You see lots of people talking about the benefits of passive income. Do something once and then sit back and make money for the rest of your life. Sounds great! The claim is that passive income is simply money that is received on a regular basis with little to no effort needed to maintain this income stream. This is not entirely true. There is a specific legal definition of what passive income is. As a disclaimer, I am not an attorney or tax professional and anything written in this article is not to be considered professional advice. So use anything I write here at your own risk. The way things are now days it pays to CYA.
The U.S. Internal Revenue Service (IRS) defines passive income as “trade or business activities in which you do not materially participate” (1). It is important to know the IRS definition of “passive income” because many types of activities that seem passive are not according to the IRS (2). You can get into trouble if you report something as passive when it’s not. And passive income does have to be reported for tax purposes. So be sure to keep accurate records.
According to the IRS, there are only two sources for passive income. The first is rental activity (2). This category includes real estate rental activities (unless under certain circumstances) and all other rental activities (even if you are an active participant)(1). The second source is a business that the taxpayer does not materially participate in (2). This usually means that you’re a non-participating partner in a business. That’s it. Just because you make money without having to work for it does not automatically make it passive income (2).
Some examples of activities that are NOT passive income streams (according to the IRS) are:
- Royalties from books, patents, or other intellectual property
- Making money from advertisements on your blog or website
- Anything dealing with stocks, bonds, or other types of securities
- Pensions or retirement income
- Recurring sales commissions
These are just a few of the activities that are considered “non-passive”. In fact, most income earning activities are considered “non-passive” to the IRS.
What does this mean for those of us seeking self-reliance? It means that most of us are going to have few or no passive income streams in our financial plans. You’ll want to think carefully about getting into passive income opportunities unless you want to deal with owning rental properties, owning a business where you rent things out, or getting into some kind of business partnership. Be aware that all three of these options carry substantial monetary, time, and liability risks.
Many people use passive income and residual income interchangeably. I think this is a bad idea and can lead to confusion and poor decisions. What most of us are looking for are residual income streams. We’re looking for activities where we can put in the work once and then receive money from that activity over time with a minimal amount of additional effort. In my article “What is residual income?” I cover what residual income is, some types of residual income, and why residual income is important for any financial security plan.
(1) Internal Revenue Service (http://www.irs.gov/taxtopics/tc425.html)
(2) Internal Revenue Service (http://www.irs.gov/businesses/small/article/0,,id=146330, 00.html)