Everyone could benefit from additional income, and passive income is one way to try and create some extra cash. Learn how you can make passive income a regular source of earnings for you.
What is Passive Income?
Passive income is defined by the Internal Revenue Service as “unearned income” (see below), though in common parlance it has come to be known as monies that you regularly earn beyond the work you perform as an employee or as a contractor. The basic idea, it follows, is that you create a reality where you are earning income without working actively for it as part of your day job or profession.
Using the term passive is a bit of a misnomer, however, and it certainly does not mean that work is not involved. Figuring out a way to earn passive income does require an initial outlay of capital, effort, and in most cases a combination of the two.
To better understand this concept, we can consider a residential property that you own and rent out. In this instance, you have either purchased or inherited a property, which earns you money through rent payments. Unless you work in real estate, you manage this property in addition to your regular job.
Dividend-paying stocks are also a form of passive income. After an initial outlay of capital to purchase these stocks, you can expect to receive regular dividend payments. The ongoing work involved will depend on how active an investor you intend to be.
TipRanks’ Dividend Center can help you explore potential dividend-paying companies, and which ones might make sense for you to invest in.
Ways to Make Passive Income
You can use your capital, property, or intellectual assets to make passive income.
Having a nice pot of money to invest will allow you to purchase residential properties or dividend-paying stocks or funds. The regular payments you receive via monthly rental checks or quarterly dividends can go directly into your bank account.
For those without an initial amount of sufficient cash on hand, there are other ways to try to build passive income. Think creatively about the assets you own; it is possible that you possess items that people might be interested in renting. The sharing economy has allowed people to rent out their homes, cars, and even swimming pools for short periods of time.
If you do not have a physical asset that you could rent out, perhaps you could create some intellectual property that you could sell. You could write and publish an e-book, license your photographs, or even develop and teach an on-line course. Each of these would require no small amount of work, but if your creations are of a high enough quality they could bring in revenues through royalty payments for years to come.
Are Investments Truly Passive Income?
In a classic sense, investments can be considered passive income. You place your funds in an investment for a certain period, after which you receive more money than you started with (in an ideal scenario).
However, for many of these investments, you will only receive your monies at the end of this specified period of time. High-yield savings accounts, Certificates of Deposit, and bonds are essentially loans that you will be paid back. You will not receive regular income payments throughout the course of your investment.
Similar to non-dividend-paying stocks, even as the value of your investments increase, you will enjoy your cash only when you sell-off at least a portion of these assets. Your portfolio represents the wealth you are building, though it will not provide you with passive income on a regular basis.
What are the Tax Implications of Passive Income?
The short answer is that passive income is considered taxable income by the Internal Revenue Service (also known as the IRS), and usually taxed as ordinary income. That being said, there are some wrinkles to grasp.
First off, it is important to understand how the IRS defines passive income. According to them, there are two types of passive activities.
- (1) Residential real estate rentals: As in the aforementioned example, these are properties that you own and receive rental income for. (This only applies if your day job does not involve real estate transactions).
- (2) Trade or business activities in which you do not materially participate in: In other words, businesses or enterprises that you are financially invested in but do not take an active role in running. A limited partnership in which you are not the general partner is one such example.
There are a couple of benefits of having your income qualify as passive. The first, is that passive income is generally taxed using the capital gains taxation rate, which ranges from 0-20% based on your overall levels of income. (The ordinary income tax range is 10-37%). The second, is that losses from passive activities can be deducted from gains from other passive activities. (There is also a $25,000 special allowance that will allow married couples filing jointly to deduct up to $25,000 from losses on their rental properties against their nonpassive income.)
By the above definition, dividends are not considered passive income. Depending on the type of dividend you own (ordinary or qualified), dividends are taxed as either capital gains or at the same levels as your income taxes. Similarly, royalties you receive or intellectual property that you license will likely be taxed as ordinary income as well.
Conclusion: Making Passive Income Work for You
Passive income is not just for the rich and famous, and everyone has the potential to figure out mechanisms that would make it a real possibility for them.
Passive income can help line your pockets, without causing you to spend your time and energies actively working, propelling yourself and your family towards financial security.
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