Understanding passive income

The topic of passive income gives rise to many fantasies, as it fuels the aspiration, for many people, to be able to live without having to work. A dream that often turns into a mirage. To separate fact from fiction, we spoke with Lionel De Broux, Chief Investment Officer at BIL*.

To begin with, could you clarify what “passive income” actually is?

Lionel De Broux: Passive income is presented as an alternative to professional, salaried activity for generating a regular income. The idea is to have money working for you rather than having to work for money. However, this term is somewhat misleading, as it might suggest that this income is obtained without effort, which is rarely the case. Admittedly, passive income is “self-generating”, but it is often the result of an initial investment which, if not the product of work, has at least required sustained attention from its beneficiary. Let us take an example: the interest earned by lending a sum of money is indeed part of passive income, but if that sum is often the result of prior work, then passive income is rather poorly named… The same applies to someone who monitors and manages their equity portfolio in order to grow their capital.

What are the most common sources of passive income?

LDB: As I began to mention, there are financial products such as equities and bonds, which generate financial returns in the form of dividends or yields.

Another major source of passive income is, of course, property, whether residential property, a garage or office space. By letting such assets, their owner will receive rental income which constitutes passive income.

Finally, there is another, less well-known source of passive income, namely copyright royalties received by any creator through the commercialisation and exploitation of their work. We are talking about successful authors, or singers whose “hits” stand the test of time and generate significant passive income. This can also apply to a patent.

What are the attractions and the limitations specific to the different categories of investments generating passive income?

LDB: As far as limitations are concerned, this brings us back to the very ambiguity of the term “passive income”. Indeed, it quickly becomes apparent that passive income is in reality obtained through very real activity, past or present. Take the case of financial assets: to acquire them, one must first have a sufficiently large initial capital. If we exclude the case of heirs, this means there has been work upstream, the proceeds of which made it possible to purchase these assets. Furthermore, managing a portfolio is a full-time activity in its own right, and its outcome is, moreover, never guaranteed.

The reasoning is the same for property: one must first have the funds to purchase a property before receiving rental income. This is not always straightforward, especially in a country like Luxembourg where the entry ticket to the property market is very high. Finally, one must not forget that rent received does not constitute a net return. A property owner is always exposed to the deterioration of their asset and therefore to renovation costs, as well as to the payment of property taxes. Put another way, passive income is never generated out of nothing.

“Calling them passive income might suggest that they are obtained without effort, which is rarely the case.”

Have new sources of passive income emerged in recent years (digital, AI, new technologies…)?

LDB: Yes, and the most striking example undoubtedly appears with digital technology and the theme of streaming. A platform such as Spotify acts as a catalyst, for rights holders, for a very significant source of passive income generated by the streaming of music tracks.

Added to this is the issue of copyright related to AI-generated songs, whose quantity on the platform is very large. Taken individually, these works generate very little income, but it is the volume that ensures the return. Finally, still from a digital perspective, all developers of software and IT solutions can claim passive income derived from the sale and exploitation of their creations.

Is there any specific taxation applicable to passive income?

LDB: No, there is no taxation specific to passive income. Neither in Luxembourg nor elsewhere. Taxation corresponds to the tax rules of the country where the source of the passive income in question is located. Dividends are not taxed in the same way as property, which in turn is not taxed in the same way as copyright royalties.

This must, of course, be taken into account when assessing the return on a given investment.

Does it make sense to integrate this type of income into an investment strategy?

LDB: Yes, provided that one bears in mind the need to be able to build up the initial capital required to generate passive income. Part of this capital may come from a paid or salaried activity, but also from financial investments aimed at growing capital through the reinvestment of generated income.

Passive income therefore fits into a long-term investment strategy based on the investor’s life cycle. This begins with the accumulation of capital through savings, followed by the investment of those savings with a growth objective. Once the capital is deemed sufficient, the strategy gradually evolves towards an approach more focused on income generation. The composition of the asset portfolio thus adapts over time, according to the objectives pursued and changes in strategy.

What should an investor be particularly mindful of when approaching the topic of passive income?

LDB: The first thing to do is probably to define its role within a broader investment strategy. Is it a comfort income, or is it a necessary income aimed, for example, at maintaining one’s standard of living in retirement? The answer will determine the requirement for visibility and therefore the type of assets towards which to turn. However, visibility is often inversely proportional to an investment’s return. It is all a matter of balance.

Then one must take into account the distinction between gross and net, that is, what actually ends up in the investor’s pocket. If we take the example of property, costs are very high and rent received is by no means disposable income, far from it!

As is often the case, I would say that the watchword here is diversification. For investors, it is advisable to multiply and diversify the sources generating passive income.

* Content translated from French by the BIL GPT AI tool