At surface level, passive income is fairly self explanatory. It entails the earning of income in a manor that does not involve active participation.
Income earned from active participation is often referred to as ‘earned income’, so it would stand to reason that all income that isn’t active or earned income would fall under the passive income umbrella.
However, that is not the case.
There are 3 main categories of income:
In this article we will focus on passive income, but if you would like to learn more about portfolio income you can click here.
So what makes passive income passive?
According to the IRS, passive income is “net rental income” or “income from a business in which the taxpayer does not materially participate.''
It does not involve, “salaries, portfolio, or investment income”.
So if it involves your time, it is most likely not passive income.
However, just because it doesn’t require your time, it doesn’t mean it is by default passive, at least according to the technical definition.
Today, passive income has turned into a buzzword of sorts by proponents of the earn-money-online, work-from-home, and be-your-own-boss movements. While these activities may have characteristics of passive income, they do not meet the technical definition of passive income.
The two best examples of passive income are rental real estate and income received from business interests where you do not materially participate.
There are some exceptions to the rental real estate though.
If you are a real estate professional then income received from real estate related activities may not qualify, however, there may be other benefits to qualify as a real estate professional that are beyond the scope of this article.
For all intents and purposes, if you own a single family home, duplex, apartment complex, office or industrial building that generates income from tenants who pay rent, and you are not a real estate professional, then you are likely earning passive income.
Additionally, if you invested in a privately owned business in which you do not work or manage, then that too is likely passive income.
Why is passive income important?
From a financial planning perspective, passive income is important because it is a key factor in achieving financial freedom.
If you want money to be able to afford you the luxury of having more time freedom, then it is imperative that you build sources of portfolio income and streams of passive income.
Passive income is a great example of money working for you versus you working for money.
There may also be additional tax benefits to this type of income that I would encourage you to visit with your CPA about.
