Passive income is a profit from a business that doesn’t require a person’s active involvement. Examples of passive income activities are property rental, equipment leasing, and sometimes self-charged interest. However, there are some exceptions that you must consider.
Clarification of the term
Passive income is commonly described as easy money that a businessman gets effortlessly. This profit is usually associated with a relaxed and flexible schedule. And technically, it’s generated from an enterprise which doesn’t require a person’s significant involvement in business processes. In fact, if the person gets engaged in the activity, his income won’t be passive anymore.
One of the main differences of passive income is an absence of material participation in a business. The Internal Revenue Service (IRS) outlines standards that define the participation:
- a businessman shouldn’t spend more than 500 hours per year to the activity that profits him;
- a businessman shouldn’t spend more time on the activity than other people involved;
- a businessman’s participation shouldn’t be regular and permanent.
So, if a person invests some amount of money in a company and gets a percentage from its earnings, this income will be passive until he doesn’t get involved in any significant business processes. For example, if the person starts to promote his business ideas, hire employees, make other important changes, and spend more time on the activity, this income will count as active.
Types of Passive Income
A businessman can profit from different types of passive income activities. It’s important to define either of them in particular.
Property rental can be a passive income activity. But there are a few exceptions. Above all, if working with a property is your specialization then this income will count as active.
If you rent out your own property to an enterprise in which you’re actively involved, your income won’t be passive. However, this restriction doesn’t spread out on rent contracts signed before 1988. Likewise, if you rent out land, your income will count as active.
Self-charged interest. There are a few exceptions for counting self-charged interest as passive. For instance, if you loan money to a limited partnership or S corporation and you are a part of that partnership or company, then your interest from the loan won’t be considered as passive.
Portfolio income. Some specialists consider portfolio income as passive, because mainly that type of activity doesn’t require a person to be fully involved in it. Having said that, the IRS doesn’t always define the profit from interest, dividends, or capital gains as passive. Therefore, it’s better to advise on that matter with a specialist.
In addition, it is important to mention some special considerations on passive activity loss and managing your passive activities. It’s possible to allocate tax deductions on passive activity for the next tax year if you record a loss on your passive activity.
Grouping your activities. It can be reasonable to group some of your passive activities into a larger one using some of their common features. It’s easier for a person to manage one business instead of spending time on several enterprises.
Activities can be organized by a simple attribute like geographical location, types of businesses, or the same primary audience, etc.
For instance, if you own a thrift store and a music store both in Chicago and in San Francisco you can group these businesses by the following features:
- types of business (music stores and thrift stores);
- location (two stores in Chicago and two stores in San Francisco);
Also, you can group all of your stores into one business or leave them all separately.
Tax obligation. Just like any other earnings passive income is liable to tax. Usually, passive income is taxed similarly to a regular job wage. However, there are some possibilities for a businessman to use tax deductions. Better to consult on this matter with a tax professional.
- A person shouldn’t be significantly involved in a business in order for it to be considered as passive.
- The Internal Revenue Service (IRS) sets out a number of rules for material participation in a business.
- There are different types of passive income: rental properties, equipment leasing, etc.
- Passive income is liable to tax. But there are different rules for its tax obligation.
- Some passive enterprises can be united into a larger business for saving time and effort.
- Investment income is a questionable topic towards its passiveness.