The Definition of Passive Income According to the IRS
What is passive income?
There are a lot of articles and gurus telling you what passive income is, and in reality what they count as passive income is really a side hustle or another business you have to manage.
Passive income is earnings you receive from other sources than an employer or contractor. It comes from work already completed or that requires little activity or involvement on your part. Any income is subject to tax by the IRS but the amount of tax depends on the type of income, such as passive or nonpassive.
Passive income defined by IRS
According to the IRS, passive income can come from two general sources:
Rental income
Income from a business in which you do not “materially participate on a regular, continuous and substantial basis.”
“Materially participate” means you are actively involved in earning income from that source. The IRS has three general criteria to determine material involvement:
If you have dedicated more than 500 hours in a business venture to that venture.
If your participation has been “substantially all” of the participation in an activity for the tax year.
If you have dedicated 100 hours to a business venture or activity and that is at least equal to the amount of time others have been involved in it.
Ultimately, to take advantage of passive income opportunities, you will need to do two things:
Make an investment.
Find or hire others to tend to the business so you have to do very little to maintain it. Sometimes, you can partner with others responsible for running a business.
The IRS also provides five examples of what could be considered passive income:
Renting or leasing out equipment
Renting out real estate (with some exceptions - see note)
Being the sole owner of a business or farm in which you do not materially participate
Being a part owner in a business but do not participate in its day-to-day operations
Being a limited partner in a business
Note: According to IRS rules, leasing out property counts as active income even if you’re loaning your own property to a company in which you conduct business.
The only exception is for land you gained ownership of before 1988.If you have questions about passive income sources, it’s best to consult the IRS standards for passive income and potentially, a tax professional.
Non-passive income defined by IRS
Income is non-passive when you are actively involved in earning it. The IRS considers the following as nonpassive income:
Salaries
Wages
Guaranteed payments
Sale of undeveloped land or other investment properties
Royalties
Stock and mutual fund dividends
Active stock trading
Active ownership of a business or farm
Active participation in an S corporation or limited liability company (LLC)
Active participation in a trust
