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Passive Income

Definition

Passive income is income resulting from cash flow received on a regular basis, requiring minimal to no effort by the recipient to maintain it.

What is 'Passive Income'

Earnings an individual derives from a ren​tal property, limited partnership or other enterprise in which he or she is not materially involved. As with non-passive income, passive income is usually taxable; however it is often treated differently by the Internal Revenue Service (IRS). Portfolio income is considered passive income by some analysts, in which case dividends and interest would be considered passive.

Explaining 'Passive Income'

There are three main categories of income: active income, passive income and portfolio income.

Self Charged Interest

When money is lent to a partnership or S-corporation acting as a pass-through entity (essentially a business that is 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. As the IRS language reads, ‘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’. 

Property

Rental properties are defined as passive income with a couple of exceptions. If you’re a real estate professional, any rental income you’re making counts as active income. If you’re ‘self renting’ meaning that you own a space and are renting it out to a corporation or partnership where you conduct business, that doesn’t constitute as ‘passive income’ unless that lease had been signed before 1988 in which case you’ve been grandfathered into having that income being defined as passive. According to the IRS, ‘it does not matter whether or not the use is under a lease, a service contract, or some other arrangement’

‘No Material Participation’

If an investor puts $500,000 into a candy store with the agreement that the owners would pay the investor a percentage of earnings, that would be considered passive income as long as the investor doesn’t participate in the operation of the business any meaningful way other than placing the investment. If the investor did help manage the company with the owners, the IRS argues, the investors income could be seen as active since the investor was working with the business. 

Benefits of Passive Income

When a taxpayer records a loss on a passive activity, only passive activity profits can receive have their deductions offset instead of the income as a whole. It would be considered prudent for a person to ensure all the passive activities were classified that way so they can 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 years earnings or losses.

Grouping Activities

To save time and effort, a person can group two or more of their passive activities into a larger activity provided they form an ‘appropriate economic unit’. When a taxpayer does this, instead of having to provide material participation in multiple activities, they only have to provide it for the activity as a whole. In addition, if a person groups multiple activities into one group and has to dispose of one of those activities, they’ve only done away with part of a larger activity as opposed to all of a smaller one. 


Further Reading


Board game for teaching fundamental aspects of personal finance, investing and accounting
patents.google.com [PDF]
… also essential, as it is related to behavioural finance, behavioural economics, and consumer … The individual investment decisions for generating passive income vary according to demographic characteristics … and mostly includes teenage or working-age men with high incomes …

CFC legislation, passive assets and the impact of the ECJ's Cadbury-Schweppes decisionCFC legislation, passive assets and the impact of the ECJ's Cadbury-Schweppes decision
papers.ssrn.com [PDF]
… also essential, as it is related to behavioural finance, behavioural economics, and consumer … The individual investment decisions for generating passive income vary according to demographic characteristics … and mostly includes teenage or working-age men with high incomes …

Neither passive nor powerless: reframing economic vulnerability via resilient pathwaysNeither passive nor powerless: reframing economic vulnerability via resilient pathways
www.tandfonline.com [PDF]
… also essential, as it is related to behavioural finance, behavioural economics, and consumer … The individual investment decisions for generating passive income vary according to demographic characteristics … and mostly includes teenage or working-age men with high incomes …

Passive investment strategies and efficient marketsPassive investment strategies and efficient markets
onlinelibrary.wiley.com [PDF]
… also essential, as it is related to behavioural finance, behavioural economics, and consumer … The individual investment decisions for generating passive income vary according to demographic characteristics … and mostly includes teenage or working-age men with high incomes …

The taxation of passive foreign investment: lessons from German experienceThe taxation of passive foreign investment: lessons from German experience
onlinelibrary.wiley.com [PDF]
… also essential, as it is related to behavioural finance, behavioural economics, and consumer … The individual investment decisions for generating passive income vary according to demographic characteristics … and mostly includes teenage or working-age men with high incomes …

Repatriation taxes, repatriation strategies and multinational financial policyRepatriation taxes, repatriation strategies and multinational financial policy
www.sciencedirect.com [PDF]
… also essential, as it is related to behavioural finance, behavioural economics, and consumer … The individual investment decisions for generating passive income vary according to demographic characteristics … and mostly includes teenage or working-age men with high incomes …

Examining passive and active recruitment methods for low-income couples in relationship educationExamining passive and active recruitment methods for low-income couples in relationship education
www.tandfonline.com [PDF]
… also essential, as it is related to behavioural finance, behavioural economics, and consumer … The individual investment decisions for generating passive income vary according to demographic characteristics … and mostly includes teenage or working-age men with high incomes …

The effect of financial knowledge and demographic variables on passive and active investment in Chile's pension planThe effect of financial knowledge and demographic variables on passive and active investment in Chile's pension plan
www.cambridge.org [PDF]
… also essential, as it is related to behavioural finance, behavioural economics, and consumer … The individual investment decisions for generating passive income vary according to demographic characteristics … and mostly includes teenage or working-age men with high incomes …



Q&A About Passive Income


What are the three main categories of income?

The three main categories of income are active, portfolio and passive.

What is passive income?

Passive income is an individual's earnings from a rental property, limited partnership or other enterprise in which he or she is not materially involved.

What does it mean when money is lent to a partnership or S-corporation acting as a pass-through entity (essentially a business that is designed to reduce the effects of double taxation) by that entities owner?

When money is lent to a partnership or S-corporation acting as a pass-through entity (essentially a business that is designed to reduce the effects of double taxation) by that entities owner, the interest income on that loan can qualify as passive income. As the IRS language reads, 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. Rental properties are defined as passive with exception. If youre real estate professional any rental incomes youre making counts as active incomes. If youre self renting meaning that you own space and are renting it out to corporation where conduct business thats doesnt constitute as passively unless lease had been signed before 1988 in which case grandfathered into having having have being defined defined has been has been has been being defined has been defined has been defined has been being defined has being definitioned definitioned definitioned definitioned definined definined definined definined defiend defiend defiend defiend dfinned dfinned dfinned dfinned deinne deinne deinne dein

How does passive income differ from portfolio income?

Portfolio income is considered passive by some analysts, in which case dividends and interest would be considered passive.