Passive Income

Definition

Passive income is generally derived from three sources:

Rents: Income earned from leasing property to tenants.
Royalties: Earnings from intellectual property such as books, music, or patents.
Investment Earnings: Dividends, interest, and gains from the sale of securities and other investments.

The Tax Reform Act of 1986 further categorizes passive income and loss as distinct from active income (earned from active participation in the production of goods and services) and portfolio income (earnings from investment sales and interests).

Examples

Here are a few detailed examples of passive income:

Rental Property: If you own an apartment building and lease out the units to tenants, the monthly rental payments you receive are considered passive income, provided you are not involved in the day-to-day operations.
Dividends: If you own shares in a dividend-paying company, the periodic payments you receive are passive income.
Digital Products: If you create an online course, e-book, or software and generate sales or usage revenues automatically over time, the earnings from these sources can be classified as passive income.
Royalties from Creative Works: Authors and musicians often receive periodic income through royalties from their published books or songs being played or downloaded.

Frequently Asked Questions

Q: Can anyone earn passive income? A: Yes, anyone can earn passive income if they acquire assets that generate revenues without requiring active involvement.

Q: What are the tax implications of passive income? A: Passive income is typically subject to different taxation rules than active income, and certain tax deductions might apply. It’s advisable to consult a tax professional for specific regulations.

Q: Is rental income always considered passive? A: Not always. If you are heavily involved in managing the property, the IRS may consider it active income.

Q: Can losses from passive income sources offset active income? A: Generally, passive activity losses can only offset passive activity income and cannot usually offset wages or active income.

Q: Are there limits to how much passive income you can earn? A: There’s no formal limit on the amount of passive income one can earn, but IRS scrutiny and regulations can vary based on the income levels and sources.

Active Income: Income generated from active involvement in a job or business, such as wages, salaries, and commissions.
Portfolio Income: Earnings derived from investments, including dividends, interest, and capital gains.
Passive Activity Income: Specifically refers to revenue linked to passive activities, often highlighted by tax codes to differentiate from active or portfolio income.
Tax Reform Act of 1986: A major U.S. federal tax code reform that redefined various types of income and created specific distinctions between passive, active, and portfolio income.
Royalty Payment: Credited to owners of intellectual property for each use or sale of their works.
Depreciation: The gradual reduction in the value of tangible property over time, which may have tax implications for property owners.

Online Resources

References

IRS Publication 925: Passive Activity and At-Risk Rules.
“The Tax Reform Act of 1986: A Technical Explanation” by Michael J. McIntyre and Oliver Oldman.
“Investing in Apartment Buildings for Beginners” by Jim Ingersoll.

Suggested Books for Further Studies

“Rich Dad Poor Dad” by Robert T. Kiyosaki
“Passive Income Blueprint: Your Practical Guide to Passive Income & Financial Freedom” by Patrick Whithersson
“The Book on Rental Property Investing” by Brandon Turner

Real Estate Basics: Passive Income Fundamentals Quiz

### Which source can be classified as passive income? - [ ] Freelance writing jobs - [x] Royalties from a book - [ ] Salary from a day job - [ ] Commission from sales > **Explanation:** Royalties from a book qualify as passive income because they are earned from intellectual property without active involved effort post-creation. ### What legislation created the distinction of passive vs. active income? - [ ] Financial Literature Act of 1980 - [ ] Real Estate Act of 1982 - [x] Tax Reform Act of 1986 - [ ] Income Tax Act of 1990 > **Explanation:** The Tax Reform Act of 1986 created the distinction between passive income (e.g., rent, royalties) and active income. ### Which of the following is not considered passive income? - [ ] Dividend income - [x] Wages from a part-time job - [ ] Rental property income - [ ] Earnings from limited partnership > **Explanation:** Wages from a part-time job are categorized as active income, as they result from direct and active work. ### Can passive activity losses generally offset active income? - [ ] Yes, always. - [ ] It depends on the type of passive income. - [ ] No, passive activity losses can only offset portfolio income. - [x] No, they typically can only offset passive activity income. > **Explanation:** Passive activity losses usually can offset only passive activity income, not active income. ### What is an example of gaining passive income through investment earnings? - [x] Holding dividend-paying stocks - [ ] Earning overtime at work - [ ] Selling homemade crafts - [ ] Conducting day-to-day property management > **Explanation:** Dividend payments from stocks represent passive income from investments, implying earnings without direct involvement in operations. ### Which type of income does IRS often scrutinize to differentiate between passive and active categories? - [ ] Commercial sales income - [ ] Personal gains from hobby - [x] Rental income - [ ] Salaries of employees > **Explanation:** Rental income often gets scrutinized by the IRS to ascertain if it constitutes passive income or if substantial management efforts make it active income. ### Are royalties from intellectual property considered passive income? - [x] Yes, always - [ ] Only if they exceed certain thresholds - [ ] No, they are portfolio income - [ ] Only when involving partnerships > **Explanation:** Royalties from intellectual property, like books or music, are passive as they generate revenue without requiring the creator's ongoing active involvement. ### Financial gains derived from which investment are considered passive income? - [x] Limited partnership profits - [ ] Self-employment contracts - [ ] Hourly freelance projects - [ ] Teaching fitness classes > **Explanation:** Profits derived from limited partnerships are categorized under passive income as investors generate gains without requiring active participation. ### For rental income to be considered passive, an individual must: - [x] Not be actively managing the property - [ ] Directly manage the sale of all rents - [ ] Earn more than $50,000 annually - [ ] Lease more than three properties > **Explanation:** Rental income is considered passive when the owner isn't actively managing the property, relying on others for daily operations. ### Which statement is true about passive income from digital products? - [ ] It requires constant updating post-launch. - [ ] It counts as active income. - [ ] It can't support long-term financial growth. - [x] It offers passive earnings after initial effort. > **Explanation:** Digital products, after initial creation and launch, generate passive income as they continue to earn revenue without ongoing active involvement.