What is passive income? Types, ideas, and how to get started
Passive income can diversify your revenue and build financial resilience. Here's how to get started.
December 2023 | Published by Xero
Published Monday 15 June 2026
Table of contents
Key takeaways
- Passive income is money you earn with minimal ongoing effort, such as rental income, dividends, or revenue from digital products. It can help smooth out cash flow and reduce your reliance on a single revenue source.
- The IRS treats passive income differently from active income, with specific rules around passive activities and rental properties. Understanding these distinctions can help you plan your tax obligations more effectively.
- Small business owners are well positioned to create passive income streams by turning existing expertise into digital products, online courses, or affiliate partnerships.
- Tracking passive income alongside your core business revenue gives you a clearer picture of your total financial health. Accounting software like Xero can help you organize multiple income streams in 1 place.
What is passive income?
Passive income is a term that gets used a lot, but it's worth understanding what it actually means for your finances and your business.
At its simplest, passive income is earnings you receive from a source that doesn't require your direct, day-to-day involvement. Unlike active income, where you're trading time for money through a salary, hourly wages, or hands-on client work, passive income keeps flowing with minimal ongoing effort once you've done the initial setup.
Think of it this way: active income stops when you stop working. Passive income continues generating revenue even when you're focused on other parts of your business or taking time off.
The IRS has its own definition worth knowing. According to the IRS, passive activities include any trade or business in which you don't materially participate, plus most rental activities regardless of your level of involvement. Material participation generally means you're involved in the operations on a regular, continuous, and substantial basis.
This distinction matters because the IRS applies different rules to how passive income is taxed and how losses from passive activities can be used. You'll find more on that in the tax section below.
Types of passive income
Passive income streams generally fall into a few broad categories, and understanding these categories can help you decide which approach fits your situation best.
Business-based passive income comes from building systems or products that generate revenue without requiring your constant attention. This includes digital products, licensing, franchising, or automating parts of an existing business. If you already run a small business, this category often offers the most natural entry point.
Investment-based passive income involves putting money to work through financial instruments. Dividend stocks, bonds, real estate investment trusts (REITs), and rental properties all fall into this bucket. These streams typically require capital upfront but can produce consistent returns over time.
Non-business passive income covers earnings from creative works, royalties, or other assets. This might include royalties from a book you've written, licensing fees for photography, or revenue from content you've published online.
According to Xero Small Business Insights, US small business sales growth averaged just 2.4% year-over-year in 2025, around half the long-term average of 5.5%. This volatility highlights why many business owners look beyond their core revenue for additional income streams.
Passive income ideas for small business owners
As a small business owner, you already have knowledge and an audience that can be turned into passive income. Here are some practical ideas to consider.
Digital products
You can package your expertise into downloadable products that sell on autopilot. These work especially well because there's no inventory to manage and no shipping to worry about.
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Disclaimer
This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.
- Templates and spreadsheets related to your industry (for example, budgeting templates, project plans, or design assets).
- Ebooks or guides that solve a specific problem your customers frequently ask about.
- Printable planners, checklists, or worksheets.
- Stock photography or design elements if you have a creative background.
Online courses and workshops
If you're skilled at teaching, online courses let you share your knowledge once and sell it repeatedly. Platforms like Teachable, Udemy, or Skillshare make it straightforward to host and sell courses without building your own infrastructure.
Consider topics where you already answer questions from clients or peers. Those frequently asked questions often make the best course material.
Affiliate marketing
You can recommend products and services you already use in your business and earn a commission when your audience purchases through your referral link. This works well if you have a website, blog, email newsletter, or social media following.
The key is to recommend products that genuinely align with your audience's needs. Authenticity builds trust, and trust drives conversions.
Content creation and advertising
A blog, YouTube channel, or podcast that attracts a steady audience can generate passive revenue through advertising, sponsorships, or paid memberships. While building the audience requires upfront effort, the content you create can continue earning for months or years.
Licensing your expertise
If you've developed proprietary processes, software tools, or training materials, you can license them to other businesses. This is particularly relevant for consultants, contractors, and service providers who've built repeatable systems. It can also work well as a side hustle alongside your primary business.
Investment-based passive income streams
Investing is one of the most traditional paths to passive income. Here's a quick overview of common investment-based options to explore.
Dividend stocks
Some publicly traded companies pay regular dividends to shareholders. By building a portfolio of dividend-paying stocks, you can create a recurring income stream. The amount depends on how much you invest and the dividend yield of the stocks you choose.
Bonds and bond funds
Bonds are essentially loans you make to governments or corporations in exchange for regular interest payments. Bond funds pool multiple bonds together, offering diversification. They're generally considered lower risk than stocks, though they typically offer lower returns as well.
Real estate investment trusts
REITs let you invest in real estate without buying or managing physical property. They're traded on major stock exchanges and are required to distribute at least 90% of their taxable income to shareholders as dividends.
High-yield savings accounts and CDs
These are the most straightforward options. High-yield savings accounts offer better interest rates than traditional savings accounts, while certificates of deposit (CDs) lock your money for a set term in exchange for a guaranteed rate. Both are FDIC-insured up to $250,000.
Rental property
Owning rental property can provide a steady monthly income, though it's worth noting that it requires more hands-on management than other investment options. You'll need to handle tenants, maintenance, and property taxes. Some owners hire property managers to reduce their direct involvement.
Xero doesn't provide financial advice. Before making investment decisions, it's a good idea to consult a qualified financial advisor who can assess your individual circumstances.
How to get started with passive income
Getting started with passive income doesn't have to be complicated. Follow these steps to build a plan that fits your business and your goals.
1. Assess your skills, assets, and resources
Start by taking stock of what you already have. What knowledge or expertise do your customers value? Do you have existing content, tools, or processes that could be packaged into a product? What financial resources could you allocate toward investments?
The best passive income streams build on strengths you already have rather than requiring you to start from scratch.
2. Choose a stream that fits your situation
Not every passive income idea suits every business owner. Consider how much time you can invest upfront, how much capital you have available, and your comfort level with risk.
If you're short on capital but have deep expertise, digital products or online courses might be the right fit. If you have savings to invest but limited time, dividend stocks or REITs could be a better match.
3. Set it up and launch
Once you've chosen your path, put in the work to get it running. Create the product, set up the investment account, or build the content library. This is where most of the effort happens, and it's normal for this phase to take weeks or even months.
Set realistic expectations. The ongoing effort will be significantly less than what you put in during the setup phase.
4. Track your income and expenses
As your passive income starts flowing, you'll want to track it separately from your core business revenue. This gives you a clear picture of how each stream is performing and helps you make informed decisions about where to invest more time or money. Knowing your numbers also helps when you're looking to increase profits across the board.
Accounting software like Xero makes it straightforward to categorize and monitor multiple income streams in 1 dashboard. You can see exactly how much each stream contributes to your overall financial health.
How is passive income taxed in the US?
Understanding how the IRS treats passive income can save you from surprises at tax time. Here's a general overview of the key rules.
The IRS defines passive income as earnings from 2 sources: rental activities, and trade or business activities in which you don't materially participate. This is different from portfolio income (like interest and dividends), which has its own tax treatment, though the terms are sometimes used interchangeably in casual conversation.
One of the most significant rules involves passive activity losses. Generally, you can only use losses from passive activities to offset income from other passive activities. You can't use passive losses to reduce your active income or portfolio income. Unused passive losses are carried forward to future tax years.
There are exceptions. For example, if you actively participate in a rental real estate activity and your adjusted gross income is below a certain threshold, you may be able to deduct up to $25,000 in rental losses against non-passive income.
Different types of passive income may also be subject to the 3.8% net investment income tax (NIIT) if your modified adjusted gross income exceeds certain levels. For 2025, the threshold is $200,000 for single filers and $250,000 for married couples filing jointly.
Tax rules around passive income are complex and change frequently. Xero doesn't provide tax advice, so it's strongly recommended that you consult a qualified tax professional to understand how passive income applies to your specific situation.
Manage your passive income streams with Xero
Building passive income is a smart move for any small business owner looking to diversify revenue and create more financial stability. Whether you're selling digital products, investing in dividend stocks, or earning rental income, keeping track of every dollar matters.
With Xero Accounting Software, you can organize all your income streams in 1 place and see your complete financial picture at a glance. That way, you can focus on growing your income instead of chasing down numbers. Get one month free.
FAQs on passive income
Here are some frequently asked questions about passive income.
What is the difference between active and passive income?
The IRS draws a clear line: active income comes from work in which you materially participate, while passive income comes from activities where you don't. This distinction affects how losses are treated at tax time, because passive losses generally can't offset active earnings.
What are the best passive income ideas for beginners?
High-yield savings accounts and CDs are the simplest starting points because they require no specialized knowledge and carry very low risk. If you have a skill or area of expertise, creating a simple digital product like a template or ebook is another accessible option.
Can you live off passive income?
It's possible, but it typically requires either significant capital invested across multiple streams or years of building income-generating assets. Most people use passive income to supplement their active earnings rather than replace them entirely.
Is passive income taxable?
Yes, passive income is taxable in the US. The IRS applies specific passive activity rules that govern how this income is reported and how related losses can be used, so consulting a tax professional is recommended.
How much money do you need to start earning passive income?
It depends on the type of passive income you're pursuing. Digital products and content creation can be started with very little capital, while investment-based streams like dividend portfolios or rental properties may require thousands of dollars upfront.