If your day job isn’t earning you quite enough money, you might be thinking of investing in crypto or renting out part of your home. Both options – and plenty of others – can help you earn more money, but they all require some extra knowledge on your end. Namely, you should fully understand the difference between passive and non-passive income and what it means come tax day. Below, learn everything you should know.
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What Is Passive Income?
Passive income is any money you earn from business activities in which you aren’t materially involved. It describes most money-earning activities that require minimal work. You might have to invest some time or money in the activity early on, but after that, you can mostly sit back and relax.
How Does Passive Income Work?
The above definition of passive income, though used often, only somewhat attests to its true formal definition. In fact, the Internal Revenue Service (IRS) uses several tests to identify an income stream as non-passive. By extension, the opposite of these conditions defines passive income.
The IRS will classify you as a material participant in an activity – thus making the activity non-passive – under any of the below conditions.
- You participated in the activity for more than 500 hours per year.
- You put in more than 100 hours of work on an income-earning activity involving more people than just you. This rule only holds true if your total hours are equal to, or more than, those of any other participants in the activity.
- You provide personal service in a field in which “capital isn’t a material income-producing factor” and have done materially so for at least three years. Most business services meet this definition.
- You participated by far the most in an activity of anyone involved in it. This rule only holds true if your participation encompasses more than 500 hours per year.
Examples of Passive Income
Given the above criteria, several forms of hands-off activities count as passive income. Some examples of passive activities include:
- Renting real estate. Cordoning off part of your home as an Airbnb is perhaps the most classic example of passive income. You won’t materially participate in the activity since, after initial setup and investment, you’ll just clean occasionally or hire someone to do so for you. Alternatively, you could buy real estate outside your home to rent. You’ll pay a good chunk upfront, but after that, you’ll barely participate in the business.
- Buying a business but not managing it. As with buying new real estate to rent, purchasing a business requires upfront investment and then little else. Once you legally own part of all of a business, you’re entitled to shares of its profits even if you don’t manage anything. It’s about as low-participation as income gets.
- Uploading online courses. Beyond a certain threshold, uploading online courses may qualify as non-passive income. That would be the case if you were constantly creating and uploading videos. However, if you spend significantly fewer than 500 hours per year on your videos, you won’t qualify as a material participant. At the same time, you’d earn money every time someone bought access to your videos, with no extra work for you.
- Creating apps. As with uploading online courses, creating apps can qualify as passive income if you put minimal work into it. You might invest plentiful time and money into initially making your app, but once it’s uploaded, you can sit back and let people buy it. Your share of the income will be passive.
- Selling stock music. Just as stock photos exist for theoretically infinite businesses to use in all kinds of projects, so too does stock music for videos. You could pursue this passive income path if you have a knack for creating music that would fit well under YouTube videos or TV commercials. In that case, uploading a song every now and again could net you passive income every time someone buys your music for their content.
- Investment income. Technically, the IRS classifies investment and passive income separately. However, this distinction is purely technical. For starters, the IRS taxes both types of income in almost entirely the same ways. Additionally, investment income fits the passive income bill to a tee. You’ll just make an upfront time and money investment, then sit back and – if you’ve played your cards right – watch your money grow.
What is Non-Passive Income?
Non-passive income, also known as active income, describes any income for which the IRS would classify you as a material participant. It entails all work that you actively perform instead of letting go on without your involvement. Most people must classify the bulk of their income as non-passive for tax planning purposes.
How Does Non-Passive Income Work?
Non-passive income is extremely straightforward as compared to passive income. It encompasses personal and business income stemming from activities that demand the bulk of your time and attention. That means your day job or the money you earn from materially participating in businesses that you own. As such, non-passive income is taxed as ordinary income, whereas only certain taxes levied on ordinary income are levied on passive income.
Examples of Non-Passive Income
The below examples of active income should clarify the passive vs. non-passive income distinction:
- Job-related income. Any of your income that you report to the IRS on a W-2 or 1099-NEC form is job-related income. This income, which comprises your wages, is entirely non-passive. So too is any money you earn from commissions, tips, bonuses, and employment (including self-employment).
- Business income, under some conditions. If you own part of all of a business in which you materially participate, your business income is non-passive. For example, if you own the same business for which you work 40 hours per week all year round, your business income is non-passive. If you own a business but have hired other people to manage it in your place, your business income would be passive.
- Active stock trading. This type of investment income differs from simply putting money into stocks, bonds, or cryptocurrency and then sitting back. It instead describes spending ample time trading stocks in hopes of turning a profit. It’s similar to what Wall Street stockbrokers do all day, except you’re doing it for and by yourself.
Difference Between Passive And Non-Passive Income
Perhaps you’ve long thought about things like stocks as passive income and running a business as active income. As you now see, this view paints a picture that’s slightly simpler than how it actually works. More accurately, the distinction between passive and non-passive income comes down to two factors.
- Activity. A passive activity is one that doesn’t meet the IRS’s material participation definition. As such, one-time investments, Airbnb rentals, and ownership of businesses in which you don’t participate count as passive income. On the other hand, employment earnings, participatory business ownership, and hands-on, time-consuming stock trading count as non-passive income.
- Tax rates. If you’ve ever paid taxes on your employment income, you’ve probably noticed that your tax rates can get pretty high. That’s because federal taxes on non-passive earnings actually comprise income, Social Security, and Medicare taxes, not to mention others. Passive income taxes are simpler, as they’re exempt from Social Security and Medicare taxes. They’re also taxed at capital gains rates instead of income tax rates.
- Losses and taxes. When offsetting losses for your taxes, you can group passive income and losses together. You can do the same for non-passive income and losses. However, you can’t group passive and non-passive income and losses together. This means that if your passive loss exceeds your non-passive income, you’re still looking at a hefty tax burden. As such, risky passive income streams aren’t a viable method for lowering your taxes.
How To Earn More Passive Income
When done right, setting up passive income streams can help you achieve greater financial freedom than if you had a single active income source. Just be sure to understand the IRS’ definition of material participation and the potential tax ramifications before you get started. Once you’re ready to begin your passive income journey, read MoneyMash’s guide to quickly earning money for some inspiration.