What is Passive Income?
Passive income refers to earnings that aren’t dependent on a traditional job, and that take less time and effort to maintain.
🤔 Understanding passive income
Passive income is income that you derive from sources other than paid labor. Common sources include owning rental property, participating in a limited partnership, or any other enterprise in which one is not actively involved. Many people rely on an employer for all of their earnings for a year. But others turn to passive income, which is a way to increase their sources of revenue without putting in as much continual effort. Once set up, the income happens without much work from you. The Internal Revenue Service (IRS) acknowledges passive income and classifies it as either passive business activities, rental activities, or self-charged interest. There are other forms of income that require little effort on the part of the earner, such as dividend investing, but the IRS doesn’t classify them as passive income. As with the money you’d earn from your employer or work as a contractor, passive income is subject to income taxes.
Suppose you work full-time as an elementary school teacher. You and your husband decide you’d like to create a passive income stream to help finance your future retirement. The two of you decide to invest in rental properties. You buy a small rental property, fix it up, and begin renting the units out to tenants. The revenue that you and your husband make from your rental properties is passive income under the IRS definition. Many forms of passive income require little effort. Rental income is unique because the IRS classifies it as passive income regardless of how much effort it takes.
Passive income is like multiple streams flowing into one lake…
Imagine the lake is your bank account. All of the neighboring streams and rivers flow into that lake. The streams and rivers represent passive income. The more streams that are flowing into your lake, the more streams of passive revenue you have going into your bank account. Many forms of passive income are just like a stream, where they naturally flow into the lake with little effort.
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- What are the different types of income?
- What are the different types of passive income?
- What is the benefit of having additional streams of income?
- What are some alternative income ideas?
What are the different types of income?
There are three primary types of income: passive income, active income, and portfolio income. According to the Internal Revenue Service (IRS) definition of passive income, it refers to passive business activities, rental activities, or self-charged interest.
Active income refers to earnings you bring home from work. For most people, their active income is their salary or wage, tips, and commission. If you’re a business owner who runs the day to day of your business, then your business income is active. Active income describes any worker who is paid as a result of the time they spend on their job or how much they produce in a job.
The last type of income is portfolio income, which refers to earnings from capital gains, dividends, and interest from your investments. Even though portfolio income could be considered passive — in that it doesn’t require the same time investment as active income — the IRS does not include it in its definition of passive income.
What are the different types of passive income?
The Internal Revenue Service (IRS) definition of passive income includes three primary income sources. The first is trade or business activity in which you don’t materially participate — where you aren’t involved in the day-to-day activities. The next type of passive income is any rental activity, regardless of how materially you participate, as long as you aren’t a real estate professional. The final type of passive income is self-charged interest.
There are plenty of other activities that are generally considered to be passive income, such as investing and affiliate marketing. However, what the IRS deems to be passive income is treated differently within the tax code than other forms of income.
Business activity is considered to be passive income if you don’t engage in material participation. There are a few tests you can use to determine if you materially participate in a trade or business activity for any given tax year according to the IRS:
- You spent more than 500 hours actively working on the business
- You were the only participant in the business (for example, you’re a sole proprietor)
- You spent more than 100 hours working on the business and contributed roughly the same number of hours as other participants (for example, a partnership where you and your partner both spent over 100 hours without one of you having spent significantly more time)
- You spent more than 100 hours working in the business and spent more than 500 hours working in any business (for example, suppose that you are a partner in multiple businesses and spent at least 500 hours on business activities, with at least 100 of those hours devoted to one of the businesses)
- You’ve met the above IRS requirements for material participation in at least five of the past 10 years
- You’ve met the above IRS requirements for material participation for any three preceding years, and the activity is a personal service activity
Income that you make from a rental activity is a type of passive income, even if you materially participate. Rental activity refers to a situation where you rent your property to customers, and the money you receive is primarily due to the money the customers paid for the use of the property.
There are some exceptions to the IRS definition of rental activity. For example, as of March 2020, rental activities generally don’t count as passive income if the amount of time for which customers rent the space is under one week. As a result, many property owners (though not all) using sites like Airbnb to rent out their homes can’t count those funds as passive income.
Rental activities also don’t count as passive income if you’re a real estate professional. According to the IRS, you qualify as a real estate professional if more than half of the services you perform in a year are in real property trades or if you performed more than 750 hours of service during the year in real property trades.
It’s important to note that whether rental income qualifies as passive income has nothing to do with how much time you spend on it. Owning a rental property can be a significant time and labor investment, especially if you’re maintaining the property yourself.
The third type of income that the IRS deems to be passive income is self-charged interest. Self-charged interest is usually income or a deduction you received as a result of a loan between you and a partnership or S corporation. In some cases, loans between S corporations can also qualify.
For the income from this interest to count as passive income, you must have a direct or indirect ownership interest in the company. The loan could be one that you made to the company or one that the company made to you. In the situation that you’ve lent money to the company, the passive activity for tax purposes would be the deduction you take for the interest, not the interest income.
What is the benefit of having additional streams of income?
One author, Tom Corley, looked into the question of multiple revenue streams when writing his book “Rich Habits.” More specifically, he looked into the habits of millionaires for five years. One of the things he learned is that well over half of the millionaires he studied have at least three streams of income, and many have even more than that.
But regardless of whether you strive to be a millionaire someday, there are reasons to add some streams of extra income. Having additional income streams can help to create income stability.
Suppose you have several streams of income in addition to a full-time job. If you’re laid off from your job, you still have money coming in. If you were relying entirely on your employer for your earnings, you wouldn’t have any money coming in.
Generating passive income isn’t just a short-term plan — It’s also a great way to plan for the future. Many people seek out financial independence, where they can quit their jobs and live just off of their passive income streams.
What are some alternative income ideas?
The Internal Revenue Service (IRS) may have a pretty narrow definition of passive income. But there are plenty of income opportunities that don’t require devoting 40 hours per week to them. No one income type will be best for everyone. What works for one will not fit well for another. However, here are some income and business ideas that don’t meet the IRS definition of “passive,” but also don’t require a full-time commitment.
These all have varying risks — including not getting your original investment back or not being able to turn a profit from the income. All of these require extensive research and possibly consulting with a professional before trying them.
Some stocks are dividend stocks, meaning the company returns some of its profits to the shareholders in the form of dividends. Companies usually distribute these dividends quarterly.
Affiliate marketing is when individuals make money in the form of commission by recommending products to others. Anyone can attempt to earn affiliate income by recommending products with an affiliate link on their website or social media pages.
Affiliate marketing can be especially attractive for those without money to invest in their passive income venture, since there’s usually a low start-up cost. However, in many cases, there are disclosure rules that must be followed when promoting affiliate links.
Capital gains refer to the profit you make if you sell an asset such as a security or real estate for more than you paid for it.
Imagine that you invested $1,000 in the stock market. After a few years of a bull market (meaning a period of stock market growth), your investment has grown considerably. You decide to sell the stock and earn a profit.
This profit is a capital gain. You’ll have to pay taxes on your capital gains, but the rate varies by how long you hold on to the asset before selling. Of course, this is easier said than done as it is also very possible to end up with capital losses as well. All investing carries risk; always consider investment objectives.
Some investments allow you the opportunity to earn interest rather than just dividends or capital gains. Debt securities such as bonds and certificates of deposit usually result in interest payments for the investment. You could also put your money into a money market account or high yield savings account to potentially earn higher interest than you would in a traditional savings account.
If you’ve got creative talent, you might be able to make money through royalties. Royalties refer to income you make for the sale or licensing of something creative you make. Royalties could come from a book, musical album, screenplay, drawings, or even photography.
Rent out your stuff
Do you have anything of value that you aren’t using all the time? There are plenty of services that allow you to rent your property to other individuals. Some sites will also allow you to rent out your car or RV.
Online education is a rapidly growing industry, and not just for universities that offer online classes. There are plenty of ways that ordinary people can make money by educating others online.
First, you could sell an online course. Sites like Udemy, Teachable, and SkillShare allow you to sell your online course through their website. You could also sell a course on a website of your own.
You don’t even need to charge for your information to educate people online. If you set up an education website, you could choose to offer your content to students for free in the form of blogging, and then use third-party ads to potentially bring in revenue.
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