At its simplest, passive income is income you receive without having to do any work. Sounds like magic and it would be if it were true. In fact, if it were true we would call it free money. It isn’t really free and “passive” is the key word here.
Colloquially, passive income is any money that you earn from an activity or investment that does not require too much effort. Usually, passive income will require some initial effort and that effort will create a flow of income that continues over a period of time where you are no longer expending any effort. In IRS terminology, you are not materially participating in the activity that is creating the income.
So, let’s take a step back and look at the types of income you can receive and why they matter.
Types of Income (from Uncle Sam’s Perspective)
As far as you and I are concerned, we are earning money – either by working for it or by investing it. So these categories are truly for tax classification purposes because the IRS treats each one differently and they provide you different tax benefits (or the opposite of benefits).
Before I explain this further, please note my disclaimer that I am not a tax advisor who is authorized to interpret IRS rules and regulations. This article is based on what I have learned along my wealth building journey from CPAs and tax professionals. Before you take any action that impacts your finances or taxes, make sure you consult your CPA and/or tax advisor.
Active income is obvious. It is money you earn when you perform a service either in a job or as an hourly worker or as an independent contractor. Typically, any earnings obtained via a W2 or a 1099-MISC would fall into this category. The IRS refers to this category as earned income which include wages, salaries, and tips.
A large number of people fall into this category. If you’re in a high-income job, that’s great! However, this is not the best category of income for tax effectiveness. Apart from the federal income tax, you have to pay social security, medicare, state income taxes (in most states), city/county income taxes (in some crazy parts of the country) and often a contribution toward unemployment insurance. On top of that, you have very few avenues to get deductions that can reduce the tax burden.
To build wealth for ourselves and our children, the goal needs to be to gradually push as much income as possible into not being active. That’s where the non-active categories come in handy.
In my view this is a silly category. But who am I to convince the man (I mean the taxman) that he’s made our lives needlessly complicated. For the taxman, passive income and portfolio income are similar though with an important difference. The similarity is that both involve making an investment in a business and receiving a profit without working for that business.
Let’s say you gave a $1,000 loan to your friend for running an ad campaign for his business. Your friend repays the loan to you over 12 months with 5% simple interest. You earned that interest without participating in your friends business or being involved in his advertising campaign. This income is not active. However, how do you know if it’s passive or portfolio?
There is a strong likelihood that your tax advisor will say this is portfolio income. The reason is that your income was interest on a loan to a third party business. So, portfolio income is money you receive from dividends, interest, and capital gains. This is not an exhaustive list but is generally representative.
The good news is that the tax code provides favorable tax treatment of portfolio income. Dividends and capital gains are taxed at a lower rate than earned income and your portfolio income is usually not subject to social security or medicare taxes.
So, if you decide to invest in dividend-paying stocks and funds, good for you! Very advantageous for making income without work and paying lower taxes on it.
The Two Types of Passive Income
As far as you and I, the ordinary folk, are concerned, portfolio income is passive since we don’t have to work for it. We’ve agreed that the IRS prefers to complicate things. So, from a tax standpoint, passive income is money you earn from:
- a rental property
- a limited partnership or a business in which you are not actively participating.
In fact, to be even more technical, the IRS defines passive income as either “net rental income” or “income from a business in which the taxpayer does not materially participate.” Remember the term “materially participate.” I will dwell on it a bit further ahead.
The IRS also is very nitpicky about each of the types of passive income.
Rental properties are generally considered passive income. There is an arcane exception for “self-renting,” where you cannot receive passive income by renting space you own to a business that you conduct from that space, unless the lease was signed before 1988. I don’t even want to try and explain that.
There is another critical exception – rental income is not passive income if you are a real estate professional (REP). If you are an REP, then please please please make sure you have a CPA handling your taxes!
Yet another exception – if you hold land for investment, any income from that is considered as active and does not qualify under passive activity rules. Strangely enough, it seems that if your land creates a loss, you can claim that as a passive loss! Let’s not try to understand the logic here. Head shake!
Now, let’s consider the second type of passive income – investing in a business. This one is interesting. Earlier, instead of giving a loan to your friend, you had offered him the $1,000 in exchange for a 5% share of his business. Now, the profit share payments you receive from his business would be passive income instead of portfolio income.
Why does it matter? There are a lot of opportunities in rental properties and businesses to have passive losses due to expenses, depreciation, and write-offs. When you are a passive investor in a business (remember that rental property is already passive), you can now offset much of that passive income with the passive losses. This is not possible with portfolio income. Understand that often these passive losses are not an actual loss of money. For instance, the tax code allows the business to calculate the reduced (depreciated) value of an asset (such as a property it owns) over time and reduce the profits by the depreciated amount.
We’ll talk more about depreciation in a future article. For now, just understand that passive income provides an opportunity for passive losses which is a good thing. It reduces your tax burden significantly. In fact, group investing in large scale commercial real estate usually provides the opportunity to offset most of the passive income you would earn from the investment.
So, receiving passive income from a limited partnership or business in which you do not materially participate is very beneficial. A limited partnership is basically any business in which there is at least one general partner who runs the business, and limited partners who do not participate in the business. General partners have unlimited liability for the debt, and limited partners have limited liability up to the amount of their investment. The business does not have to be a limited partnership for you to earn passive income. The only criteria is that you do not “materially participate.”
As usual, the IRS has lots of rules about material participation. Some of these are:
- If you’ve dedicated more than 500 hours to a business or activity from which you’re profiting, that is material participation.
- If your participation in an activity has been “substantially all” of the participation for that tax year, that is material participation.
- If you’ve participated up to 100 hours and that is at least as much as any other person involved in the activity, that also is defined as material participation.
The good news is that if you simply invested in a business and then didn’t lift a finger except receive and deposit your profit share checks (or confirm an electronic deposit) and picked up the partnership K-1 tax form every year to file your tax returns, your income from that business is passive! There is no disputing it.
If you’re nerdy about this stuff, read this IRS publication 925 and have a blast!
If you want to make money without having to work forever, start investing in things that create portfolio income and/or passive income – preferably both. Let your money make money for you.
Even better, if you want to make money without having to work forever and also save big time on taxes along the way, invest in rental properties for passive income. And even better, if you want to save even more taxes by offsetting the passive income with passive losses, then invest in businesses in which you don’t work and whose business is to own rental properties. It’s the best of everything!
Businesses that own rental properties and produce passive income for investors is the world in which I live. We accomplish this through group investing. You can create your own group to do this yourself, or you can work with us to build your group and income-generation opportunities, or you can join our group and deposit the checks 🙂