Step 36: Income stream 4: Capital Gains

The fourth income stream that we’ll look at is that of capital gains. Whether or not you feel like working towards developing this income stream or not (some people don’t), capital gains in a key source of income to many people.

Capital gains are the profits one makes when selling something at a higher price than the original purchase price they paid. The difference with profit income is that profit income comes from something you made or created over time as part of your regular business activity, whereas a capital gain involves an original investment, and then the value of this investment increasing over time, but not a result of a regular business activity.

A capital gain is especially common with real estate (i.e. you buy your house for say $200.000 and sell it for $220.000, resulting in a $20.000 capital gain), but also with bonds to a small amount and especially shares from the stock market.

Conversely there is also something known as capital loss, which refers to the opposite situation, when something is sold for less than the original price that was paid. This is obviously not a very desirable situation you want to be in, but unfortunately isn’t uncommon when there is a market crash and people sell there shares at bargain prices,  Similarly, it can also happen on the housing market and we have seen in recent years that the once popular belief that a house is always a good investment and can only ever increase in value, sadly many have experienced first-hand that this doesn’t always work out.

People selling at prices below what they had paid often happens out of necessity (e.g. they really have to get the house sold because they already have a second mortgage on a new house), or out of fear (e.g. a worry hat if they don’t sell today, tomorrow they will get even less for their shares or house).

Let’s for now just say you have been warned about the risks of a capital loss, and return to our original focus again, which was capital gains :).

One important aspect is to establish or at least think about whether or not a capital gain was worth the time, money, original investment and risk or insecurity. Imagine that you sell a house at a price that is $30.000 above the price that was paid for it. This in theory sounds great, but let’s consider the following factors:

• Maybe you already moved to a new house several months ago, meaning you have been paying two mortgages at the same time, in which case you might have had to take out a higher mortgage for your second house than your original plan, as you didn’t have the money from your other house available, or maybe you had to eat into your savings.
• The $30.000 most likely won’t be cash in hand as you’ll be charged taxes over this.
• Let’s imagine also that this first house was bought 20 years ago. Due to inflation, prices on average double every 20 years, or said in a different way: money looses half its value every 20 years. So the $30.000 that was made on this estate, in reality is only $15.000, as the original price would have been a lot higher now than 20 years ago if corrected for inflation.
• You and your family might have had quite some worries about this house in the last few months: what if you was going to take another year to sell the house? Did you have to take down the price further? How were you going to pay for it for another year?

Then sometimes capital gains can also be a great (and often passive) way to make money. There are years when the stock market returns more than 10% and a long-term average of 7% is what most experts work off, which is definitely an interesting (though absolutely not guaranteed) income source.

All in all, capital gains are an interesting way to make money but whether that is with property or stocks and bonds, it isn’t completely risk-free and for every person who can tell you they made a lot off money on the stock market or housing market, you can probably find somebody who has experienced the opposite.

Step 36 – Income stream 4: Capital Gains – in more detail:

• Think about whether this is an income stream that you feel comfortable with and want to pursue further. We will look at shares and investing in the stock market later on, but in the mean time start thinking about this possibility and investigate options.
• If you do, think about what asset you would like to focus on to buy and sell.
• Property can be a very interesting business opportunity, especially if you have an eye for opportunities and know when and what to sell. Obviously this requires quite a bit of startup capital or a second mortgage, so this might not be something you can or want to pursue at the moment, although some combine buying a property-to-let to generate a rental income (see step 39) with the possibility of making a capital gain on it in a few year’s time: the rent received pays off (a part of) the mortgage untilthe property might be worth a lot more to sell again.
• Another way of making money on the property market is buying a property that is in (slight) disrepair, doing it up and then selling it again just months after. Especially if you have an eye for these opportunities and if you are handy with DIY tasks yourself.
• Another possible way, though difficult to plan for but not entirely impossible, is to build up a company and once it is successful sell it for a lot of money.
• Think of other ideas and options, talk to people, read up on the various possibilities on the internet and then decide whether any of these options sound at all interesting and doable to you.

Generating income through capital gains can be a very interesting and good way to make money, although it can be very unreliable and not without risk. As the assets require time to increase in value, it is difficult to plan ahead so much into the future, as one never really knows what tomorrow will bring. Relying on making money in this way is therefore unpredictable, but nevertheless as a possible side income it can also be attractive to pursue.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.