If making money with minimal effort is a dream of yours, passive income just might be the answer.
But what exactly counts as passive income? Let’s look at the different ways the IRS says you can earn passive income and how it affects your taxes.
What is passive income?
Informally, passive income is a term used by many self-employed professionals and business owners as money made on autopilot. You often put in the hard work up front and continue to reap the benefits with minimal effort.
On the more technical side, the IRS says passive income can fall into one of two categories:
- Trade or business activities in which you don’t materially participate during the year
- Rental activities, even if you do materially participate in them (unless you are a real estate professional)
What are the tax benefits of passive income?
Aside from the obvious benefit of making money with little effort, passive income has some nice tax benefits, too.
Passive income is taxed at the capital gains tax rate, typically lower than your income tax rate (0, 15, or 20 percent, depending on your income level). For this reason, it’s generally more favorable to have your income be classified as passive for tax purposes.
What types of passive income meet the IRS rules?
For an income stream to be considered passive by the IRS, it should fall into one of the following categories.
Rental activities
Most rental properties are defined as passive income, with a few caveats.
If you’re a real estate professional, your rental income is considered active income, not passive. You also cannot claim passive income on “self-renting” income — for example, if you rent your property to one of your own business entities. Any income earned from leasing land does not count as passive income, either (though you may be able to take advantage of passive income loss rules in this situation).
Example of passive income rental activity: You purchase a condo or duplex and rent it out to single-family tenants. The net rental income you collect on this property is considered passive income.
‘No material participation’ activities
To help taxpayers determine if an income stream meets the requirements for passive income, the IRS lists seven “material participation tests.”
Ask yourself:
- Did you participate in the activity for more than 500 hours?
- Did your participation in the activity comprise a substantial part of all the participation in the activity during the year?
- Did you participate in the activity for more than 100 hours during the year and at least as much as any other person involved?
- Did you participate in multiple activities for more than 100 hours each during the year, and did your participation in all such activities exceed 500 hours when combined?
- Did you materially participate in this activity for any 5 of the past 10 tax years?
- Did you materially participate in this activity for any 3 of the past 10 tax years, and is the activity a personal service activity that involves your personal time and effort? Examples include health and veterinary services, consulting, performing arts, law, accounting, engineering, architecture, and actuarial science.
- Did you participate in the activity on a regular, continuous, and considerable basis?
Example of a passive income activity with no material participation: You purchase a business and hire someone else to run it for you. You do not help manage the company or participate in the business operation, but you earn a percentage of all business earnings.
Self-charged interest
According to the IRS, if you loan money to a pass-through entity that you own (such as a partnership or S corporation), the interest income earned on the loan can qualify as passive income if the loan proceeds are used in a passive activity. This is also true the other way around — when your S corp or partnership collects interest on a loan made to you.
Example of self-charged interest passive income: **waiting to hear back from Andrew about this part, ignore for now
Do dividends and interest count as passive income or ordinary income?
Frustratingly, the answer to this question is, “It depends.”
Dividends are ways that profits are distributed to shareholders. The IRS does not consider most dividends to be passive income; however, some dividends can qualify if they meet the following conditions:
- The dividend is paid by an American corporation or “qualified foreign entity” eligible for the benefits.
- You held the stock for at least 60 days within the 121-day period that ends 60 days before the ex-dividend date (ex-date).
Fittingly, dividends that meet these criteria are called “qualified dividends” and are subject to capital gains tax rates.
Can I deduct my passive activity losses against my income on my taxes?
When filing your federal tax return, you can use Form 8582 to calculate any passive activity losses (PALs) for the tax year.
You can use passive activity losses to offset profits from other passive activities, but you can’t deduct PALs against nonpassive income.