Passive income, from an income taxes standpoint, is income generated from activities, business interests, or other sources that you do not have an active material participation in, and therefore does not include income that you earn from active work, a job, or other formal employment. Since passive income generates cash flow without requiring your personal time, it can be a way to amass wealth on the path to achieving financial stability. For this reason, many individuals planning for retirement or those with substantial financial resources often consider passive income streams a key part of building a sustainable financial portfolio for their future.   

Defining Passive Income:

Passive income refers to earnings derived from activities in which you do not materially participate. This stands in contrast to non-passive income, or earned income, which is typically income from services rendered or an activity in which you do materially participate. Passive income provides the means for individuals to cultivate revenue streams that are not inextricably tied to their time and physical presence.

Non-Passive vs. Passive vs. Portfolio Income:

Generally, non-passive income is income that you earn by trading your time for money and includes income sources such as salaries, wages (W-2), contractor/self-employment income, or income from businesses in which you materially participate. On the other hand, passive income is income that you receive from interests where you have very limited or no material participation at all in the income-generating activities. The IRS determines ‘material participation’ based on seven tests, the most common being one based on the hours one devotes to an activity. To be considered passive, an individual must not have participated in the activity for more than 500 hours during the tax year. Some examples of passive sources of income include the income you collect through the ownership of private-equity interests, ownership of real estate, rental properties, and business interests where you do not participate in the business, interests in Real Estate Investment Trusts (REITs), certain oil and gas investments, the income generated from activities in certain types of trusts, and many more.

While income that comes from activities you don’t directly participate in can generally be thought of as passive income, the IRS applies special rules to certain types of income, called ‘portfolio’ income, that would otherwise fall into that broad passive income category. This distinction is especially important when it comes to losses since only passive activity losses can offset passive activity income. In general, portfolio income items are defined as being income with respect to interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business as well as the gains and losses from the disposition of property that produces these types of investments.

To learn more about the various types of income, including the passive activity rules and how the IRS treats them, see IRS Publication 925 (2022), Passive Activity and At-Risk Rules.

Examples of Passive Income:

INVESTING

Investment in Surgery Center, Hotel, Restaurant:

Passive investments in various business ventures such as ambulatory surgery centers (in most cases), hotels, and restaurants can offer diversified and regular income streams. These investments allow for profit-sharing without the need for investors to be actively involved in the daily operations. In each case, the revenue generated - whether it's from medical procedures, room bookings, or restaurant sales – contributes to the passive income of the investor.

Private Equity Investments:

Private equity investments involve investing directly into private companies or buying out public companies, resulting in a delisting of public equity. Investors typically receive income from these investments when it is passed through to the individual partners generally partnerships.

Equipment Leasing:

Investing in equipment leasing can provide regular rental income. This involves purchasing equipment and leasing it to businesses that need it but prefer not to buy it due to cost or other.

Oil & Gas Investments:

Certain types of oil and gas investments provide unique investment options that can generate passive income.

Other Limited Partnership Investments and Business Interests:

In a limited partnership, investors (limited partners) provide capital but have limited liability and do not participate in day-to-day management. Because of this structure, limited partners receive passive income from the profits the partnership generates. The businesses in which the limited partnership operates may include anything from manufacturing to generating intellectual property for which the investors will earn royalty or patent income.

REAL ESTATE

Rental Properties:

Rental properties are one of the most popular means of generating passive income, especially for investors who are not considered “real estate professionals.” By buying residential or commercial properties and leasing them for rental income, investors can accumulate regular rental income while potentially profiting from property value appreciation over time. By engaging the services of professional property management companies, investors can ensure day-to-day operations are handled effectively. Generally, this type of rental activity is a passive activity even if you materially participate, unless you are a real estate professional.

Rental of:

• • Commercial Office Building
  • Medical Office Building
  • Industrial Properties
  • Farmland
  • Vacation Rentals

Taxation of Passive Income

Passive income is subject to a unique set of tax rules that differ in many ways from the rules applied to other types of non-passive income such as salaries and wages. While non-passive income is typically reported on a W-2 or a 1099 and subject to FICA taxes, passive income is reported on Schedule E of Form 1040 and is not subject to FICA taxes. It is also subject to the Net Investment Income Tax, which is a 3.8% tax that applies to individuals, estates, and trusts with an income above certain thresholds. Passive income can be reported through 1099s or K-1s, depending on the nature of the income. Finally, investors considering long-term planning goals, both for income generation and tax strategy, should be mindful that passive activity losses generally may only be used to offset passive activity income.  

Conclusion

Passive income presents a transformative approach to wealth accumulation beyond the traditional exchange of time for money. By diversifying income sources and investing in various passive income streams, individuals can enhance their financial stability and strive for greater financial independence. Comprehensive research, professional advice, and continuous education are essential in exploring the diverse passive income options available. With perseverance and meticulous planning, individuals can chart a course to financial prosperity through passive income.

Finally, while we hope you find this information helpful, it is important to note that this area of the tax code is highly complex and these statements should not be considered tax advice.  Investors should always consult with a tax professional for guidance based on their individual facts and circumstances before making any investment decisions.