Passive Income: Definition, Three Major Types, and Examples

What are 3 forms of passive income?

What Exactly Is Passive Income?

Passive income, also known as unearned income by the Internal Revenue Service (IRS), is income that requires little effort to obtain. It is the inverse of active income, which is earned from a job or business venture that necessitates active participation.

Earnings from a rental property, limited partnership, or other enterprise in which a person is not actively involved are examples of passive income. While these money-making ventures may have required some effort at first, they now generally pay out automatically and without the recipient breaking a sweat.

Passive income, like active income, is usually taxable, but the IRS often treats it differently.

KEY POINTS

• Passive income is earned from sources other than an employer or a contractor.
• It can be generated by earning interest on savings, receiving cashback or rewards on a credit card, renting out a space, investing in dividend-paying stocks, and other means.
• The IRS has specific rules for determining whether a taxpayer has actively participated in a business, rental, or other income-producing activity, known as material participation.
• A taxpayer can deduct a passive loss from income earned from passive activities.

Recognizing Passive Income

Income is classified into three types: active income, passive income, and portfolio income. Earnings from a rental property, limited partnership, or other business in which a person is not actively involved—for example, a silent investor—are examples of passive income. It can also include bond or savings account interest, dividends paid out by a stock investment, and unemployment benefits.

In recent years, the term “passive income” has been thrown around a lot. It has been used colloquially to define money earned on a regular basis with little or no effort on the part of the person receiving it.

Depending on who you ask, definitions differ. The IRS, whose opinion is very important in these matters, excludes a number of 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 debt cancellation income.

The IRS defines passive income as “net rental income” or “income from a business in which the taxpayer does not materially participate,” and it can include self-charged interest in some cases.

Some analysts consider portfolio income to be passive income. However, the IRS does not always agree that income from dividends, interest, and so on is passive, so consult a tax professional on the subject.

Passive Income Types

Passive income includes self-charged interest, rental properties, and businesses in which the income recipient has no material participation. For income to be considered passive, specific IRS rules must be followed.

Self-imposed interest

When a partnership or an S corporation lends money to a partnership or an S corporation acting as a pass-through entity (basically, a business designed to reduce the effects of double taxation), the interest income on that loan-to-the-portfolio income can qualify as passive income. “If the loan proceeds are used in a passive activity, certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity deductions,” the IRS states.

Property for rent

With a few exceptions, rental properties are considered passive income. Any rental income you earn as a real estate professional counts as active income. If you’re “self-renting,” which means you own a space and rent it out to a corporation or partnership where you conduct business, that doesn’t count as passive income—unless the lease was signed before 1988, in which case you’re exempt from having that income defined as passive.

Land leasing income is also not considered passive income. A landowner, on the other hand, can benefit from passive income loss rules if the property loses money during the tax year.

Any earnings from holding land for investment purposes would be considered active.

‘No material involvement’ in a business

If you invest $500,000 in a candy store with the understanding that the owners will pay you a percentage of the profits, that is considered passive income as long as you do not participate in the business’s operation in any meaningful way other than making the investment. If you assisted the owners in managing the company, your income could be considered active because you provided “material participation.”

The IRS has established guidelines for material participation. All of the following are examples of material participation:

If you’ve invested more than 500 hours in a profitable business or activity,

If you participated in an activity that accounted for “substantially all” of the participation for that tax year,

If you’ve spent up to 100 hours participating in the activity, that’s at least as much as any other participant.

Making Money From Passive Income

Passive income can be a great way to supplement your regular earnings from your day job and generate some extra cash flow. And there are numerous approaches to obtaining it.

Some of the simplest and most accessible ways to generate passive income are:

• Rent out a garage, a room, or, if you have one, a house or apartment. This can be a temporary or long-term arrangement.
• Spread knowledge: There is a chance that there are people out there who will pay you for your knowledge and expertise. You could consider creating an online course or writing an ebook. There is money to be made if you have something worthwhile to share and a good market strategy. Starting a YouTube channel is another option.
• Sell items online: Thanks to online marketplaces like eBay, it’s relatively simple to sell items to people all over the country or the world. This could include anything from items sitting in your attic to purchasing items on sale and then reselling them for a higher price.
• Sell photos: The internet offers a plethora of opportunities for passive income. Another option is to sell the rights to your photos to others through a specialist platform like Getty Images, Alamy, or Shutterstock.
• Peer-to-peer lending: With peer-to-peer (P2P) lending, you can operate like a financial institution, making personal loans to other people through a third-party intermediary and collecting interest payments.
• Invest in income stocks: Many well-established companies on the stock market pay a regular cash payment to their shareholders known as a dividend. You have the option of reinvesting the money back into the stock or withdrawing it as income and using it as you see fit.
• Put your money in a savings or certificate of deposit: It is possible to open a bank account that pays interest on credited funds. The rate of return is typically determined by interest rates in the broader economy as well as how long the bank is permitted to hold the funds before you can withdraw them without penalty.

The Taxation of Passive Income

The IRS typically taxes passive income at the same rate as wages from a job. Certain types of income, however, may be taxed at a different rate, and deductions can sometimes be used to reduce the liability.

When you record a loss on a passive activity, only the profits from that activity can be deducted, not the income as a whole. To maximize your tax deduction, make sure that all of your passive activities are classified as such. These deductions are allocated for the following tax year and applied in a reasonable manner that takes into account the earnings or losses of the following year.

You can combine two or more passive activities into one larger activity to save time and effort, as long as you form an “appropriate economic unit,” according to the IRS. Instead of having to provide material participation in multiple activities, you only have to provide it for the activity as a whole when you do this. Furthermore, if you include multiple activities in one group and have to eliminate one of them, you’ve only eliminated part of a larger activity rather than all of a smaller one.

The organizing principle for making a grouping an appropriate unit is relatively simple: if the activities are located in the same geographic area; if the activities have similar business types; or if the activities are somehow interdependent—for example, if they have the same customers, employees, or use a single set of books for accounting.

For example, if you owned a pretzel shop and a sneaker shop in Monterey, California, and Amarillo, Texas, you would have four options for grouping their passive income:

• Combined into a single activity (both businesses were in shopping malls)
• Geographically organized (Monterey and Amarillo)
• Sorted by business type (retail sales of pretzels and shoes)
• They could also remain ungrouped.

What Are Some Forms of Passive Income?

Passive income is defined as money and losses generated by a business in which a person is not actively involved. Some examples are renting out a property (as long as it’s not your main job) or getting a share in a limited partnership.

Is passive income considered investment income?

People often say that passive income is money made from activities that don’t require active participation. But the Internal Revenue Service (IRS) does not consider interest, dividends, and capital gains, which are earnings from investments that don’t require much work, to be passive income. Instead, they are classified as portfolio income.

Is passive income taxed?

The IRS does, in fact, collect taxes on passive income. This type of income is frequently taxed at the same rate as salary, though deductions can sometimes be used to reduce the liability. It might be a good idea to talk to a tax expert about how to make the most of your specific situation to limit your tax obligations.

How Can I Earn $1,000 Per Month Through Passive Income?

There are numerous methods for generating passive income. Renting out a space, such as a bedroom or an entire house, investing in securities that pay dividends or interest, and selling goods and services online as a side hustle are some examples.

In conclusion

Passive income is income generated by someone other than an employer or contractor. The definition can be interpreted in different ways and can be a little different depending on where you look. Passive income, according to the IRS, comes from either rental property or a business that does not require active participation.

Passive income, which can be a great way to boost personal finances in many cases, is money earned from work done upfront. And, thanks to the internet, it is now easier to access than ever before.