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What is Passive Interest?
When you are looking to invest, there are hundreds of different ways to do it from stock market index fund investing to real estate investing to starting your own business. The key to figuring out what is right for you is what type of investor do you want to be? The good news: most types of investments have a variety of both types.
Passive income is the money you earn from activities that aren’t defined as active. What is active again? Anytime you are performing a service or supplying a good in exchange for money. You are actively earning that money. It also means that you are participating directly in the company.
It is important to distinguish between active and passive income/interest because the IRS can view those types of earnings differently, and therefore potentially tax them differently. Be sure to always check with a tax professional on these delineations.
What’s an example of active vs passive income as it relates to “material participation” in a business?
- Active income: you go work for a company, providing a good or service, and get paid to do so
- Passive income: you invest some of your own money into the same company, but you do not participate in the operation of that business at all
So, what about passive interest?
Passive interest means essentially collecting returns on a passive investment. As stated above, in a passive investment you have no responsibility over the day to day management of whatever you’re investing in, you are merely putting money into something and making money off of the returns.
So why do people love passive income and interest?
Because active income is typically subjected to higher tax rates. Active income such as holding a job is necessary to build up your initial wealth for investing, but you will want to start looking at moving more of your income into passive investing in the long run. As always, it’s best to always check with a tax professional for more information.
How to determine if you have material participation in a business.
The IRS defines material participation as such: a trade or business activity isn’t passive actively if you materially participated in the activity. They also provide a material participation checklist you can use to help determine if your investments would qualify as active or passive based on material participation. Below is a list from the IRS website but you can get more information here.
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
What is self-charged interest?
When you invest in an S Corporation (specific type of corporation that 100 shareholders or less that allows for the corporation to pass income directly to the shareholders and avoid double taxation), the interest from that income can qualify as passive income.
Different Types of Passive Interest
- Investing: A good example of passive investing is minimizing how many transactions you make by investing in grouped stocks like index funds. Index funds allow the investor to minimize their buying and selling of individual stocks by buying into grouped stocks or stocks that represent a portion of the overall market. This allows investors to avoid fees associated with trading stocks more frequently.
- Real Estate: Rental properties are generally defined as passive income; however, there are a few exceptions to that rule. If you’re a real estate professional, then any income you receive count as active income. If you’re “self-renting” a space out to a corporation or business where you actually conduct business, then it is not considered passive income unless that lease was signed before 1988. Income derived from leasing out land does not qualify as passive income either.
Passive vs Active: Which is right for you?
Only you can determine which type of investing is right for you, and everyone’s situations will be different. However, it is important to research different types of passive vs active investing so that you can fully optimize your portfolio and take advantage of tax opportunities given to passive investors by the IRS.