Passive income is money you make while you sleep. It's great because it's easy to set up, and it doesn't require much maintenance once it's running. It differs from active income – a job for example – which requires specific performance in order to generate the payment of income. This type of income is often produced by providing something of value – the use of which is paid for on an ongoing basis.
The Internal Revenue Service (IRS) categorizes income as follows:
This form of income comes about by the beneficiary taking specific action to generate this financial compensation. A job, contract work, or selling goods are examples of activities that the IRS classifies as active income generators. This income also typically attracts the highest rate of tax.
As the name suggests, a revenue stream derived from investment capital gains, interest, annuities, stock gains, and dividends constitute this form of income. It attracts a lower rate of tax than active income.
Passive income is limited to two sources. These are either enterprises that require no active involvement by the beneficiary or rental activities. Losses from passive activities can be offset against passive income for tax purposes. Tax on passive income is lower than that of active or portfolio income. For these reasons, it’s important to make sure that it is truly passive income as classified by the IRS.
A common misconception is that passive income requires no effort whatsoever on the part of the beneficiary and so any income derived in this way should be classified as passive. This is not the case as the effort or financial resources required to generate the income stream are typically invested upfront. It is merely a question of when the effort or investment was made. In the case of a book or song being written, the work had to take place for there to be something of value. The passive aspect comes in after the fact, where payment is made for making use of the song or book and the beneficiary does not need to take any action. Interest on investments works on the same principle – the upfront financial investment must be made in order for interest to be made payable.
With this in mind, as well as the IRS classification, the only true passive income streams come from rental property and limited business partnerships. Some passive income streams require more effort than others and are dependent on how involved the beneficiary wishes to be. Acquiring a rental property remains the traditional method for those wanting to generate a passive income with options as to the return on investment and the level of engagement desired.
The determination of how passive the income will be for a rental property, hinges on how much of the work the beneficiary allows to be outsourced. The Landlord can choose to personally manage the leasing, maintenance and administration functions required to generate the rental income, or he/she can delegate this responsibility to a managing agent to handle on their behalf.
When earning passive income, it’s crucial to have a thorough understanding of what the tax implications are. Performing due diligence up front will allow an investor to reap great financial benefits and avoid any unnecessary penalties.
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