What is passive income?

Passive income can be loosely defined as investment returns that require little to no effort to attain. However, just because these ventures don’t necessarily require a hands-on approach to deliver gains doesn’t mean that you won’t have to work to obtain and maintain them.

Acquiring passive income can provide an additional layer of financial security and independence. An extra income stream may offer you the ability to explore your small business ambitions or fulfil lifelong travel aspirations. It might also allow you to more quickly pay off your home loan, thus reducing the interest charges on your mortgage.

The opposite of passive income is active income. This is where you work for the cash you earn. For most people their main supply of active income would be the remuneration they receive for their full-time job.

Generally, more money means more time. Imagine if you could retire sooner, repay your credit card debts, grow your savings and/or bolster your investment portfolio to generate further sources of passive income. Let’s explore the different types of passive income and ways in which you might procure these potentially profitable investments.

Different types of passive income

There are an abundance of passive income sources. These can be broken down into three main categories.

Capital gains earnings

Capital gains are the profits derived from particular assets that you’ve sold for a higher price than you bought them for. This includes everything from investment properties and shares to foreign currency and cryptoart, as well as intangible assets like leases, licences, business goodwill and contractual rights.

There’s a lot to learn about capital gains and how these assets are taxed. Despite its high-profile status, many Australians don’t know all that much about the Capital Gains Tax (CGT), so it may benefit your investment strategy to familiarise yourself with the ins and outs of this form of passive income.

Rental income

If you have purchased an investment property, you may decide to lease it as a means of drawing a passive income. While the payments you receive may technically be considered passive income, you could end up having to work harder than you expect for these funds.

Owning a property generally involves making regular repayments on any loans, paying necessary land taxes, insurance premiums, council rates, strata fees (if you’ve purchased a unit) bills (depending on the lease agreement) and covering property maintenance and repair costs. This doesn’t include the duties associated with renting out the property.

One way to streamline this operation and make it a more passive source of income is to enlist the services of a real estate agent or property manager. It’s their job to take care of the day-to-day issues that may arise between tenant and owner. Plus, they can also assist with listing the property, setting the rental price, conducting open houses, finding and vetting prospective tenants, performing regular inspections, managing bills and more. 

If you decide to rent out your owner-occupied property or lease a house or unit that still has a mortgage owing, there are some important details you may want to consider before renting.

Interest, dividends and royalties

This type of passive income is derived from interest earned on money deposited into high interest savings accounts, term deposits, government bonds and other interest-accruing accounts. Typically, there is little to no work or upkeep required but it’s sensible to keep track of all your returns to ensure that you’re receiving an optimal rate, meeting any necessary earning and taxation requirements and not paying exorbitant fees or charges.

You can also score dividends by investing in stocks or shares. Dividends are a bit like a quality investment property that makes both capital gains and delivers rental income. If your dividends are ‘franked’, you’ll also receive a tax credit that might allow you to minimise your taxable income.

Another form of passive income is to earn royalties. There are many ways this can be achieved. For example, you may write a book or pen a song that explodes in popularity. If your contracts and copyright are in order, you’ll be able to receive a passive income from the use and/or sale of your intellectual property in perpetuity.

Don’t forget to pay tax

Taxable income is money you’ve earned during the financial year that is subject to income tax - this includes passive income.

You may be able to claim tax deductions, reducing your taxable income, on a range of specific costs. Most deductions are typically work-related expenses related to your income. Non work-related expenses may include gifts and charitable donations; the cost of managing tax affairs; income protection insurance; and interest, dividend and other investment income deductions.

Should I borrow to invest?

You may not have the cash outright to acquire assets such as properties, shares and bonds. Borrowing to invest can provide the opportunity to establish or grow your portfolio and accumulate wealth. However, consider these questions:

• How much are you willing to risk?
• How safe is the investment platform?
• Have you built a diverse portfolio?
• When do you expect to see a return on investment (ROI)?

Typically, an investment is a long-term holding that is intended to deliver financial benefits over time.

If you’ve acquired a home loan and, over time, built up additional equity, some lenders will allow you to borrow to invest using your home as security. The Australian Securities & Investments Commission (ASIC) Moneysmart platform warns against this action in reference to first home buyers and owner occupiers:

“Do not do this. If the investment turns bad and you can't keep up with repayments you could lose your home.”

Past performance is not a reliable indicator of future performance, though it's sensible to conduct research.

After years of scrimping and scrambling to stay ahead on rent and bills, many young Aussies don’t know what to do if they find they have a bit of money to spare. Discover 10 popular investment options that may suit your financial goals.