The Truth About Active Income vs. Passive Income

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Oh yes, there is a difference. More than you know.

You may already know there is a difference and you may know generally what that difference is, but it’s likely you don’t truly grasp the implications of those differences. For the record, there is nothing wrong with either of them. But if you want to maximize your returns down the road, you do want to make sure you really do have a solid feel for how these two differ.

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Definitions: Active vs. Passive Income

Using Investopedia, which should be in every investor’s browser favorites, the definitions of active income and passive income are as follows:

Active Income: Income for which services have been performed. This includes wages, tips, salaries, commissions and income from businesses in which there is material participation.

Passive Income: Earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not actively involved.

Investopedia goes on to explain that passive income does not include earnings from “active business participation”. To go a less formal route on defining these two terms I’ll tell you my own interpretations of them:

Active income means you are doing something in order to receive that income. Some kind of work. Some kind of effort. You are not hands-off. You have to exert some kind of energy and time towards earning that income. Passive income means you are earning regular income with little to no effort required to keep it coming. You are for the most part hands-off.

Source of Income vs. Your Goals

Why does it matter which one you are earning if it’s all income?

Oh it matters. It matters because accomplishing your goals depends on understanding these terms very clearly. What is the most common reason investors give as to why they are getting into real estate investing or why they are already in it? Financial freedom. Those who want financial freedom very clearly define that goal as being able to use real estate as a vehicle to eventually break loose of their current career and not have to work for their income. Okay, cool, a goal! And an amazing goal at that. Okay, so financial freedom, let’s talk about that.

In theory, and keeping it at the highest most basic level, financial freedom means you have to do no work in order to receive income. So once you are financially free, you no longer have to worry about money. What does that look like to you? Maybe you are like me and plan to do a lot of traveling, take up new hobbies, take random college courses to learn new things (for fun, not because I have to), spend epic amounts of time snowboarding and playing in the woods, and as always, sleeping in. Or maybe you are the polar opposite and plan to wake up early and hang out on your couch all day and watch TV.

There is a term both of these plans fall under. It’s called “lifestyle design”. You get to design your life exactly the way you want it.

Isn’t that the point of financial freedom?

If you don’t care about lifestyle design, you can just stay at your current job, right? With financial freedom, you can do whatever you want. You can actually start forming lifestyle design before you are financially free too, just like I have. Even though I spend the majority of my time working on my company, I have positioned myself to be completely on my own schedule, I work whenever I want to for as much or as little time as I want, I sleep in most days, I live at the beach, I can stop working in the middle of the day to go have lunch with a friend, go to the gym, walk the dogs or, shoot, stop working completely for the day and do whatever I want instead! Hiking, snowboarding, surfing, margaritas, whatever.

I wanted these freedoms so I began pursuing a means to have those, which in my case ended up being starting my own company that I could work from anywhere and with no deadlines whatsoever (although the no deadline thing does make things hard sometimes). The income from that company is planned to continue buying more passive income investments so eventually I hit total financial freedom where I can keep living my current lifestyle minus the work part. All of this is called “lifestyle design.”

So let me recap the circle I just made here:

Investing – leads to – Financial Freedom – leads to – Lifestyle Design

Are you totally convinced that I have completely diverged from talking about active vs. passive income? I don’t blame you. I would have forgotten about those by now too. But let’s bring them back now. Ok, how do those relate to lifestyle design? Well, I’m assuming we have established that your personal lifestyle design does not involve working, correct? Do you remember which kind of income requires you to work for it? Active income. So then for complete lifestyle design, do you want to have to rely on any active income? No. You only want passive income because passive income doesn’t require much, if any, work on your part. Then you are free to travel or play or watch TV all you want.

Now you know you don’t want to deal with any active income, but what investing methods are considered active?

Active vs. Passive Investment Methods

A couple weeks ago I wrote an article that broke out the very broad categories of real estate investing that someone can get involved with. (See: Which Real Estate Investing Route Should You Go?). Of these categories, the split goes 50/50 for which ones produce active income and which produce passive income.

Active Income Investments: Flipping and wholesaling. You have to do work in order to see money from these. You have to be hands-on. Note: I do still stand by my argument that wholesaling is not actually an investment at all, but for the sake of so many people thinking it is, I am including it. Another note: It is possible, if you are really slick and good, that you could be decently hands-off for a flip. But that is long down the road of being an advanced flipper so for now, I’m leaving it here.

Passive Income Investments: Rental properties and paper/notes. If done correctly, both of these will provide you with earnings regardless of whether you are hands-on or off.

The Real Difference

Active income investing is, while it still may be an actual investment, a job. It is a J-O-B. So many people don’t see it like that, but that is what it is. Flipping houses is a job. Wholesaling is most definitely a job. Heck, landlording a rental property is a job. I say it again- a J-O-B.

This is important to understand this because it is a difference of how you spend your time. No-joke big-time investors make money in their sleep without putting in any effort because they invest in passive income investments. If you are putting in effort, while you might be making bank and doing great at it, you are working. You are making a lot of income because you are rocking out a J-O-B. The no-joke big-time investors, if you’ll notice, also put in a lot of effort but their effort is not on what is currently making them income, it is on finding the next thing that will provide them more income!

If you like the “job” of wholesaling or flipping or landlording, or whatever it is you may be doing actively to earn income, rock on with it. Especially if you are using the income from that job to buy passive investments with, which is how one really becomes successful- find ways to fund buying passive investments that will lead you towards financial freedom. On that note too though, you can work any job or build a business to earn income that you can use to invest in passive investments. It doesn’t have to be flipping or wholesaling or landlording, albeit you do learn a lot about investing working those jobs, but it can be any job you want totally outside of real estate if you want it to be. Real estate is just a great way to earn some fat cash, which is why so many people stick with it. And if you do that, you are awesome still, as long as you realize you are working a job.

It all comes down to your goals. There is nothing wrong with flipping, wholesaling or landlording, as long as you are understanding of the fact, and okay with the fact, that you are working for your money. I personally have no desire to work in those capacities, so I stick with passive income investments. I did, however, start a business in order to fund those investments. I started a business in lieu of using flipping or wholesaling to earn capital. You can do whatever you want, but at least be clear on what it is you are actually doing, i.e. working for your money versus investing your money.

Well, let’s have it. Bring on your thoughts.

Photo Credit: TheGoogly via Compfight cc

About Author

Ali Boone

Ali Boone is a lifestyle entrepreneur, business consultant, and real estate investor. Ali left her corporate job as an Aerospace Engineer to follow her passion for being her own boss and creating true lifestyle design. She did this through real estate investing, using primarily creative financing to purchase five properties in her first 18 months of investing. Ali’s real estate portfolio started with pre-construction investments in Nicaragua and then moved towards turnkey rental properties in various markets throughout the U.S. With this success, she went on to create her company Hipster Investments, which focuses on turnkey rental properties and offers hands-on support for new investors and those going through the investing process. She’s written nearly 200 articles for BiggerPockets and has been featured in Fox Business, The Motley Fool, and Personal Real Estate Investor Magazine. She still owns her first turnkey rental properties and is a co-owner and the landlord of property local to her in Venice Beach.


  1. Sharon Vornholt

    Hey Ali –

    You did a great job of defining active income and passive income which I believe confuses a lot of people.

    You also touched on something that I like to talk about, and that is creating a lifestyle business. You may need to make choices today that will allow you to live a future lifestyle. A lot of folks do this with a “JOB” now to fund their investing so they can live off of passive income later.

    I’m sure this article will get a lot of folks thinking.


    • Thanks, Sharon! And yes, I agree…plan now for how to live the life you want later. If that’s doing active investing now to fund passive, great. If wholesaling or flipping is your only plan, what are you going to do with that income now or eventually when you don’t want to do those things.

      Hopefully it does trigger thinking 🙂

      Thanks for the comment!

  2. Ali, I think most of your article makes sense. However, I want to focus on one statement you made:

    “The no-joke big-time investors, if you’ll notice, also put in a lot of effort but their effort is not on what is currently making them income, it is on finding the next thing that will provide them more income!”

    You are right on. However, why do these “no-joke big-time investors” choose to continue working a “J-O-B” rather than sticking solely with their passive income? It is because “financial freedom” doesn’t exist. It’s a myth. Everyone on the planet has financial limits, and like it or not, that’s just the way it is. No one is financially free.

    • I think you need to re-read the article, John. Ali already stated some continue working to use the income from that job to buy more passive income. And as others have stated, perhaps because they really love to what they do and choose to continue working.

      Also, financial freedom is different for every person – that’s where lifestyle design comes in. If you determine that you need $4,000 or $8,000/month (your financial limit, as you called it) to allow you to never have to work again and live the kind of life you want, then you have achieved financial freedom through lifestyle design when your passive investments produce that income. It’s a very straight forward concept, and tons of investors have proved it’s doable.

      • Sharon, you missed my point completely. If you feel you need $8000/month to live the life you want, and you get that $8000/month through passive income, you may feel financially free for a few months. However, next year, you’re not going to be wanting $8000/month + 3% inflation; you’re going to be wanting $16,000/month. This is greed 101. It’s normal. It’s natural.

        If you own five skyscrapers, you’ll want six, and until you get the sixth one, you’ll feel trapped and limited, not “financially free”. It’s just the way it is.

        • Thanks for your insights Jon. Great points as far as always wanting more and/or inflation changing how much you need to be financially free, etc.

          I disagree however that your latter scenario doesn’t mean financial freedom…the one of always wanting more. Just because you want more, and may try to get more, doesn’t mean you aren’t financially free. You are free if you can stop working that minute and still live on the passive income. Doesn’t mean you have to stop working on it.

          I also disagree that every person will crave more and have to go for more. That may be a true statement for a lot, but it doesn’t have to be true and it isn’t for everyone. The other perspective of that is that most likely the people who get themselves to financially freedom, because it is no small feat, are the type of people who are extremely driven and motivated to further challenge themselves, so it’s doubtfully in their nature to stop once they actually can.

          But good things to think about and thanks for pointing those out! Good for people to consider.

  3. Interesting how most of America buys lottery tickets or dreams of what it would be like to be rich and at the same time they hate the rich.

    The above dreams of sleeping in, not working a JOB but having an unending stream of capital to buy bling and vacation.

    On the other hand my goals are to invest so I can continue to work a JOB as long as possible, but not depend on income from my JOB. I have some kind of sickness, I like to work and get huge satisfaction from contracting hvac. However I no longer need to work in the ghetto, or take on work to pay the bills, allowing me to pick and chose the projects I like to do.

    Don’t get me wrong I like to vacation, I just like the vacation to be a tax write off. This year we are attending a business conference in Hawaii. This my kind of JOB, and I never plan to retire.

    • I’m with you Dennis. My whole goal, for years, was to get myself into a position to be able to go back to flight instructing but not be reliant on the income (because it isn’t good). I didn’t know how I would do it, but I ended up starting my own business that I work whenever I want, so now I can pop out to the airport for a couple flights a week and have fun with it, not care about the income (or lack there of) and enjoy it. That is a “job” I will probably always work, but it’s because it’s fun and not required for the income.

      Great comment!

  4. @Jon Kepler do you really think NO ONE is financially free? There are a number of reasons people continue to work- they enjoy it, they want more, etc. Everyone has a different idea of what they need to be financially free. At the end of the day of your passive stream pays for all of your expenses, you can be financially free.

    • My thoughts exactly, Pete.

      I doubt, if we were to set a litmus for what it means to be one of Ali’s “no-joke, big-time” investors, the truth is none of them *have* to continue working. They work because they love it. Or, as you say, because they want more.

      My goal is to generate enough passive income (ultimately; for the next few years, I’m definitely working for it both with a day job and property managing my investments) to do what I want, when I want, how I want, and where I want. We all define that “what, when, how, and where” differently, and to each of us, financial freedom means something different.

  5. This article is great, defining the differences and emphasizing the advantages of passive income. I believe it might be helpful to list some of the tax advantages of passive income vs active income as well. These include and are not limited to: cash-flow, being able to claim depreciation, deductable loan interest, tax free refinancing and deferred taxes on sale of property via 1031 exchanges. It’s the difference between 50% taxed income and potential tax free income.

    • Absolutely Greg. That is a great comment and you’re right, it would be helpful to have an explanation of that. I can speak on the passive side of taxes but not the active side. Are you interested in elaborating with some more knowledge of your own on the tax side?

      Great point.

  6. Hi Ali,

    We’re completely aligned on this.

    Investors spend too much time calculating Return On Equity and Return On Investment, and not enough calculating Return On Time.

    With professional management covering my 21 units, my Return On Time in essentially infinite.

    Would I derive some pleasure from “Doing It Myself”? Sure. But is that the best life has to offer? No.

    Monday I leave with my wife to go surf Kauai, then the South China Sea the following week.

    I like your post!

    • Ali Boone

      You’re the coolest person ever Keith! I agree with you completely. Some people don’t have bigger dreams and desire for adventure like I do, and clearly you do too, and that’s totally fine. But I’m all for sucking up every bit of adventure I can, which just doesn’t include landlording. Nothing about that appeals to me.

  7. Good points in the article and comments on this subject.
    There are positive and negative aspects of both.
    In the short term there are valid reasons to favor active strategies but ultimately without passive income you can’t ever stop.

    I do lots of rehabs. I like it and make a lot of money. It is a lot of work and I get taxed to death on it. I take most of the profits and buy rentals with good cash flow.
    In time I’d like to systematize that business to have little day to day involvement as well as have full-time PM to handle the rentals fully. Then I will only work on what I like and only as much as I want.

  8. Great article, I am a great example started selling real estate at 19, have been in Real Estate sales for close to 38 years.

    Did my first flip at 19, made $25,000 that was in 1975-76 had no concept what I was doing, made 35,000 in sales that first year, still had no idea what I was on to.

    I flipped properties pretty consistently every year with a couple big investment, built a condo project, a Motel, turn keyed a convience store , lots of single family flips, lot splits. Just for myself and a couple family members.

    Kept a commercial corner that I bought in 1980’s, own single family homes, duplex’s, and commercial properties. Its been a lot of fun having all the freedom to do what I want,

    By far the best thing I did was to retain properties, it takes a lot more effort it’s not about fast cash, it’s about a long term game plan.

    The big difference in Real Estate is leverage which can be either good or bad depending on your timing and wiliness to stay long term and ride out the dips. Think about having one million dollars in single family California Real Estate in 2012, in November 2013 it’s now worth 30-50% more, timing is important but staying in the game long term is what it’s about.

  9. I’m confused by your reference to passive income. Passive income doesn’t mean totally free money or money earned without work although you make several references to making money in your sleep without any effort. Now, I understand the concept of passive income but I have to believe that you must still work to obtain that passive investment/ income and then work to maintain it right? Owning a company, in itself, is a lot of work and is thus still considered a JOB right? It’s not till after a lot of blood sweat and tears that one can reach a point where they can say theyve achieved financial freedom with passive income. Maybe you can add a little clarity for me. I’m only in my beginning stages of real estate investing and read as much as I can to learn.

    • You bet Jeff. There are plenty of ways to misinterpret the meaning of passive income, and it can definitely seem a little gray especially if you are newer.

      No matter what, if you own something, you will have to put some effort towards it, yes. Even if you are as hands-off as possible, you may need to use your brain occasionally. Although I would say with mine, I might have to use my brain for a total of a 30 minutes or less a year. The only thing I do for my properties are answer emails or calls from my property manager and give him approval to do random things. That doesn’t even happen that often though. The most ‘work’ I ever do on my properties, other than give approval for repairs, is stress if there is a vacancy or turnover or something. Stressing is pretty passive though. Oh, and I spend 20 minutes or less gathering any documents I have for my accountants come tax time.

      Now, if I were landlording my own property, that would be having to do work, yes. If I rehab a rental property, that is work. None of that work is passive, it’s active. However, with rental properties you luck out because regardless of how much work you put into them, they are still classified as passive investments when it comes to taxation.

      So that is where it gets a little weird too- tax classifications, which might be slightly different than the term defining how much work you do. Owning a business will always be taxed as active income. Rental properties will always be taxed as passive income. The reason being (all theoretical to an extent) is that, in theory, if the business stops selling or performing, income is lost. In theory, rental properties can continue to make money if you do no work on them. If I had a rockstar property manager who constantly handled everything about the property, I could technically do zero work and still receive income. In theory, even if the PM stopped working the property, if a tenant stayed there forever and kept sending money, you get income with no work. Not all that realistic for you to never be involved, and most certainly to succeed without a PM, but taxes assume it’s possible. Work has to continue to happen with a business for it to make income, therefore it’s active.

      Not sure if all that helps, but most of it is based off theory but there are ways to make passive more passive, if that makes sense.

  10. The big difference in Real Estate is leverage which can be either good or bad depending on your timing and wiliness to stay long term and ride out the dips. Think about having one million dollars in single family California Real Estate in 2012, in November 2013 it’s now worth 30-50% more, timing is important but staying in the game long term is what it’s about.

  11. What you say is true. You can have both active and passive income at the same time. Active income will come from your JOB. At the same time, you can use a portion of your active income to invest, in stock market for instant. The money you invest will slowly grow bigger base on the dividend you receive, that’s your passive income.
    Besides than stock market and property investment as some mentioned earlier, there is another way to earn extra passive income is online marketing. Put your effort at the beginning, income will come in future without you being there. You will harvest what you plant. That’s multiple of passive income.

    • Ali Boone

      Totally agree Phoebe. And I’d even add another one– educational material for example. Create an educational piece, like an eBook or even a real book, once and keep collecting the income without having to work for it.

      The trick is always just knowing what is truly passive and what isn’t.

  12. Tyler Wilson

    Thanks to Ali (and everyone) for breaking down the income differences. I’d like to approach active vs. passive from a different angle, to get your thoughts.

    Let’s say I am a parttime real estate investor with buy and hold rentals. I have a normal W-2 job but decided for educational purposes to take/pass the state real estate licensing exam. Now if I have an opportunity and want to work on nights/weekends as a real estate agent, does my passive rental income now get taxed (and much higher) as active income? Or does this come down to whether I work +\- 500 hours as an agent?

    Apologies for switching the comment thread to a tax issue, but feel taxes are the root of active vs. passive income decisions.

    • Ali Boone

      Hey Tyler, good question. The thing is that the income you receive on your rental properties is not the same as the income you earn as an agent. Since they are different income streams, they would get taxed appropriately per each one–rental properties as passive and agent income as active.

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