Passive income offers an excellent opportunity to generate wealth. However, discussions about this topic often get narrowed down to just a few common strategies. In this post, we’ll explore the major passive income categories and provide practical examples to help you begin building your portfolio.
Rental And Business Income – The IRS Definition Of Passive Income
Most people understand passive income as money earned regularly with minimal effort. Numerous money-making activities could fit this broad definition.
The IRS takes a more specific approach. According to IRS Publication 925 “Passive Activity and At-Risk Rules”, passive income stems from two sources, called “passive activities”:
- Rental activity
- Trade or business activities in which you do not materially participate.
The publication specifically excludes “salaries, portfolio, or investment income” from this definition. This distinction exists because the IRS handles taxes and deductions differently for rental properties and businesses compared to salary and investment income.
What activities qualify as rental and non-participation business ventures?
Rental Activity
The classic example involves owning a single-family home and renting it to tenants. This qualifies as rental activity and generates passive income because owners receive monthly payments while claiming deductions for property expenses (mortgage interest, maintenance, depreciation, etc.)
This definition extends to larger ventures including multiple rental properties, apartment complexes, and commercial real estate.
Businesses Without Participation
Business ownership represents another cornerstone of passive income. When you invest in a successful venture, you earn a portion of its profits. Under IRS guidelines, this income remains passive as long as you don’t participate regularly in daily operations.
Consider Peter Thiel’s early Facebook investment. Before the platform became a household name, investor Peter Thiel became one of their first major backers, investing $500,000. Unlike many other investors, he didn’t participate in the coding or marketing activities driving Facebook’s growth. This investment ultimately paid off spectacularly when he sold most of his stake for over $1 billion in cash.
What You Can Do
Want the passive income benefits of property ownership without buying real estate? Consider purchasing REIT (real estate investment trust) shares. REITs own and operate income-generating properties like apartment buildings, medical facilities, offices, and hotels.
REITs might be even more “passive” than direct property management since becoming a shareholder requires only an online transaction. In return, you’ll receive at least 90 percent of the REIT’s taxable income. According to the Motley Fool, the average REIT dividend runs approximately 5 percent—an attractive return for simply owning shares!
Want to find the next Facebook but prefer not risking $500,000? Start with just $10 using platforms like Worthy Bonds. This service evaluates loan requests from small businesses and creates bonds to fund their operations. Bondholders receive a 5 percent annual return.
Portfolio Income
While the IRS doesn’t classify portfolio income as “passive,” many passive income enthusiasts disagree. After all, how much involvement is required to earn interest, capital gains, or dividends?
Consider these examples:
- Interest Income. When you deposit money into CDs (certificates of deposit) or high-yield savings accounts, funds literally accumulate interest while sitting untouched—sometimes for years.
- Capital gains. Compounding investment effects cause earnings to grow on top of initial contributions plus previously accumulated returns. Simply by contributing regularly to your retirement funds or investment portfolio, you can multiply your money repeatedly over time. Check out this free compound interest calculator from Investor.gov to see the potential.
- Dividends. Simply by being a shareholder, dividend stocks send quarterly payments to investors. Explore great companies from the Dividend Aristocrats list.
What You Can Do
New to investing and unsure where to begin? Let technology handle the heavy lifting.
Robo-advisors have revolutionized investing for newcomers, offering simple and popular entry points. These algorithms match investment options based on your risk tolerance and return expectations. Start with services like Betterment, Wealthfront, or M1 Finance.
Two Other Popular Types Of Passive Income
Two additional passive income categories—income-producing assets (beyond rental properties or business income) and reverse passive income—don’t appear in IRS definitions but remain popular among investors.
Income-Producing Assets
Income-producing assets include anything you build or create that generates ongoing passive income. Examples include:
- A website generating advertising revenue
- An ebook collecting monthly royalties
- An online course with regular enrollments
- Software or apps with monthly or annual licensing fees
While these assets require initial time and investment, they can operate on autopilot once established. As financially tangible assets, you can eventually sell them for a lump sum when ready to move on.
Reverse Passive Income
Sometimes earning money means never spending it. While more abstract, reducing future debt payments or expenses creates reverse passive income by freeing up previously unavailable cash flow.
For instance, someone who refinances their mortgage from 5.0% APR to 4.0% APR might save roughly $100 monthly on payments plus thousands in long-term interest. This exemplifies reverse passive income.
