How is residual income taxed?

Types of Income

Renting out a few properties means you're earning residual, or passive, income.
Renting out a few properties means you're earning residual, or passive, 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:

  1. 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.
  2. 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].
  3. 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.