opinion?  Do you disagree?

Comments

  1. Larry says:

    “Even though the IRS defines it as such, investing in the stock market isn’t passive.”

    Sorry, but that’s not how the IRS defines passive income. This is what the IRS actually says (quoted from its website): “While the following may seem passive, generally none are passive income: Portfolio income, including interest, dividends, royalties, annuities and gains on stocks and bonds.”

    The whole IRS purpose of defining passive income is so that affected taxpayers can determine whether they can offset passive income against passive losses: Quoting again:
    “Generally, losses from passive activities that exceed the income from passive activities are disallowed for the current year. Unused passive losses are carried forward to all future years. A similar rule applies to credits from passive activities.” But if losses are passive, they generally cannot be deducted if there is no passive income..

    The IRS further says: “Passive activities are trade or business activities in which you do not materially participate.” It doesn’t say that there is any kind of “set and forget it.” But there are all kinds of tests for what qualifies as material participation, such as working more than 500 hours towards the activity in any year. But rentals are always considered passive even if there is material participation, except if you materially participated as a real estate agent.

    I think this is one of the most complicated areas of the entire IRS code.

  2. BeatingTheIndex says:

    IJ,

    I agree with you that up to certain amount, your passive income stream needs to be followed (dividends, websites, sales…).

    After a certain amount such as 10M$ for example, in my opinion, you can invest in a ladder of GICs, set and forget. The 2-3% return will be largely sufficient to fund a comfortable lifestyle until the end!

    • Investor Junkie says:

      Well if you have $10M most people wouldn’t care if they generated ANY return. At a 4% withdraw rate that’s $400,000 annually.

  3. retirebyforty says:

    Nnoooo! Why are you telling me this? You are destroying my dreams. You dream killer. ;)

  4. Mike@atfinancialplan.com says:

    I thought about this for a few minutes and have concluded that most people think (myself included) that passive income is income that you generate that isn’t wage or work income.

    I think about the risks of working – becoming disabled, obsolete, having to downsize your job, etc. These risks threaten your income. If you can’t work, then you don’t make money.

    All the other forms of income don’t involve ‘work’ because you could in practice hire someone to do it on your behalf (even the blogging!). Whereas work necessarily means you make the money.

    • Investor Junkie says:

      Aren’t you really referring to owning a business? In owning a business you can give tasks to others, unless you are a manager you can’t do that when working for someone else.

  5. charles says:

    everything does involve effort…in the beginning. But sometimes, once you start things off, they can be construed as passive income. Take blogging for example. Sure you have to take time and effort to write articles, but once you have a sustainable blog, the money naturally flows in and the level of effort required becomes less and less.

  6. Investor Junkie says:

    Money naturally flows? Are you stating you generate income on your blog that comparable to your current or existing job?

    All businesses have an initial curve and IMHO to make a living out of blogging is slightly higher than other types of business that have more instant income producing. If you are congrats as you are in the minority.

    If you didn’t tend to your blog after a few years I can assure you it will not generate anywhere near the income it does now. Hence why I think residual is a better term.

  7. Sandy @ yesiamcheap says:

    I think the old way that eHow generated some passive income. Sure, you had to write the initial article, but articles that I wrote 1.5 years ago are still generating (tiny bits of) income for me. That’s as close as I’ll get I guess.

  8. moneyedup says:

    Yes it does exist. I still get paid over $200 a month for ehow articles I wrote two years ago. I haven’t had to do anything except write an promote the articles at the time they were published. I don’t know how long it will last but it is truly passive income.

    This same idea can be applied to many different channels. If you are investing, I agree, you have to stay on top of your investment.

    • Investor Junkie says:

      What where the articles about? How are you paid that amount monthly? eHow pays a one time fee

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