What Is Passive Income and How Does It Work?

Kelly Hernandez
A table has some cookies, a plant, eyeglasses, a cup of tea, and a chalkboard that reads "passive income" on top of it.

Passive income is income that you earn regularly from a source that is not your employer or contractor. According to the Internal Revenue Service (IRS), passive income can come from either a property or business in which you don’t actively participate, such as renting out an investment property you own and collecting this rent monthly.

While passive income is sometimes referred to as “easy money” since it doesn’t require your participation, building up a reliable source of passive income can be work. That said, if you can figure out how to make passive income, it may become another stream of income to help with monthly expenses, or it may help you work toward fulfilling your financial goals, such as retirement.

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How Does Passive Income Work?

In the most basic terms, passive income is money you earn without working for it. Once a passive income stream is set up, you don’t have to participate or engage in regular activities to continue making a profit.

One of the greatest advantages to having a source of passive income is that if this investment experiences a loss, you don’t have to worry about your active source of income taking a hit since active and passive incomes are not managed together. There are also different tax rates for passive income earnings when compared with regular income, so you can take advantage of tax benefits. There are a few ways you can earn passive income.


The IRS may not define stock investments as passive income, but investing in the stock market can allow you to earn income without working at it regularly. You could also invest money into an individual retirement account (IRA) or another retirement account to earn passive income.

Before you invest in stocks or other investment vehicles, do your research to ensure you feel comfortable with the outlook for your investment. Risky investments can sometimes backfire and cause you to lose money instead of earning it.

Self-Charged Interest

You earn self-charged interest as passive income when you make a loan to a company in which you’re invested, then collect on interest payments that the company makes to you. In this position, you’re loaning a lump sum of money to a company at a specific interest rate over a certain loan term.

Before you can set up this passive income stream, you’ll need to save up the money to use for the loan. As long as you use the loan proceeds in a passive activity, the IRS allows you to apply passive income tax rules to the profit you made from self-charged interest.

Rental Properties

Buying properties and renting them out to tenants is a great way to make passive income. However, in most cases, if you can’t pay the full purchase price for a rental home, you’ll need to take out a mortgage, which is paid off slowly over several years. Therefore, you may not be able to pocket this passive income until the rental home is paid off.

With this long-term plan, you’ll need to be patient and not expect to see earnings for a while. However, rental properties can allow you a direct income stream and since the IRS identifies them as passive income, you qualify for tax deductions.

Keep in mind, there are certain risks that come with allowing tenants to live in your investment properties. There’s always a chance your tenants won’t keep up with home maintenance and may cause damage or that they won’t pay rent, which can reduce your potential passive income.

Material Participation and Passive Income

You can earn passive income if you invest in a store, rental property, or business but don’t participate in business decisions or work within the organization. However, if you invest but also actively manage a store, rental property, or other investment designed to earn income, it’s called “material participation,” and what you earn is no longer defined as passive income.

If you engage in material participation, the IRS categorizes your earnings as “active income” and you lose some of the tax benefits associated with passive income. You’re engaging in material participation with your investment if:

  • You’ve dedicated more than 500 hours to the business or activity you’re profiting from.
  • Your participation in this activity, investment, or business is considered “substantially all” that you’ve been participating in this year to make money.
  • You’ve participated in this investment for up to 100 hours, which is just as long, if not longer, than other workers have participated.

How to Make Passive Income

To set up a steady source of passive income, you’ll need to have patience and be realistic about the earnings you expect to make. If you want to be afforded the tax benefits for passive income, be sure you keep within the legal limits as defined by the IRS.

To eventually earn a passive income, you’ll need to:

  1. Decide how you’d like to make passive income.
  2. Save up the initial capital you’ll need for your idea(s).
  3. Invest your money in these plans and set up your passive income stream.
  4. Use tools, such as passive income apps, to help you achieve your earnings goals.

Passive Income Apps

If you’re looking for multiple streams of passive income, you can download and utilize passive income apps on your smartphone. These apps don’t require much participation but you can regularly obtain small earnings or rewards.


You probably already use your smartphone to shop online. After you download Drop and create an account, you can open the app and use it to browse your favorite online stores and make purchases. The more online purchases you make through Drop, the more rewards points you earn. These points can be used as discounts for future purchases with the online stores you frequent, saving you money on the things you were already planning to buy.


The Acorns smartphone app makes investing and diversifying small investments easy. Provide the app with access to your spare change, up to $5 per day, and it automatically invests this money into up to six different exchange-traded funds (ETFs). You can watch your money grow over time when you invest your daily spare change with Acorns.

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