It's been called passive income, recurring income, leveraged income, the best type of income and "the holy grail of investing" [source: Threetypes.com]. Residual income is the opposite of income that you actually work for, which is known as linear or active income.
Compared to the daily grind of earning active income, passive, residual income can come easy. When you own or create something that makes its own money while you are off doing something else, that money is residual income.
You don't have to be Paul McCartney to rack up residuals. You might own properties that you rent out even though you're not a Realtor. Maybe a blog you started took off, and while you no longer work there, you still collect part of the profits. Or perhaps you're a serial entrepreneur who creates companies and moves on. You, too, are earning residual income.
But the regular dividends from that stock that you inherited? Those don't go into the residual bucket.
It's an important distinction because the Internal Revenue Service pays attention to how your residual or passive income is treated on your income tax return. It turns out that some taxpayers try to fit income into the passive category as a way of offsetting and possibly deducting passive losses [source: IRS]. Don't try this at home.
You'll be better able to avoid that once you learn the difference between active and residual income, and how residual income is taxed.
Types of Income
Residual income is synonymous with passive income. But just because income seems passive, that doesn't mean it falls under that category in the eyes of the IRS. Lottery winnings, for example, seem passive but aren't. Passive income specifically means that the income comes from a rental activity or a business in which you do not materially participate [source: IRS].
Generally, income falls into three categories:
- Active income is what you earn from your work or primary activity. It's sometimes referred to as linear income because the amount you earn is directly related to the amount of work you put in. It's fairly consistent.
- Portfolio income includes dividends from stock, bond or mutual fund ownership. Annuity payments also fall under this category. Dividends can be taxed as ordinary income, and certain qualified dividends are taxed at capital gains tax rates [source: IRS].
- Passive or residual income is earned from activities or businesses in which the earner does not materially participate. It's sometimes called leveraged income because one piece of work can create a stream of income that grows over your lifetime.
Material participation is key here because it's different from active participation. There are a lot of guidelines to help you determine whether your participation is material but, in general, the IRS advises that any work you do in connection with an activity in which you own an interest is treated as material participation. In the example above, buying a lottery ticket would be considered material participation [source: IRS].
Types of Passive Income
If the material participation aspect seems confusing, that's because it is. Fortunately, the IRS is very specific about what does and does not qualify as passive income. It falls into two categories: real estate and business income.
If you are a real estate agent, broker or builder, your rental properties don't produce residual or passive income. But if you own a handful of properties that generate rent, that money is considered passive. There are exceptions: Income from leased land might not be considered passive, nor will rental income if you work within a building you own. Property owners might need to clarify this point with an accountant.
Similar rules hold true for passive business income. Your must not be materially involved in the business during the year the income is taxed. It's from past work. If you are not materially involved with — but benefit from — the sale of a company, the gain on the sale will be considered passive.
There might be cases with gray areas, and a tax expert should be able to help you sort out the differences.
Reporting Residual Income
Residual or passive income is taxed in the same way as earned income. The amount you pay is based on your adjusted gross income and federal tax bracket, in addition to your bracket for state and local taxes, if they apply. You pay income taxes for the year in which the gains are received.
The difference is in the losses. Most taxpayers know that certain tax gains can be offset by tax losses, which limits the amount of tax you owe. You may only offset passive income losses with passive income gains — they can't be interchanged or used against gains from other types of income. If you don't have the passive income, your losses are disallowed and will be carried forward for future use [source: Fishman].
Real estate rules differ slightly, however. Generally, rental income is taxed at ordinary income tax rates. But you may take deductions from rental income for depreciation, repairs and expenses. You can sell a property and move the assets into a new property without taking a tax hit. If a property is sold, the income is taxed at capital gains rates [source: IRS]. And with real estate, there is a way to deduct a portion of passive loss from your active income. It's a special allowance that lets individuals who materially participate in a passive rental activity deduct up to $25,000 lost from a non-passive activity [source: IRS].
How to Report Residual Income
Residual income and other types of income are generally reported on Schedule E. Business income may also be listed on Schedule C, and farming income is listed on Schedule F.
In all cases, passive income will be from a venture in which you don't materially participate. If the income is from the sale of a piece of real estate, it may be listed as a capital gain or capital loss on Schedule D. You might also have to include supporting documentation, like a Share of Income statement, by filing a Schedule K-1 with your federal return.
If you are taking passive losses or credits, you must also file federal tax form 8582. If you are still trying to sort out the difference, the form 8582 worksheet is a great resource for defining passive, active or portfolio income [source: IRS].
- Fishman, Stephen. "Can You Deduct Your Rental Losses?" Nolo. November 2013. (Nov. 14, 2014) http://www.nolo.com/legal-encyclopedia/can-you-deduct-your-rental-losses.html
- Internal Revenue Service. "Passive Activity and At-Risk Rules." (Nov. 19, 2014) http://www.irs.gov/publications/p925/ar02.html#en_US_2013_publink1000104579
- Internal Revenue Service. "Passive Activity Loss ATG - Chapter 3, Passive Income." December 2004. (Nov. 14, 2014) http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Passive-Activity-Loss-ATG-Chapter-3-Passive-Income
- Internal Revenue Service. "Special $25,000 Allowance." Publication 925. (Nov. 14, 2014) http://www.irs.gov/publications/p925/ar02.html#en_US_2013_publink1000104571
- Internal Revenue Service. "Topic 404 – Dividends." Aug. 19, 2014. (Nov. 14, 2014) http://www.irs.gov/taxtopics/tc404.html
- Internal Revenue Service. "Topic 414 – Rental Income and Expenses." Aug. 19, 2014. (Nov. 14, 2014) http://www.irs.gov/taxtopics/tc414.html
- Internal Revenue Service. "Topic 425 – Passive Activities – Losses and Credits." Aug. 19, 2014. (Nov. 14, 2014) http://www.irs.gov/taxtopics/tc425.html
- ThreeTypes.com. "Three Types of Income." (Nov. 14, 2014) http://www.threetypes.com/philosophy/the-3-types-of-income/