For many people, passive income sounds like the dream. After all, who doesn’t want to earn extra income on autopilot? Especially in 2022, as we are all dealing with the effects of high inflation rates.
Let’s look at what society considers to be passive income, how to get started earning passive income, and how much work it actually takes to maintain passive income streams.
Passive income explained
When you hear the term “passive income,” you’re probably envisioning an effortless side hustle or investment opportunity that you can use to “get rich quick” or obtain financial freedom.
While it’s true that passive income is a great way to pad your salary and make extra money with minimal effort, it’s important to set realistic expectations. There is no “one size fits all” approach when it comes to choosing which income streams work for you. In the beginning, many passive income streams require a lot of upfront work or a significant monetary investment (or both) before you can sit back and start reaping the benefits.
What does the IRS consider passive income?
In this article, we’re going to be discussing what society considers to be passive income. But on the more technical side, the IRS has strict rules for what qualifies as a passive activity from a tax standpoint.
You can read more about the formal passive activity rules and how to report that income on your taxes in this article.
Beginner-friendly ways to generate passive income
- Renting out your house or other property
- Renting out or selling household items
- Advertising and affiliate marketing
- Investing your money
- Opening a high-yield savings account
- Using credit cards that offer cashback or other rewards
- Creating or selling goods online (eBooks, photography, designs, apps, Etsy, etc.)
How to build wealth with passive income
Let’s dive into the passive income ideas listed above and how to report each income source on your federal income tax return.
1. Renting out your home or other property
If you live in an area with a lot of tourism, renting out your space could be a great passive income opportunity. Websites like Airbnb and VRBO make it easy for you to market your listing, connect with tenants, and set your own rental rules. You could choose to rent out one room in your house or your whole place — the choice is yours. (Although, if you are a renter yourself, always be sure to check your lease or ask your landlord about their subletting rules.)
Planning on being gone for a short period? You could also consider renting out your house while you are away.
The IRS has a special “minimal rental use” rule allowing you to rent out your residence for less than 15 days a year without needing to report any rental income. However, you cannot deduct any rental expenses to reduce your taxable income. This could be especially lucrative if you live in an area near a major yearly event that draws many visitors to your city for a short period.
You can learn more about the tax implications of owning different kinds of rental properties in this article.
2. Renting or selling household items
If you want something even more low-risk, you could start renting out useful household items that not everyone has but occasionally needs. When you already have certain items on hand, there could be little to no upfront cost for you. Think hobby-specific items like tents, campers, and camping supplies or expensive gear for household projects like power tools, lawn mowers, etc. Carsharing apps like Turo even allow you to rent out your vehicle.
Reporting this income on your tax return depends on if you are in the business of renting your personal property or not. If you are a business, you’ll report that rental income and any expenses on Schedule C. If you are not a business, you can report that income on Schedule 1, line 8k, of your 1040.
You can also consider selling items you have around the house that you rarely use or need. Just be aware that in 2022, the IRS implemented new reporting thresholds for goods sold via third-party payment apps and online marketplaces (like Venmo, eBay, etc.). If you accept credit cards or payment through these apps, it might be a good idea to familiarize yourself with these changes.
3. Affiliate marketing
Do you have a large online following? Maybe you run a website, write a blog, or have thousands of Instagram followers — if so, affiliate marketing could be an option to earn some extra cash.
Here’s how affiliate marketing works: You promote a third-party product on your social media account or website. Every time someone clicks on your promotion and makes a purchase, you earn a small commission.
Income tax, Social Security, and Medicare taxes for income earned by affiliate marketing are generally not withheld upfront, so you must remember to set some cash aside to pay any income taxes or self-employment taxes when the time comes.
4. Use your money to make money (dividend stocks, bonds, other investments)
Why not use the money you already have to make even more money?
If you have some extra cash on hand, there are many ways to invest it and watch it grow. Dividend stocks are one way to go. As a dividend stock shareholder, you’ll typically receive quarterly dividend payments from the company — and all you have to do is own the stock.
Your dividend income will be reported to you during tax season on Form 1099-DIV. Ordinary dividends or stock sales are taxed at capital gains tax rates. Qualified dividends that meet certain requirements are taxed at lower capital gain rates.
How much dividends are taxed also depends on how long you held the stock before selling. Short-term capital gains (when you held the item for a year or less) are taxed as ordinary income, while long-term capital gains (when you held the item for longer than one year) can be taxed at a rate of 0, 15, or 20 percent, depending on your filing status and taxable income.
Another method some investors like to use is a “bond ladder,” where you stagger purchases of multiple bonds set to mature at different times over the years. Once one bond matures, you collect any interest and use the principal to buy a new set of bonds. After redeeming a bond, you’ll receive Form 1099-INT for your taxes detailing how much interest the bond earned. Treasury bills, notes, and bonds are subject to federal income tax but exempt from all state and local income taxes.
5. High-yield savings accounts
Some online banks offer savings accounts with higher interest rates than you would typically receive at your standard local bank. While a high-yield savings account won’t make you rich, it can act as a way for you to maximize your earning potential on your emergency fund or other savings. And since these banks are often online, you’ll be able to pick the highest interest rate available rather than settling for whatever rate your local bank offers.
Like savings bonds, any interest you earn on your high-yield savings account will be reported to you on Form 1099-INT.
6. Cashback credit cards
If you already pay your bills with a credit card, it could be advantageous to apply for a credit card with a cashback rewards program (just be wary of any annual fees).
The IRS generally considers cashback rewards to be a discount or rebate rather than a source of income, so the cash you receive from these types of credit cards is typically not taxable.
7. Creating or selling goods online
Sometimes you can turn your hobby into a source of revenue. Artists can sell their designs or art online via sites like Etsy, photographers can offer digital or photo prints for sale, tech-savvy developers can design an app for public use, writers can put an eBook up for sale — just to name a few ideas.
While all these options require a lot of upfront work, they could be potential sources of passive revenue in the future if you manage to find the right demand.
As long as you aren’t selling as a formal business such as a corporation or partnership, you’d report any income generated through online sales as a sole proprietor using Schedule C.