Passive income can be a wonderful way to make money. Yet, it sometimes can get over-simplified into just a handful of the ways that people typically use it. In this post, we’ll look at a few of the major categories for passive income and give you a few examples of how you can start building up your portfolio.
Rental And Business Income – The IRS Definition Of Passive Income
Most people know of passive income as being when you regularly earn money with little to no effort. Many different money-making activities could fall underneath this definition.
However, if you were to ask the IRS, they would have a different opinion. According to IRS Publication 925 “Passive Activity and At-Risk Rules”, passive income is defined as coming from two sources, or “passive activities”:
- Rental activity
- Trade or business activities in which you do not materially participate.
Interestingly enough, the publication goes on to say that passive income “does not include salaries, portfolio, or investment income.” This is most likely because the IRS treats taxes and deductions for rental properties and businesses differently than it does for the income you earn from your salary and investments.
What exactly constitutes rental and business without participation activities?
As you might guess, the classic example of someone who owns a single-family home and rents it out to a tenant would be considered a rental activity and therefore passive income. This is because they will receive payments every month as well be able to claim deductions for their rental property expenses (mortgage interest, maintenance, depreciation, etc.)
This definition could even be expanded to larger rental ventures such as owning several rental properties, an apartment complex, or even commercial property.
Businesses Without Participation
Business ownership is another staple of passive income. When you invest in a venture and it performs successfully, you’re entitled to a cut of the profits it generates. Under the IRS’s definition, as long as you don’t regularly participate in the day-to-day operations, then this would also be considered passive income.
For example, back before Facebook was a common household name, investor Peter Thiel became one of their first big investors putting $500,000 into the company. He, like many other investors, did not actually participate in any of the coding or marketing activities that Facebook was using to grow itself. Ultimately, this investment paid off big as he ended up selling most of his stake for more than $1 billion in cash.
What You Can Do
If you’d like to take advantage of the passive income benefits of being a landlord but don’t want to actually buy any properties, then you can do this through purchasing shares of a REIT (real estate investment trust). REITs are companies that own and operate income-producing real estate such as apartment buildings, medical facilities, offices, hotels, etc.
In some ways, REITs could be considered to be even more “passive” than physically managing property because all it takes is just going online and becoming a shareholder. In return, you can expect to receive a payout of at least 90 percent of the REIT taxable income. According to the Motley Fool, the average REIT dividend is approximately 5 percent. That’s not a bad payout for doing more than just owning a few shares!
Similarly, if you’d like to find the next Facebook to invest in but would rather not gamble with $500,000, then why not start with just $10 using a site like Worthy Bonds. This is a service that vets the loan requests of new small businesses and creates bonds to fund their activities. In return, you the bondholder are paid a 5 percent annual return.
Even though the IRS does not define portfolio income to be “passive”, there are many passive income enthusiasts who do. After all, how much involvement or activity is needed on your part to earn interest, capital gains, or dividends?
Consider the following:
- Interest Income. When you park your money into a CD (certificate of deposit) or high-yield savings account, the money literally just sits there accumulating interest; sometimes for years.
- Capital gains. Thanks to the compounding effects of investing, your earnings will grow on top of your initial contributions plus any earnings you’ve already accumulated. For doing little more than just regularly contributing to your retirement funds or investment portfolio, you can easily end up multiplying your money over and over again over the long-term. You can see this for yourself using this free compound interest calculator from Investor.gov.
- Dividends. For doing nothing more than simply being an owner, dividend stocks will send quarterly payments to their shareholders. You can find a lot of great companies to invest in from a list called the Dividend Aristocrats.
What You Can Do
If you’d like to get involved with investing but aren’t really sure where to start or what to pick, then why not let an app do it for you.
Robo-advisors have become an incredibly simple and popular way for young people to get into the world of investing. These are just algorithms that pair-up investment options based on your tolerance for risk and reward. Try a service like Betterment, Wealthfront, and M1 Finance to get started.
Two Other Popular Types Of Passive Income
Two other commonly used types of passive income that aren’t identified by the IRS at all are income-producing assets (that aren’t rental properties or business income) and reverse passive income.
Income-producing assets could be anything that you build or create that goes on to generate passive income for years to come. Examples might be:
- A website that generates advertising revenue
- An ebook that collects royalties every month
- An online course that people regularly enroll in
- A software or app where people pay a monthly or annual license fee
Though these assets may take some time and investment to make initially, they can then operate in auto-pilot once they are established. Plus, since they are financially tangible, you can eventually sell them for one-lump sum when you no longer wish to own them.
Reverse Passive Income
Sometimes you earn money by never spending it at all. Though this idea can be a little more abstract, effectively if you reduce your future debt payments or expenses, you’re engaging in revise passive income because it will free up more cash flow that you didn’t previously have.
For example, someone who refinances their mortgage from a 5.0% APR to a 4.0% APR might save $100 or so per month on their mortgage as well as thousands of dollars in interest over time. That would be an example of reverse passive income.