Creating a passive income stream is a way to earn extra money without taking much of your time and effort. People who have talents they would like to share, property they would like to rent or capital they would like to invest may be able to take part in passive income opportunities. However, the IRS has particular standards of what can and cannot be classified as passive income.
In this article, we explain what passive income is, ways you may generate passive revenue streams and semi-passive opportunities for income.
What is passive income?
According to the Internal Revenue Service, passive income is any income gained from renting property or equipment (regardless of the lender’s involvement) or the involvement in partnerships or other business enterprises in which you do not “materially participate on a regular, continuous, and substantial basis.”
Being “materially involved” means that the taxpayer is actively involved in earning income from a particular source. There are three general criteria that the IRS has established to determine material participation:
You are materially involved in a business venture if you have dedicated more than 500 hours to that venture.
You are materially involved in an activity if your participation has been “substantially all” of the participation in that activity for the tax year.
You are materially involved in a business venture or activity if you dedicated 100 hours to it and that is at least equal to the amount of time others have been involved in that activity.
The IRS also provides five examples of what could be considered passive income. The following all qualify as passive activities:
- Rent or lease equipment.
- Rent out real estate (with some exceptions).
- Become the sole owner of a business or farm in which you do not materially participate.
- Become a part owner in a business but do not participate in its day-to-day operations.
- Become 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 any land you gained ownership of before 1988._
What is nonpassive income?
Income is nonpassive when you are actively involved in the process of earning it. The above activities are considered passive because the taxpayer doesn’t do much to make money from those sources. If you do the following, the IRS would consider what you’re doing not to be passive activities:
- Earn a salary.
- Earn wages.
- Receive guaranteed payments.
- Receive income from interests and dividends.
- Receive income from stocks and bonds.
- Sell undeveloped land or other investment properties.
- Earn royalties.
- Own a business or a farm in which you have an active role.
- Participate actively in a partnership, an S corporation or a limited liability company (LLC)
- Participate actively in a trust.
Related: Work From Home Jobs That Pay Well
Ways to generate passive income
Ultimately, to take advantage of passive income opportunities, you will need to do two things. First, make an investment. Second, find people who will help you by participating in certain activities. In most cases, to earn passive income you need to hire someone else to tend to a business venture or take part in an activity so you will have to do very little to maintain it. Sometimes, you can partner with others responsible for running a business.
Here are a few ways you can generate passive income according to the definitions and examples provided by the IRS:
Renting or leasing equipment: You can earn passive income by leasing equipment through your business. If you lease equipment through a standing business, customers sign a long-term agreement to rent the equipment. Again, this is only passive income provided you take no active role in the business. That means you would have to hire someone to take care of the day-to-day responsibilities and interact with renters.
Renting out real estate:
You can earn passive income by buying an apartment building and having paying tenants: This counts as passive income as long as you are not a hands-on landlord, but instead hires someone to manage the building and be responsible for collecting rent, making repairs, etc.
You can rent out other forms of housing provided its management is like that of an apartment building: Again, you will have to hire someone to manage the property and interact with tenants.
Owning or buying a business or farm:
Become the sole owner of a farm but do not materially participate in its operations: To do this, you will have to hire someone to tend to the business or farm.
Own a vending machine business: If you buy a vending machine business, that could be a passive or non-passive activity depending on what you do with the business. If you find businesses to place your machines and ask those businesses about employee preferences for items you stock in those machines, you are substantially taking part in the business. However, if you hire someone to stock the machines and delegate other substantial responsibilities to others, this is a passive activity.
Buy a blog or website: Starting a blog is a nonpassive activity given the amount of work you need to do to keep it running and earn money. However, you can turn a blog into a passive source of income if you buy one that’s already established and hire someone else to write posts and manage it daily. The same principle for buying a blog applies to buying any other website and getting others to run it.
Becoming a limited partner in a business: If you become a silent partner in a business, you do not actively play a role in it. You are an investor, and will thus earn any profits made from the business, but you do not have a say in how the business is run.
Becoming a part owner in a business:
You can become a nonactive part owner of a business, such as a limited liability company (LLC): An LLC is a partnership-like business, and the level of participation for each member can be outlined in the company’s charter. As long as you don’t take part in the day-to-day operations of that business, but some other members do, any income you earn from the business is considered passive.
Become a part owner of an S corporation: If you were to become a part owner of a business entity like an S corporation (in which the business itself is not taxed), you will reap any profits the business produces. However, if you don’t take an active role in this business, you are earning those profits passively. Alternatively, you can use an S corporation as a pass-through entity, meaning you can avoid double taxation.
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Semi-passive income opportunities
Some activities are commonly regarded as passive income because they involve little effort or only initial effort, but are not regarded as passive income by the IRS. Although non-passive, these activities can still be worth considering if you have a limited budget or want to find an alternative way to earn an income:
Become part of a peer-to-peer lending group: When people take part in peer-to-peer (P2P) loaning, one person loans to a borrower through a third-party intermediary. These loans might be a good source of income for lenders due to the interest rates alone. Lenders can earn interest rates as high as 10% each year. This isn’t a completely passive activity because lenders are given a say regarding with whom they lend.
Start a blog: Starting a basic blog is a fairly simple process. However, to make money, a blogger needs to buy a plan with a hosting site and sign up with a company to allow that company to host ads on their site. Some plans cost less than three dollars a month and signing up with an ad service is free. Bloggers can make money based on the volume of traffic their website gets per month or per day and if any visitors click on the ads. However, while blogs can earn income twenty-four hours a day by pairing with advertisers or using an ad service, the blogger must actively take part in running the blog by writing content, monitoring traffic, moderating comments and making sure the website is user-friendly. Each payment the owner of the website receives from advertisers is essentially a commission.
Affiliate marketing: Bloggers can earn extra money by promoting certain products, services or businesses. Bloggers might be paid just to advertise the services and receive extra commissions each time readers click any links connecting them to a business’ website. However, for this arrangement to work, bloggers must promote products, services or businesses they partner with. They will generally write blog posts and edit pages that point to those products, services or businesses.
Start an online course: This can be a good revenue stream provided that you have a large enough library and the information in the course remains highly relevant. After your work is finished, you can start earning money if there is a high enough demand for that information. This is semi-passive income because of the level of work involved to earn money from it. Not only do instructors have to make videos and reading materials for online courses, but they must actively promote their work to garner attention for it and to convince visitors to pay for exclusive content.
Write a book: Writing a book may seem like a passive income opportunity because writers can earn royalties long after the book is finished. However, royalties are treated as nonpassive income by the IRS.
Robo-investing: All you need to do to robo-invest is to sign up with an online robo-advisor, which does all the work. Robo-investors can earn money while they’re doing other things. However, robo-investors are participating in the stock market, and receiving income from stocks and bonds is considered a nonpassive activity.
Sell merchandise on a website: When people sell merchandise on a website, much of the work of selling is done for them, depending on the website they use. Users can click links to view products and pay electronically. Sellers don’t have to pitch to prospective customers or ring up purchases like they would in a physical store. However, this activity requires active participation, especially if you make your own merchandise.
Rent out your personal equipment: If you have camping or sporting gear that’s in good condition and you rarely use it, you can rent it out for extra money. This might be a lucrative activity, provided your borrowers are reliable. However, this is counted as nonpassive income if you interact directly with the people borrowing your equipment.