What is Passive Income?

by Fred Decker; Updated May 01, 2018
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Getting paid for your work is a very good thing. Getting paid over and over again for work you've already done is even better, and that's the basic concept of passive income. It's something you can take advantage of as a business, a sole entrepreneur or a private citizen, though what you consider passive income might not coincide with the way the IRS sees things.

What Is Passive Income?

There are a couple of different ways to interpret the term passive income. Often it's a catch-all term used for any income you don't actively work for, right here and right now. For example, a veteran insurance broker might have a "book" of existing business, which pays a steady stream of residual commissions. Interest and dividend income from your investment portfolio are sometimes described as passive income as well, though there's a third category – portfolio income – that's more accurate. For a business, royalties on software, books or music might be considered passive income. The definition that really counts, for tax purposes, is the one used by the Internal Revenue Service. As far as the IRS is concerned, there are only two forms of passive income: Earnings from rental properties and from businesses you've invested in but don't actively take a hand in managing.

What Is Active Income?

Your active income is any other money you make. Ordinarily, that might be your hourly wages or salary, or if you're self-employed it's your fees or income you draw from the company each month. To put it simply, it's the money you make from doing what you do. Drawing the line between active and passive income would seem to be simple enough, but the IRS has a few rules you need to be aware of. For one, your rental income only counts as passive income if you're not in the real estate business. For professionals, it's always considered active income by the IRS. If you've invested in a company and want to treat your earnings as passive income, there are strict limits on how much involvement you can have. You can't put more than 500 hours into the company through the year under any circumstances, and even 100 hours can disqualify you if nobody else has put in more hours. The toughest test of all, for really hands-off businesses, is whether the time you've put in amounts to "substantially all" of the hands-on operation of the company. In that case, it's always active income and the actual number of hours doesn't matter at all.

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How is Passive Income Taxed?

"True" passive income, as defined by the IRS, is ordinary income for most purposes. The difference is that you usually run the risk of taking a loss from that kind of income, whether it's a property sitting empty or the failure of a company you've put money into. You can minimize that risk by using the losses from one passive income to offset the gains from other passive incomes. If your brother-in-law's car wash business folds, for example, you can use the money you lost on his enterprise to reduce the tax liability on your rental properties.

Non-Official Passive Income Opportunities

If you're less concerned about what the IRS considers passive income, and more interested in ways to generate ongoing revenue streams for you or your business, there are plenty of opportunities to do that as well. You might create and monetize a YouTube channel related to your business. For example, if you're a mechanic or car-parts dealer, you can post videos of common auto repairs. Or if you're a contractor, you can post videos of common DIY mistakes. Write an e-book in your area of expertise and offer it for sale on your website, or offer a subscription-based premium service or memberships to your clients in exchange for meaningful privileges. If you have your own site or blog, you can monetize it through ad placements or affiliate-marketing links. If you write apps or develop websites, consider licensing your software or renting sites by the month, rather than selling them outright. You may make less initially, but in the long-term, those monthly payments can really add up.

About the Author

Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.

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