Passive income is income that requires little to no effort to earn and maintain. It is called progressive passive income when the earner expends little effort to grow the income. Examples of passive income include rental income and any business activities in which the earner does not materially participate. Some jurisdictions’ taxing authorities, such as the Internal Revenue Service in the United States of America, distinguish passive income from other forms of income, such as earnings from regular or contractual employment, and may tax it differently.
United States of America
The United States Internal Revenue Service categorizes income as active income, passive income, or portfolio income. It defines passive income as only coming from two sources, or “passive activities”: rental activity or “trade or business activities in which you do not materially participate.” Other financial and government institutions also recognize it as an income obtained as a result of capital growth or in relation to negative gearing. Passive income is usually taxable.
Active income is earned income including all taxable income and wages the earner receives for working. Active income includes wages, self-employment income, and material participation in an S corporation or partnership. Portfolio income is derived from investments such as dividends, interest, capital gains, and some royalties.
There are three kinds of passive activities:
- Cash flows from property income, including profits from ownership of capital, rent from ownership of resources such as rental income, cash flows from property or any piece of real estate, and interest from owning financial assets.
- Trade or business activities in which one does not materially participate during the year.
- Royalties, which are payments made by one company (the licensee) to another company or person (the licensor) for the right to use the latter’s intellectual property (book, music, video). However, the Internal Revenue Service only considers royalties passive income when they are “not derived in the ordinary course of a trade or business.”
Some limited partnerships may be considered passive as long as the limited partner does not have any role in the company and exchanges their capital investment for a share of the activities profit.
In order to be considered a rental activity, tangible property is used by customers and the income paid from the activity comes from the amount paid for the use of the property and is not considered a rental if:
- The average period of customer use is:
- 7 days or less
- 30 days or less and significant personal services were provided
- ^“Publication 550 — Investment Income and Expenses”. www.irs.gov.
- ^ Jump up to:ab “Publication 925 — Passive Activity and At-Risk Rules” Retrieved 2019-10-19.
- ^“Tax Topic 425 Passive Activities — Losses and Credits”. Retrieved 2009-06-18.
- ^“Earned Income | Internal Revenue Service”. www.irs.gov. Retrieved 2018-05-12.
- ^“Earned Income vs Passive Income vs Portfolio Income: A Comparison – Just Ask Ben Why”. Just Ask Ben Why. 2015-06-22. Retrieved 2018-05-12.
- ^ Jump up to:ab “Publication 925 (2017), Passive Activity and At-Risk Rules | Internal Revenue Service”. www.irs.gov. Retrieved 2018-05-12.
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.