Passive income is a trending word nowadays, but what is passive income after all? What is the difference between active and passive income. Learn more in detail in this active vs passive income comparison.
Regardless of the college or high school you went to; it’s likely that they didn’t teach you much about financing and money-making.
However, as you step into practical life, it’s crucial to be familiar with these things, especially once you’re required to be financially independent.
Keeping it short and simple, all money falls into two categories: active income and passive income. Both these kinds have their own benefits and long-term results.
In this active vs passive income comparison, you’ll learn the difference between the two and how you can earn from both streams individually or simultaneously.
So, let’s dive right into it.
What Is Active Income?
What Is Active Income?
Active income refers to the money you earn by actively performing a duty or service. It includes commissions, tips, wages, and salaries from the job/s you’re actively doing.
The most common type of active income is the paycheck you get from your employer. However, active income isn’t limited to that since some other factors also come into play.
For an income to be considered active, it must pass the Material Participation Tests by the Internal Revenue Service in the US.
Material Participation is a criterion set by the IRS to determine if a taxpayer materially partook in an income-producing activity, including rental, business, or trade.
To prove material participation, a taxpayer has to pass at least one of the seven tests.
Material Participation Tests
The taxpayer or their spouse should meet one of the material participation tests to qualify a venture as an active income.
Although there are seven material participation tests, here are the three most integral ones that form the basis of others too.
- The taxpayer participated in the venture for over 500 hours in the tax year.
- The taxpayer was substantially involved in business activities.
- The taxpayer was involved in the venture for 100 hours, and no other individual in the business worked for more than 100 hours.
The material participation tests can be a bit tricky to understand since the time spent on a business does not always count in the number of hours.
For example, if you’ve spent time as an investor, it would not count in your 500 or 100 hours unless there’s proof of your direct involvement in the management activities of the business. Moreover, any time you spend commuting is not counted in the duration.
As an owner, any work you don’t do customarily is not counted in the material participation hours. Most importantly, if you participate in a managerial activity in a way that other managers do not get any compensation, it does not count towards your total hours.
Even if you own a business, it’s not considered your active income unless you’re actively participating in it.
Simply put, you should be working to make the money instead of getting capital benefits without putting in active participation.
Active vs Passive Income: A Simple Example
Here’s a simple example to explain how two people working in the same company, being co-owners, can have different types of income.
For instance, A and B have an online business with a 50% interest each.
A does most of the work, like packaging orders and dropping them off for shipping. The IRS would consider his income as active.
On the other hand, B also contributes to the business but in the marketing department. B works under 100 hours a year.
Thus, her income would be called passive by the IRS even though she puts in work.
The material participation rule helps stop people who’re not actively participating in a business from leveraging their work to generate tax losses and write them off.
What is Passive Income?
What Is Passive Income?
Passive Income refers to the earnings from a limited partnership, rental property, or a stream in which an individual does not actively participate.
Although usually taxable, the regulations are different for passive income.
Like active income, material participation tests also apply to passive revenues. If you do not meet any of the tests, your income is considered passive by the IRS.
Grouping Passive Income
If you’re fortunate enough to have multiple streams of passive income, you must know how to group them too. For example, let’s suppose you own three different properties – a house, warehouse, and shop – in different states.
Now, you can group them in one of the following four ways:
- According to their activity (they’re all rentals).
- Grouped by type (storage, residence, commercial).
- According to geography (different states).
- Ungrouped
Active Income vs Passive Income: A Simple Example
We can use the previous example for a passive vs active business income comparison. In that example, B worked less than 100 hours a year, although she contributed to the online business through her marketing skills.
However, she was not actively working in the day-to-day activities of the business.
Therefore, B was earning a passive income among the duo.
Active vs Passive Income: Taxation Differences
Active vs Passive Income – Tax Differences
When speaking of active income vs passive income, a common question that comes up is: is passive income taxable? To understand this, we need to consider two things.
First, what is the difference between active income and passive income? Second, how does the IRS tax people in the US?
Let’s discuss this in detail.
Income Tax in the US
Quite simply, the IRS has a tax code that gives different tax treatments to incomes, depending on varying factors.
One of the critical distinctions in this regard stems from the treatment of revenues as ordinary or passive.
Active or ordinary incomes fall under the seven tax brackets set by the IRS. The taxable treatment in these tiers goes from 10% to 37%, with the latter having gone down from 39.6% after the 2018 tax reforms.
On the other hand, passive income may be more beneficial because it does not come under these brackets. Instead, passive income gets favorable rates due to long-term capital gains.
Active vs Passive Income Real Estate
Active vs Passive Income Real Estate
Benefits and Disadvantages of Active Investing
Real estate investors who like the idea of being a landlord may find active real estate investing exactly what they are looking for, or maybe not. Here are some of the benefits and disadvantages of active real estate investing:
Benefits:
- Maximum control over the real estate investment.
- Tax benefits flow directly to the investor.
- Minimum fees since a leasing agent and property manager isn’t being paid.
Disadvantages:
- Investors must understand the ins and outs of managing rental property.
- Requires detailed knowledge of the market, including growth trends and landlord-tenant laws.
- Least liquidity because large amounts of capital are tied up in the property down payment.
- Difficult to scale up and diversify a real estate portfolio when every investment is actively managed.
Active Income Investments:
Active investors are responsible for a variety of tasks, including analyzing deals, purchasing the property, updating the property, renting and dealing with tenants, and ensuring that all of the housing, zoning, and other regulatory laws are followed.
Two examples of active income investments are property flipping and short-term rental investments.
Property flipping.
An investor has to find an owner willing to sell below the market price, accurately estimate the cost of repairs and renovations, and flip the property fast enough to make a profit before market conditions change.
Short-term rental investments.
Short term investments can include activities such as renting out a room, owning and managing a vacation rental property where tenants turnover quickly, or even owning a rental property where the tenant is on a month-to-month lease.
Gross rental income can be higher with short-term rentals, the landlord isn’t saddled with the same tenant, and repairs can be easier to stay on top of because the owner is inside the property more frequently.
However, short term investments also require more work. That’s because owning a short term rental property is similar to being in the hospitality business. An investor is constantly looking for the next guest, making sure the place is fully furnished and clean, and doing everything possible to make sure a short term tenant leaves a good review.
Self-storage investing.
Self-storage is an attractive investment due to potentially high gross revenues combined with low operating expenses. Smaller self-storage properties require a low level of ongoing property management, making the asset class a potential option for active real estate investing. Investors can develop a self-storage project from the ground up, or invest in an existing property.
However, although profit margins on self-storage investments can be high, many investors choose to passively invest in a self-storage project as a limited partner. That’s because successfully developing a self-storage facility requires a high level of experience and knowledge.
Land must be purchased in markets where demand is high and supply is low, developers need to understand local municipal zoning procedures, and construction costs and timelines must stay at budget so that the property can be quickly leased-up.
“Though it may appear easy, self storage management requires experience and knowledge.”
Benefits and Disadvantages of Passive Investing
Passive real estate investing can be the perfect match for investors who want to realize the benefits of owning real estate without having to directly manage or own the property. Here are some of the benefits and disadvantages of passive real estate investing:
Benefits:
- Requires minimal knowledge of managing investment real estate.
- Easier to diversify by investing small amounts of capital in multiple projects.
- Access to investment-grade properties that are difficult for smaller investors to purchase on their own.
- Liquidity may also be greater when investing in publicly traded REITs.
Disadvantages:
- Much less control over the real estate investment.
- Not all tax benefits may flow directly to the investor.
- More overhead and fees paid to third parties who oversee the investment and share in the profits.
Passive Income Investments:
Passive real estate investors outsource the majority of the investment process to a fund manager or general partner of a private equity investment. These professionals literally see hundreds of investment opportunities each year and can select deals that offer the highest potential return while working to minimize risk.
Two examples of passive income investments are investing in long-term rental properties and REITs.
Investing in rental properties.
Investing in long-term rental property is one of the most common types of passive real estate investing. In residential real estate, long-term tenants typically sign a 12-month lease, while tenants in commercial properties often have lease agreements of 5 years, 10 years, or more.
Because residential rental property is in short supply in most markets across the country, tenants often renew their lease. Recent research reports that the average U.S. renter stays in a building 27.5 months. This means that investors who own long-term rental properties spend less money on tenant-turn expenses, such as marketing, leasing, and repairing the property each time a tenant leaves.
Special use property such as self-storage exhibits similar characteristics. The average rental duration of a self-storage unit is 14 months, with nearly 50% of self-storage customers renting for more than one year. With about 13.5 million households – or 10.6% of all households in the U.S. – renting a self-storage unit, the industry generates annual gross revenues of $39.5 billion, according to SquareFoot Storage Beat.
Self-storage investors may also see better returns than owners of residential rental property. The national average cost per square foot of a self-storage unit is $0.91 per month, which is about the same cost to rent an apartment in some cities. Owning and operating a self-storage facility is also much less labor intensive. With a national average occupancy of about 92%, the average profit margin of self storage operators is 41%, roughly double the average profit margin of all industries.
REITs
Real estate investment trusts (REITs) are an easy way to own shares of income producing real estate. Many of the largest REITs such as American Tower, Prologis, Public Storage, and Equity Residential are publicly traded on the major stock exchanges.
REITs are highly liquid, because shares can be traded just like any other stock or bond. Many REITs focus on specific real estate asset classes, such as single-family rental property or self-storage.
There are some potential drawbacks to investing in a REIT as well. For example, dividends are taxed as regular income, and there may be multiple levels of management and transaction fees. With that being said, investing some capital in one or more REITs may be a good way to diversify an investment portfolio.
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