Passive Income: What It Is, 3 Main Categories, and Examples

What Is Passive Income?

Passive income—or unearned income, as the Internal Revenue Service (IRS) calls it—is income that requires minimal effort to obtain. It is the opposite of active income, which is income received from a job or business venture that requires active participation.

Passive income includes earnings derived from a rental property, limited partnership, or other enterprise in which a person is not actively involved. While these money-generating ventures may have initially required some effort, they now generally pay out automatically without the recipient breaking out a sweat.

As with active income, passive income is usually taxable, but it is often treated differently by the IRS.

Understanding Passive Income

There are three main categories of income: active income, passive income, and portfolio income. Passive incomes include earnings from a rental property, limited partnership, or other business in which a person is not actively involved—a silent investor, for example. It can also include interest generated from a bond or savings account, dividends paid out by a stock investment, and unemployment benefits.

Passive income has been a term used relatively loosely in recent years. Colloquially, it has been used to define money being 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 derived from the cancellation of debt.

Passive is defined by the IRS as either “net rental income” or income from a “business in which the taxpayer does not materially participate,” and in some cases can include self-charged interest.

Types of Passive Income

Passive income includes self-charged interest, rental properties, and businesses in which the person receiving income does not materially participate. There are specific IRS rules that need to be followed for income to be considered passive.

Self-Charged Interest

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

Rental Properties

Rental properties are defined as passive income with a couple of exceptions. If you’re a real estate professional, any rental income that you’re making counts as active income. If you’re self-renting, meaning that you own a space and rent it out to a corporation or partnership where you conduct business, that does not constitute passive income—unless that lease had been signed before 1988, in which case you’ve been exempted into having that income defined as passive.

Income from leasing land does not qualify as passive income, either. However, a landowner can benefit from passive income loss rules if the property nets a loss during the tax year.

‘No Material Participation’ in a Business

If you put $500,000 into a candy store with the agreement that the owners would pay you a percentage of earnings, that would be considered passive income as long as you do not participate in the operation of the business in any meaningful way other than making the investment. If you helped in managing the company with the owners, then your income could be seen as active, because you provided “material participation.”

The IRS has standards for material participation. The following are all considered examples of material participation:

• If you’ve dedicated more than 500 hours to a business or activity from which you’re profiting
• If your participation in an activity has been “substantially all” of the participation for that tax year
• If you’ve participated up to 100 hours and that is at least as much as any other person involved in the activity

How to Make Money from Passive Income

Passive income can be a great way to generate some extra cash flow and supplement regular earnings from your day job. And there are many different ways to go about obtaining it.

Some of the simplest, most accessible ways to make money from passive income include:

1. Rental income: Rent out a garage, room, or a house or apartment if you have it. This can be a short-term or longer-term arrangement.
2. Spread knowledge: There’s a chance that there are people out there who will pay for the knowledge and expertise you’ve acquired. You could think about creating an online course or writing an ebook. There is money to be made, provided that you have something good to share and a decent market strategy. An alternative is to start a YouTube channel.
3. Sell goods online: Thanks to online marketplaces such as eBay, it’s relatively easy to sell stuff to people all over the country or globe. That could be anything from things sitting in your attic to buying items when they are on sale and then selling them on for closer to their retail value.
4. Sell photos: The internet provides all kinds of opportunities to make passive income. Another option is to sell the rights to the photos you’ve taken to other people via a specialist platform such as Getty Images, Alamy, or Shutterstock.
5. Peer-to-peer lending: With peer-to-peer (P2P) lending, it’s possible to operate like a financial institution, making personal loans through a third-party intermediary to other individuals and collecting the interest payments.
6. Invest in income stocks: Many well-established companies on the stock market pay their shareholders a regular cash payment known as a dividend. You can choose to reinvest that money back into the stock or withdraw it as income and use it as you wish.
7. Park your money in a certificate of deposit (CD) or savings account: It’s possible to open a bank account that pays interest on the money credited. The rate of return usually depends on interest rates in the broader economy, and how long the bank is allowed to hold the funds before you can retrieve them without paying a penalty.
   

Tax Treatment of Passive Income

The IRS usually taxes passive income at the same rate as salary 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 liability.

When you record a loss on a passive activity, only passive-activity profits can have their deductions offset, as opposed to the income as a whole. It would be prudent to ensure that all your passive activities were classified that way to make the most of the tax deduction. These deductions are allocated for the next tax year and are applied in a reasonable manner that takes into account the next year’s earnings or losses.

To save time and effort, you can group two or more passive activities into one larger activity, provided that you form an “appropriate economic unit,” according to the IRS. When you do this, instead of having to provide material participation in multiple activities, you only have to provide it for the activity as a whole. In addition, if you include multiple activities in one group and have to dispose of one of those activities, then you’ve only done away with part of a larger activity as opposed to all of a smaller one.

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

For example, if you owned a pretzel store and a sneaker store located in malls in both Monterey, Calif., and Amarillo, Texas, you would have four options for how to group their passive income:

• Grouped into one activity (both businesses were in shopping malls)
• Grouped by geography (Monterey and Amarillo)
• Grouped by type of business (retail sales of pretzels and shoes)
• Or they could remain ungrouped 

The Bottom Line

Passive income is basically earnings generated from someone other than an employer or contractor. The definition can vary slightly depending on the source and is open to interpretation. According to the IRS, passive income comes either from rental property or a business that does not require active participation.

In many cases, passive income, which can be a great way to boost personal finances, is money earned from work done up front. And, thanks to the internet, it is now more accessible than ever.