Passive income or “unearned income,” as the Internal Revenue Service (IRS) calls it is income that requires minimal effort to earn. It is the opposite of “active income”, which is income earned from a job or business that requires active participation.
Passive income includes earnings derived from the rental of property, a limited partnership or other enterprise in which a person does not actively participate. At first, these ways to make money may have taken some work, but now they are often paid automatically, without the recipient having to do anything. Like active income, passive income is generally subject to taxation, but is often treated differently by the tax authorities.
In a Nutshell
- Low effort income is referred to as passive income.
- Active income, which is money made via a job or business that necessitates active engagement, is the opposite of passive income.
- Earnings from the rental of real estate, limited partnerships, or other businesses in which a person is not actively involved are considered passive income.
- “Net rental income” or “revenue from a business in which the taxpayer does not materially engage,” according to the IRS, are examples of passive income.
- A excellent approach to increase your cash flow and augment your regular income from your day job is through passive income.
Passive Income
Understanding Passive Income
There are three main categories of income: active income, passive income, and portfolio income. Passive income includes earnings from a rental property, a limited partnership, or other business in which a person is not actively involved, e.g., a silent investor. Interest earned on a bond or savings account, dividends paid on a stock investment, and unemployment benefits may also be included.
In recent years, the term “passive income” has been used relatively loosely. Colloquially, it has been used to define money that is earned regularly with little or no effort on the part of the person receiving it.Definitions vary depending on who you ask. The IRS, whose opinion on these matters is very important, rules out quite a few things that could be considered passive income, including “interest, dividends, annuities and royalties not derived in the ordinary course of a trade or business,” income tax refunds and income from the cancellation of debts.
“Passive income is the key to financial freedom.”
Warren Buffett
The IRS defines passive income as “net rental income” or “income from a business in which the taxpayer does not substantially participate” and, in some cases, may include self employment interest.Some analysts consider portfolio income to be passive income. However, the IRS does not always agree that income from dividends, interest, etc. is passive, so it is advisable to consult a tax professional on this issue.
Types of Passive Income
Passive income includes self employment interest, rental property, and businesses in which the person receiving the income does not materially participate. There are specific IRS rules that must be met for income to be considered passive.
Interest Collected on Own Account
When money is loaned to a partnership or S corporation that acts as a pass through entity (essentially, a business designed to reduce the effects of double taxation) by the owner of that entity, the interest income from that loan may be treated as passive income. “Certain interest income or deductions collected on its own account may be treated as gross passive activity income or passive activity deductions if the loan proceeds are used in a passive activity,” the IRS states.
Rentals
Rental properties are defined as passive income, with a couple of exceptions. If you are a real estate professional, any rental income you earn counts as active income. If you “rent to yourself,” that is, you own premises and rent it to a business or partnership in which you conduct your business, that does not constitute passive income, unless the lease was signed prior to 1988, in which case you have been exempted from having that income defined as passive income.
Income from the lease of land is also not considered passive income. However, a landowner may benefit from the passive income loss rules if the property shows a loss during the tax year.If you own land for investment, any gains would be considered active.
“No Material Participation” in a Company
If you invested $500,000 in a candy store with the agreement that the owners would pay you a percentage of the profits, that would be considered passive income as long as you did not participate in the operation of the business in any meaningful way other than making the investment. If you collaborated in running the business with the owners, then your income could be considered active, because you contributed a “material participation.”
The IRS has rules for material participation. The following are considered examples of material participation:
- If you have devoted more than 500 hours to a business or activity from which you are profiting
- If your participation in an activity has been “substantially all” of the participation for that taxable year
- If you have participated up to 100 hours and that is at least as much as any other person participating in the activity
How to Earn Money with Passive Income
Passive income can be a great way to generate extra cash flow and supplement your regular income from your day job. And there are many ways to get it.Some of the easiest and most accessible ways to make money with passive income are:
- Rental income: Rent a garage, a room or, if available, a house or apartment. This can be a short or long term arrangement.
- Diffuse your expertise: There is a possibility that there are people who will pay for the knowledge and experience you have acquired. You can think about creating an online course or, for example, writing an e-book. There is money to be made, as long as you have something good to share and a good marketing strategy. An alternative is to create a YouTube channel.
- Sell products online: Thanks to online marketplaces like eBay, it’s relatively easy to sell things to people all over the country or the world. This can be anything from items stored in the attic to buying items on sale and then selling them for close to their retail value.
- Selling photos: The Internet offers all kinds of opportunities for passive income. Another option is to sell the rights to photos you have taken to other people through a specialized platform such as Getty Images, Alamy or Shutterstock.
- Private to Private Lending: With peer to peer (P2P) lending, it is possible to operate like a financial institution, granting personal loans through a third party intermediary to other individuals and collecting interest.
- Investing in income shares: Many well established companies in the stock market pay their shareholders a periodic cash payment known as a dividend. You can choose to reinvest that money in the stock or withdraw it as income and use it as you wish.
- Save your money in a certificate of deposit or savings account: It is possible to open a bank account that pays interest on the money paid in. The rate of return usually depends on interest rates in the general economy and how long the bank is allowed to hold the funds before you can get them back without paying a penalty.
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Tax Treatment of Passive Income
The tax authorities generally tax passive income at the same rate as wages received from a job. However, certain sources of income may be taxed at a different rate and it is sometimes possible to use deductions to reduce the tax liability.
When a loss is recorded on a passive activity, only the profits from the passive activity can have their deductions offset as opposed to the income as a whole. It would be prudent to ensure that all of your passive activities are so classified to take full advantage of the tax deduction. These deductions are carried forward to the next tax year and are applied in a reasonable manner taking into account the following year’s gains or losses.
To save time and effort, you can group two or more passive activities into one larger activity, provided you form a “proper economic unit,” according to the IRS. By doing so, instead of having to contribute the material participation in multiple activities, you will only have to contribute it for the activity as a whole. Also, if you include several activities in a group and have to get rid of one of them, you will only have eliminated part of a major activity, rather than all of a minor activity.
The organizing principle for making a cluster a suitable unit is relatively straightforward: if the activities are located in the same geographical area; if the activities have similarities in types of business; or if the activities are in some way interdependent for example, if they have the same customers, employees, or use the same set of books for accounting.
For example, if you had a pretzel store and a sneaker store in shopping malls in Monterey, California and Amarillo, Texas, you would have four options for bundling your passive income:
- Grouped in the same activity (both businesses were in shopping centers)
- Grouped by geography (Monterrey and Amarillo)
- Grouped by type of business (retail sale of pretzels and shoes)
- Or they could remain ungrouped
Wrap Up
Finally, passive income is a fantastic way to complement your primary source of income and create additional cash flow. It can come from a number of places, such as rental properties, limited partnerships, and companies in which the person getting the income doesn’t have a big stake.
Although passive income is often taxed, there are situations when the tax bill can be decreased by using deductions. Passive income can be a great method to improve your financial stability with the appropriate tactics and minimal work.
FAQs
Passive income is the money and losses that come from a business in which a person is not actively involved. For example, you could rent out a property (as long as you don’t work in real estate), lease some equipment, or invest in a limited partnership.
Passive income is often somewhat loosely defined as earnings from activities that do not require active participation. However, the Internal Revenue Service (IRS) does not classify as passive income interest, dividends, and capital gains, i.e., earnings from investments that generally do not require much active participation to earn. Instead, they fall into the category of portfolio income.
Yes, the IRS collects taxes on passive income. Often, this type of income is taxed at the same rate as wages earned from a job, although it is sometimes possible to use deductions to reduce the liability. If you want advice on how to keep your tax bill as low as possible, you might want to talk to a tax expert. They can tell you how to make the most of your specific situation.
There are many ways to generate passive income. For example, renting a space, such as a bedroom or an entire house, investing in securities that pay dividends or interest, or selling goods and services over the Internet as a sideline.
The following are the top three types of passive income:
1. Interest income: Bonds, equities, and savings accounts are examples of investments that produce this form of income.
2. Dividend income: Dividend income comes from investments like stocks and mutual funds.
3. Rental revenue: This kind of income is derived through the leasing of residential and vacation properties like apartments and homes.
Some examples of passive income are:
1. Interest from savings or certificate of deposit accounts.
2. Income from stock or mutual fund dividends.
3. Rental revenue from a property.
4. Royalties from music, books, or other artistic creations.
5. Income from a firm that requires little work to maintain.
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- Internal Revenue Service – Unearned Income
- Internal Revenue Service – Publication 925: Passive Activity and At-Risk Rules