Personal Finance

How Is Passive Income Taxed?

Do you want to boost your earnings without putting in more time at work? Setting up a way to generate passive income may be a way you can get paid seven days a week, even while you sleep.

Like the name implies, passive income is generated from passive activities, defined by the IRS as trade or business activities you don't materially participate in. This means you earn money without being actively involved or overseeing day-to-day operations. Similar to other forms of income, however, there are tax implications to consider.

Keep reading to learn more about passive income works. We'll also explore how it's taxed and discuss options to create your own passive income streams without investing a ton of time or money.

How Does Passive Income Work?

Passive income is a way to earn money on autopilot. Most opportunities require an upfront investment of time, money or both.

According to IRS Publication 925, there are two forms of passive activities:

  • Business or trade activities that you don't materially participate in.
  • Rental activities (even if you materially participate)—except for activities done to fulfill your duties as a real estate professional.

Common ways to earn passive income include investing in dividend stocks, exchange-traded funds, dividend index funds, bonds, bond index funds, rental properties and high-yield savings accounts. You can also invest in a peer-to-peer lending platform (and earn self-charged interest), real estate investment trust or become a silent partner in a business (without participating "materially").

Some passive income methods don't cost much and are within reach of many people who have an income. These methods can help you build up your retirement savings, but their proceeds may not make much of an impact on your monthly income in the short term. Unfortunately, making passive income that's enough to quit your day job and live off of requires an initial investment that's out of reach of most people.

Is Passive Income Taxable?

Just like income from a full-time job, income earned from passive activities is taxable. If you sell your interest in a passive income activity or sell a property that generates passive income, you are also responsible for taxes on any earnings you make.

The amount you owe, though, will depend on several factors, including the type of passive income source and how much time you spent on the business. Income earned from rental properties is taxed differently from earnings from business or trade activities and cash back credit card rewards. There are many sources of passive income, and you may want to consult a professional to learn more about your specific tax situation.

It can also be a good idea to consult with an accounting professional before you pursue passive income opportunities to make sure you fully understand the potential tax liability so you can be prepared come tax time. They can also provide more insights on recordkeeping and what documentation you may need when filing your return.

Ways to Earn Passive Income

If you want to start earning passive income quickly without investing a ton of time or money, consider these opportunities:

  • Create an investment fund. You can invest in stocks, bonds or both to earn passively. Before you consider this as a passive income method, however, make sure you take care of your emergency savings, retirement fund and minimal debt. If you're ready to start investing, you can use a robo-advisor, online brokerage or work with a financial advisor to open your investment account. Be mindful that returns aren't guaranteed with investment products, so you should only invest what you can afford to lose—a mistimed or unwise investment can easily wipe out your initial investment.
  • Sell unwanted items online. Consider listing items you no longer want or need on online marketplaces. Some charge a small listing fee, and others let you post for free. You don't have to market the items as shoppers will come on and browse for what they want. The only action required on your part is packing and shipping (or delivering) the items once they sell.
  • Rent out a parking space or spare vehicle. Is there a high demand for parking spaces where you live? Consider renting out a space in your garage or driveway. Renting out your car when it's not in use through a mobile app, like Turo or Getaround, can earn you a few hundred dollars per month. They simplify the rental process by connecting you with potential renters. Before pursuing this opportunity, check with your insurance company first to ensure you won't be penalized or lose your coverage.
  • Download coupon or cash back apps. Sites like Coupons.com and RetailMeNot can help you get coupons that save you big on groceries and household items. You can also use browser extensions from sites like Ibotta and Rakuten to earn rewards when shopping with your favorite brands.
  • Earn cash back from your credit card. You can get paid for making everyday purchases with a cash back rewards credit card. If you don't have a cash back rewards credit card, use Experian CreditMatch™ to find options you may qualify for. You could also opt for a travel rewards credit card that earns you points you can redeem for things like airfare and hotel stays.
  • Rent out a spare bedroom in your home. Do you have extra space in your home that you don't use often? Create a listing on Airbnb or a similar service to rent it out and streamline the payment process. You can also hire a cleaning service to tidy up the space between rentals, although this may eat into your profit.
  • Become an affiliate marketer. If you already have an online platform with a large following, take advantage of affiliate marketing opportunities. You'll have to spend a little time figuring out how to promote the product or service, but you probably won't have to invest to start earning money. But be mindful that U.S. law requires you to disclose to readers that you'll earn money if they make a purchase using your affiliate link.

Start Earning Passive Income

You can use passive income to supplement or replace your income from a job. If you haven't yet started, explore a few low-cost ideas that are relatively easy to set up to get your feet wet. Once you have some experience under your belt, you can set up multiple streams to maximize your earning potential and potentially improve your financial health.